McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Pure Competition Chapter 9

Chapter Objectives The four basic market models Conditions for pure competition Profit maximization for competitive firms The competitive firm supply curve Industry entry and exit Industry cost structure Economic efficiency 9-2

Four Market Models Pure competition Pure monopoly Monopolistic competition Oligopoly Market Structure Continuum Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Imperfect Competition 9-3

Pure Competition Very large numbers Standardized product “Price takers” Free entry and exit Perfectly elastic demand –Average revenue –Marginal revenue –Price 9-4

Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Pure Competition Price and Revenue $1179 Quantity Demanded (Sold) D = MR = AR TR PQDQD MR $ $ $ ] ] ] ] ] ] ] ] ] ] 9-5

Short Run Profit Maximization Market price is given Three questions: –Should the product be produced? –If so, in what amount? –What economic profit (loss) will be realized? 9-6

Profit Maximization Two approaches Total revenue and total cost approach –Produce where TR-TC is greatest Marginal revenue and marginal cost approach –Produce where MR=MC 9-7

Total Revenue Total Cost Approach (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) Price = $ $ $ $ $ $ Now Let’s Graph The Results… Do You See Profit Maximization? 9-8

$ $ Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Total Revenue, (TR) Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) Maximum Economic Profit $299 Total Economic Profit $299 P=$131 Total Cost, (TC) Total Revenue Total Cost Approach 9-9

Marginal Revenue Marginal Cost Approach (1) Total Product (Output) (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) $ $ $ $ $ No Surprise - Now Let’s Graph It… Do You See Profit Maximization Now? (5) Marginal Cost (MC) $

Cost and Revenue $ Output Economic Profit MR = P MC MR = MC AVC ATC P=$131 A=$97.78 Marginal Revenue Marginal Cost Approach 9-11

Short Run Profit Maximization Produce where MR (=P) = MC Suffer loss, still produce? Yes if loss is less than fixed cost –Cover variable cost Shut down if loss greater than fixed cost Produce if P > min AVC 9-12

Lower the Price to $81 and Observe the Results! Cost and Revenue $ Output Loss Short Run Loss Minimizing Case MR = P MC AVC ATC P=$81 A=$91.67 V = $

Lower the Price Further to $71 and Observe the Results! Cost and Revenue $ Output Short Run Shut Down Case MR = P MC AVC ATC P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 V = $

Short-Run Supply Curve Continuing the Same Example… Supply Schedule of a Competitive Firm Price Quantity Supplied Maximum Profit (+) or Minimum Loss (-) $ $ The schedule shows the quantity a firm will produce at a variety of prices 9-15

Short-Run Supply Curve Firms produce where MR=MC P1P1 0 Cost and Revenues (Dollars) Quantity Supplied MR 1 P2P2 MR 2 P3P3 MR 3 P4P4 MR 4 P5P5 MR 5 MC AVC ATC Q2Q2 Q3Q3 Q4Q4 Q5Q5 This Price is Below AVC And Will Not Be Produced a b c d e 9-16

Short-Run Supply Curve P1P1 0 Cost and Revenues (Dollars) Quantity Supplied MR 1 P2P2 MR 2 P3P3 MR 3 P4P4 MR 4 P5P5 MR 5 MC AVC ATC Q2Q2 Q3Q3 Q4Q4 Q5Q5 a b c d e MC Above AVC Becomes the Short-Run Supply Curve S Examine the MC for the Competitive Firm Break-even (Normal Profit) Point Shut-Down Point (If P is Below) Firms produce where MR=MC 9-17

Firm and Industry Supply Changes in firm supply –Shifts in marginal cost –Input price or technology The industry (total) supply curve –Sum of individual supply Industry supply and demand –Determine market price 9-18

Single Firm Industry p P p P 0 0 Firm and Industry Supply Economic Profit d ATC AVC s = MC $111 D S = ∑ MC’s Competitive firm must take the price that is Established by industry supply and demand 9-19

Long Run Profit Maximization Assumptions –Entry and exit only –Identical costs –Constant-cost industry Goal of the analysis –In the long run, P = min ATC –Entry eliminates profits –Exit eliminates losses 9-20

Single Firm Industry p P p P ,00080,000100,000 Entry Eliminates Profits ATC MR MC $ D1D1 S1S1 An increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium D2D2 $ S2S2 9-21

Single Firm Industry p P p P ,00080,000100,000 Exit Eliminates Losses ATC MR MC $ D3D3 S3S3 A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium D1D1 $ S1S1 9-22

Long Run Supply Constant cost industry –Entry/exit does not affect LR ATC –Constant resource price –Special case Increasing cost industry –Most industries –LR ATC increases with expansion –Specialized resources Decreasing cost industry 9-23

P 0 Q Long-Run Supply Curve Constant-Cost Industry 90,000100,000110,000 Q3Q3 Q1Q1 Q2Q2 $50 P1P2P3P1P2P3 S Z1Z1 Z2Z2 Z3Z3 D3D3 D1D1 D2D2 9-24

P 0 Q Long-Run Supply Curve Increasing-Cost Industry 90,000100,000110,000 Q3Q3 Q1Q1 Q2Q2 $50 P1P1 S Y1Y1 Y2Y2 Y3Y3 D3D3 D1D1 D2D2 $40 $55 P2P2 P3P3 How would a decreasing-cost industry look? 9-25

Pure Competition and Efficiency Productive efficiency P = minimum ATC Allocative efficiency P = MC Maximum consumer and producer surplus Dynamic adjustments “Invisible Hand” revisited 9-26

Single FirmMarket Price Quantity 0 0 Long-Run Equilibrium P MR D S QeQe QfQf ATC Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC Pure competition has both in its long-run equilibrium MC P=MC=Minimum ATC (Normal Profit) P 9-27

The Case of Generic Drugs Efficiency gains from entry –Lower price and greater output Purpose of drug patent –Encourage R&D –Cost recovery Expiration of patent on drugs –Generics enter –Profits decrease, output increase –Combined CS and PS increase 9-28

Price Quantity P1P1 P2P2 D S Q1Q1 Q2Q2 f a d c b As price decreases to f, Consumer surplus abc increases to adf Producer and consumer surplus is maximized as shown by the gray triangle Initial Patent Price Result: Greater Quantity at Lower Prices as Predicted by the Competitive Model New Producers Enter Market The Case of Generic Drugs 9-29

Key Terms pure competition pure monopoly monopolistic competition oligopoly imperfect competition price taker average revenue total revenue marginal revenue break-even point MR=MC rule short-run supply curve long-run supply curve constant-cost industry increasing-cost industry decreasing-cost industry productive efficiency allocative efficiency consumer surplus producer surplus 9-30

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