Copyright 2008 The McGraw-Hill Companies Pure Competition

Copyright 2008 The McGraw-Hill Companies 21-2 Chapter Objectives Names and Main Characteristics of the Four Basic Market Models Conditions for Perfect Competition How Do Purely Competitive Firms Maximize Profits or Minimize Losses How Industry Entry and Exit Create Economic Efficiency Differences Between Constant- Cost, Increasing-Cost, and Decreasing-Cost Industries

Copyright 2008 The McGraw-Hill Companies 21-3 Market structure In past chapters we have discussed demand, revenue, and production costs: would now like to ask, what amount of output should a firm produce and what price should they charge? Answer will depend very much on the structure of the industry the firm operates in. We have 4 models of industry structure.

Copyright 2008 The McGraw-Hill Companies 21-4 Four Market Models Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Market Structure Continuum Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Imperfect Competition

Copyright 2008 The McGraw-Hill Companies 21-5 Characteristics of Pure Competition Very Large Numbers of sellers and buyers Standardized or homogenous Product Firm becomes a “Price Taker” Free Entry and Exit Some books add in perfect information also (then called perfect competition) Graphically…

Copyright 2008 The McGraw-Hill Companies 21-6 The Market and the firm in Perfect Competition The Market P S D Individual firm P P=MR 6

Copyright 2008 The McGraw-Hill Companies 21-7 Why does a Perfectly Competitive firm face a horizontal demand curve? Because it can sell all it brings to market at the market price, therefore P always equals MR: thus the horizontal price line equals MR to the firm, and is effectively like a demand curve to the firm.

Copyright 2008 The McGraw-Hill Companies 21-8 The firm in Perfect Competition 8 P Q1 P = MR

Copyright 2008 The McGraw-Hill Companies 21-9 Profit maximization in the short run Since the firm in pure competition does not control price, the question becomes what output should be produced in order to maximize profits? Two approaches: 1. Total revenue, total cost approach: find the output at which TR exceeds TC by the greatest possible amount. 2. Marginal revenue, marginal cost approach: find the output at which MR equals MC. Mostly we will stress the latter appoach.

Copyright 2008 The McGraw-Hill Companies Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Pure Competition: TR, TC approach Price and Revenue $1179 Quantity Demanded (Sold) D = MR = AR TR PQDQD MR $ $ $ ] ] ] ] ] ] ] ] ] ]

Copyright 2008 The McGraw-Hill Companies Total Revenue-Total Cost Approach Profit Maximization in the Short Run (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?

Copyright 2008 The McGraw-Hill Companies Total Revenue-Total Cost Approach Profit Maximization in the Short Run $ $ 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) W 21.1 G 21.1

Copyright 2008 The McGraw-Hill Companies Profit Maximization in the Short Run: MR = MC approach Firm should produce an output where MR=MC. Why? (Note also that this rule can be used for all market structures.)

Copyright 2008 The McGraw-Hill Companies MC The firm in Perfect Competition 14 P Q1Q1 P = MR

Copyright 2008 The McGraw-Hill Companies Profit Maximization in the Short Run: MR = MC approach If the firm produced less than Q 1, then MR would exceed MC: could increase profit by expanding ouput. If the firm more than than Q 1, then MC would exceed MR: could increase profit by contracting ouput. The combination of these leads to the MR=MC rule. Is the firm actually making a profit, a loss, or breaking even? Need to add the ATC curve to the graph in order to show this.

Copyright 2008 The McGraw-Hill Companies ATC MC Positive profits in Perfect Competition 16 P Q1Q1 P = MR P > ATC Profit

Copyright 2008 The McGraw-Hill Companies ATC MC Losses in Perfect Competition 17 P Q1Q1 P = MR P < ATC Losses

Copyright 2008 The McGraw-Hill Companies ATC MC Zero Profits in Perfect Competition 18 P Q1Q1 P = MR P = ATC

Copyright 2008 The McGraw-Hill Companies Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run (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) $

Copyright 2008 The McGraw-Hill Companies Cost and Revenue $ Output Economic Profit Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run MR = P MC MR = MC AVC ATC P=$131 A=$97.78 W 21.2

Copyright 2008 The McGraw-Hill Companies Lower the Price to $81 and Observe the Results! Cost and Revenue $ Output Loss Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run MR = P MC AVC ATC Loss Minimizing Case P=$81 A=$91.67 V = $75

Copyright 2008 The McGraw-Hill Companies Lower the Price Further to $71 and Observe the Results! Cost and Revenue $ Output Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run MR = P MC AVC ATC Short-Run Shut Down Case P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 V = $74

Copyright 2008 The McGraw-Hill Companies Marginal Cost and Short-Run Supply Continuing the Same Numeric 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 and Results

Copyright 2008 The McGraw-Hill Companies Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use 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 No output should Be Produced a b c d e

Copyright 2008 The McGraw-Hill Companies Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use 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 No output should Be Produced 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)

Copyright 2008 The McGraw-Hill Companies Why is a firm’s MC curve above its AVC curve its Supply Curve? Because it always produces where MR = MC, except when price is below AVC

Copyright 2008 The McGraw-Hill Companies Why don’t we include the MC curve below its AVC curve as a part of its Supply Curve? Because below the AVC the firm will close down

Copyright 2008 The McGraw-Hill Companies What is the Market’s Supply Curve? It is the aggregation or sum of the short run MC curves of the firm’s in the market

Copyright 2008 The McGraw-Hill Companies Single Firm Industry p P p P 0 0 Changes in 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 W 21.3

Copyright 2008 The McGraw-Hill Companies Profit Maximization in the Long Run Assumptions –Entry and Exit Only –Identical Costs –Constant-Cost Industry Goal of the Analysis Long-Run Equilibrium –Entry Eliminates Profits –Exit Eliminates Losses

Copyright 2008 The McGraw-Hill Companies The Long Run adjustments in Perfect Competition The Market Individual firm 31 P S D P P=MR MC ATC D1 S1 P P1 QQ1

Copyright 2008 The McGraw-Hill Companies Explanation of long run adjustments  Start at price P, typical firm making zero profits  Suppose demand increases to D 1  Price rises to P1  Typical firm making positive profits  What happens in the long run?  Assuming perfect information and free entry, new firms enter the market  Supply shifts right until profits eliminated  Price comes down—but how far depends on whether costs are affected

Copyright 2008 The McGraw-Hill Companies Long Run, continued  Constant cost industry: no change in costs as new firms enter the market, price returns to P, original price  Increasing cost industry: all firms experience rising costs as new firms enter the market, final price will be higher than original price P  Decreasing cost industry: all firms experience lower costs as new firms enter the market, final price will be lower than original price

Copyright 2008 The McGraw-Hill Companies Single Firm Industry p P p P ,00080,000100,000 Supply Readjustment 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

Copyright 2008 The McGraw-Hill Companies Single Firm Industry p P p P ,00080,000100,000 Supply Readjustment 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

Copyright 2008 The McGraw-Hill Companies 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

Copyright 2008 The McGraw-Hill Companies 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?

Copyright 2008 The McGraw-Hill Companies Pure Competition and Efficiency Productive Efficiency P = Minimum ATC Allocative Efficiency P = MC Maximum Consumer and Producer Surplus Dynamic Adjustments “Invisible Hand” Revisited O 21.1

Copyright 2008 The McGraw-Hill Companies Single FirmMarket Price Quantity 0 0 Long-Run Equilibrium Competitive Firm and Market 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

Copyright 2008 The McGraw-Hill Companies Efficiency Gains From Entry: Competitive Model Predicts Lower Price and Greater Output With Increased Efficiency When New Producers Enter Market Example is Patented Drugs lose their patent protection Patents Enable Greater Profits in Support of R&D and Accelerated Cost Recovery After Patent Period Generics Enter Market Profits Decrease and Quantities Increase Combined Consumer and Producer Surpluses Increase Last Word The Case of Generic Drugs

Copyright 2008 The McGraw-Hill Companies Price Quantity Efficiency Gains From Entry: Last Word The Case of Generic Drugs 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 Together as Shown by the Gray Triangle Initial Patent Price Results: Greater Quantity at Lower Prices as Predicted by the Competitive Model New Producers Enter Market

Copyright 2008 The McGraw-Hill Companies Key Terms pure competition pure monopoly monopolistic competitionmonopolistic competition oligopoly imperfect competitionimperfect competition price taker average revenue total revenue marginal revenue break-even point MR=MC short-run supply curveshort-run supply curve long-run supply curvelong-run supply curve constant-cost industryconstant-cost industry increasing-cost industryincreasing-cost industry decreasing-cost industrydecreasing-cost industry productive efficiencyproductive efficiency allocative efficiencyallocative efficiency consumer surplus producer surplus