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

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

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

Pure Competition Although instances of “pure competition” are rare in the real world, it serves as a model for the other three types of market models Consists of very large numbers of firms Standardized product; one producer’s product looks pretty much like everyone else’s Agricultural products are a classic example; raising corn 9-4

Firms in pure competition are“Price takers” There are so many sellers that no single seller can affect the price by its decision alone Individual firms must accept the market price Firms can freely enter and exit from pure competition; there are no barriers to becoming a farmer and raising corn

Pure Competition from the viewpoint of a competitive seller The demand curve for the firm is perfectly elastic (horizontal) A horizontal demand curve means that the firm can sell as much product as it wants but only at a fixed price (because it cannot affect price However, as you will see later, the demand curve for the industry is not perfectly elastic Some Definitions: Average revenue is the price per unit for each firm in pure competition Total revenue is the price multiplied by the quantity sold Marginal revenue is the change in total revenue and will also equal the unit price in conditions of pure competition.

Pure Competition P QD TR MR TR Price and Revenue ] D = MR = AR 2 4 6 8 10 12 131 262 393 524 655 786 917 1048 $1179 Quantity Demanded (Sold) Firm’s Demand Schedule (Average Revenue) Revenue Data TR P QD TR MR $131 131 1 2 3 4 5 6 7 8 9 10 $0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 D = MR = AR 9-7

Short Run Profit Maximization The Firm’s Viewpoint The market price for the firm is fixed In the short run, the firm has a fixed plant (limited acreage) Since the firm cannot change the price, it can only increase total revenue by producing more of the product Profit can be defined as the difference between total costs and total revenue Three questions a firm will face Should the product be produced? If so, in what amount? What economic profit (loss) will be realized?; how to maximize profit 9-8

Profit Maximization Two approaches Total revenue – total cost approach Firms should produce if the difference between total revenue and total cost is profitable; i.e. the greatest difference In the short run, the firm should produce that output at which it maximizes its profits or minimizes its losses The profit or loss can be established by subtracting total cost from total revenue at each output level 9-9

Profit Maximization Firms operating at the profit maximization level may still experiences overall losses in profits They are then faced with the decision as to whether to continue production or go out of business In the short run, firms have fixed costs which are unavoidable and variable costs attributable to producing more of a product if the firm’s losses exceeds its fixed costs, the firm should not produce but should shut down By shutting down, its losses will just equal those fixed costs (there will be no variable costs because the firm is not producing

Profit Maximization Marginal Revenue – Marginal Cost approach The MR=MC rule states that firms will maximize profits or minimize losses by producing at the point at which marginal revenue equals marginal cost in the short run Three features of the MR=MC rule It assumes that marginal revenue must be equal to or exceed the minimum average variable cost or the firm will shut down The rule works in any type of industry, not just pure competition In pure competition, price = MR. Then, it follows that firms should produce that output where p = MC because P = MR

Total Revenue Total Cost Approach Price = $131 (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 (-) 1 2 3 4 5 6 7 8 9 10 $100 100 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 $0 131 262 393 524 655 786 917 1048 1179 1310 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization? Now Let’s Graph The Results… 9-12

Total Revenue Total Cost Approach 1 2 3 4 5 6 7 8 9 10 11 12 13 14 $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum Economic Profit $299 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) Total Economic Profit $299 9-13

Marginal Revenue Marginal Cost Approach (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (1) Total Product (Output) (5) Marginal Cost (MC) (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) 1 2 3 4 5 6 7 8 9 10 $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 $90.00 85.00 80.00 75.00 74.00 77.14 81.25 86.67 93.00 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 $90 80 70 60 90 110 130 150 $131 131 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization Now? No Surprise - Now Let’s Graph It… 9-14

Marginal Revenue Marginal Cost Approach $200 150 100 50 MR = MC MC P=$131 Economic Profit MR = P ATC Cost and Revenue AVC A=$97.78 1 2 3 4 5 6 7 8 9 10 Output 9-15

Short Run Profit Maximization Maximum profit at point where MR (=P) = MC If the firm suffers loss at that point, should it still produce? Yes if loss is less than fixed cost Cover variable cost of production Shut down if loss greater than fixed cost Produce if P > min AVC 9-16

Short Run Loss Minimizing Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Lower the Price to $81 and Observe the Results! MC Loss A=$91.67 ATC AVC P=$81 MR = P V = $75 9-17

Short Run Shut Down Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Lower the Price Further to $71 and Observe the Results! MC ATC V = $74 AVC MR = P P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 9-18

Short-Run Supply Curve Continuing the Same Example… Supply Schedule of a Competitive Firm Quantity Supplied Maximum Profit (+) or Minimum Loss (-) Price $151 131 111 91 81 71 61 10 9 8 7 6 $+480 +299 +138 -3 -64 -100 The schedule shows the quantity a firm will produce at a variety of prices 9-19

Short-Run Supply Curve Firms produce where MR=MC Cost and Revenues (Dollars) Quantity Supplied MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5 9-20

Short-Run Supply Curve Firms produce where MR=MC Examine the MC for the Competitive Firm Cost and Revenues (Dollars) Quantity Supplied MC Above AVC Becomes the Short-Run Supply Curve S Break-even (Normal Profit) Point MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 9-21

Firm and Industry Supply Changes in the price of variable inputs such as labor costs or technology can alter prices Increases or decreases in prices of resources can shift the marginal cost in or out The industry (total) supply curve Sum of the supply by all individual firms Industry supply and demand Determine market price The demand curve for the industry is not perfectly elastic 9-22

Firm and Industry Supply Single Firm Industry p P S = ∑ MC’s s = MC Economic Profit ATC d $111 $111 AVC D 8 8000 Competitive firm must take the price that is Established by industry supply and demand 9-23

Long Run Profit Maximization Assumptions Entry and exit of firms into the industry are the only long-run adjustments Firms in the industry have identical cost curves The industry is a constant-cost industry, which means that the entry and exit of firms will not affect resource prices Goal of the analysis In the long run, P = min ATC Entry eliminates profits Exit eliminates losses 9-24

Entry Eliminates Profits Single Firm Industry p P 100 90,000 80,000 100,000 S1 MC $60 50 40 ATC $60 50 40 S2 MR D2 D1 An increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium 9-25

Exit Eliminates Losses Single Firm Industry p P 100 90,000 80,000 100,000 S3 MC $60 50 40 ATC $60 50 40 S1 MR D1 D3 A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium 9-26

Long Run Supply Constant cost industry In a constant cost industry, the entry or exit of firms does not change the price of resources, and therefore, does not change production costs This could occur when the resource used in the constant-cost industry is only a small amount of the total resource available If production costs do not change, then neither does the Long Run ATC curve The long run supply curve of a constant-cost industry if perfectly elastic (horizontal) This means that costs are constant; if demand increases, there is no increased costs to produce more of anything 9-27

Long Run Supply Increasing cost industry Most industries are increasing cost industries LR ATC increases with the entrance of new firms because the resources are scarce, and demand for them by the firms drives up the price This is particularly true for resources that are not freely available (may be difficult to process) and supply cannot keep up with demand Because each firm experiences increasing costs with increased production, their ATC tends to shift upward Because of the increased costs of production, the industry will require higher prices and the supply curve is upward sloping

Long Run Supply Decreasing Cost Industries For some industries such as those producing computer chips, costs actually decreased as technology improved The great demand for chips has allowed producers to enjoy great benefits of economies of scale Because costs decreased, the supply curve for decreasing cost industries is downward sloping

Long-Run Supply Curve Constant-Cost Industry S P P1 P2 P3 Q $50 Z3 Z1 Q P1 P2 P3 $50 S Z3 Z1 Z2 D3 D1 D2 Q3 Q1 Q2 90,000 100,000 110,000 9-30

Long-Run Supply Curve Increasing-Cost Industry Q S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 D2 D1 D3 Q3 Q1 Q2 90,000 100,000 110,000 How would a decreasing-cost industry look? 9-31

Pure Competition and Efficiency Productive efficiency P = minimum ATC Allocative efficiency P = MC Maximum consumer and producer surplus Dynamic adjustments “Invisible Hand” revisited 9-32

Long-Run Equilibrium Pure competition has both in Single Firm Market Price Quantity MC P=MC=Minimum ATC (Normal Profit) S ATC P MR P D Qf Qe Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC Pure competition has both in its long-run equilibrium 9-33

Key Terms pure competition pure monopoly long-run supply curve 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 9-34

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