1. Unit 3: Theory of the Firm Part 1
Pure Competition
Unit 3: Theory of the Firm Part 1

2. Four Market Models Pure competition Pure monopoly
Monopolistc competition
Oligopoly

3. Pure Competition Very large number of firms
Firms produce standardized products
New firms can enter or exit the industry very easily

4. Pure Monopoly One firm is the sole seller of a good or service
Entry of additional firms is blocked
One firm = entire industry

5. Monopolistic Competition
Relatively large number of sellers
Firms produce differentiated products
Nonprice compétition – firms attempt to distinguish its product from competitors on the basis of attributes like design and quality
Entry and exit is easy

6. Oligopoly Few sellers of a standardized or differentiated product
Each firm is affected by the decisions of its rivals and must take those decisions into account in detemining price and output

7. The Four Market Models
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8. Pure Competition
All other market models are called imperfect competition
Relatively rare in the real world
Provide insight into several markets
Agricultural goods, fish products, forex, basic metals, and stocks
Very large numbers, standardized product, free entry or exit

9. Price Takers
Individual firms do not exert control over the product price
Every firm sells a small fraction of total (identical) output
Changing individual firm output will not influence the market
At the mercy of the market
Cannot change market price, only adjust to it

10. Demand
Demand schedule faced by an individual firm in a purely competitive industry is perfectly elastic at the market price

11. Market Demand Market demand is a downsloping curve
An entire industry can affect price by changing total industry output

12. Average, Total, and Marginal Revenue
The demand schedule is also its average revenue schedule.
Total revenue = Price (or average revenue) * Quantity
Marginal revenue – the change in total revenue resulting from selling one additional unit of output
In pure competition, marginal revenue = price = average revenue

13. Average, Total, and Marginal Revenue

14. Profit Maximization in the Short Run
Since purely compeitive firms are price takers, they can maximize economic profit (or minimize loss) only by adjusting output
In the short run, the firm has a fixed plant
Can only change the amount of variable resources it uses
PC will adjust their varibale resources to acheive the output level that maximizes its profit

15. Maximizing Profit
Two ways to determine the profit maximizing level of output for a competitive firm
Compare TR and TC or compare MR and MC
Both methods work regardless of market structure

16. Total-Revenue-Total-Cost Approach
Given a market price
Should we produce the product?
If so, in what amount?
What economic profit or loss will the we realize?
Break even point – TR=TC
Firm makes a normal profit but not an economic profit

17. TR/TC Approach Example

18. TR/TC Approach Graph

19. Marginal-Revenue-Marginal-Cost Approach
Firm compares the amounts that each additional unit of output would add to TR and TC
If assume producing is preferable to shutting down, a firm will produce an additional unit as long as MR > MC

20. MR=MC Rule
In the short run, the firm will maximize profit or minimize loss by producing the output at which MR = MC
If the optimal level is fractional, the firm will produce the last whole amount at which MR>MC
Only applies if producing is preferable to shutting down
If MR is not > AVC the firm will shut down
Rule applies to all market structures
In a purely competitive market MR=P=MC

21. Profit Maximizing Case

22. Profit Maximizing Case Graph

23. Loss Minimizing Case
In the short run, a firm will continue to produce at a loss as long as it can cover its fixed costs
Wherever P exceeds average variable cost but is less than Average Total costs, the firm can pay part, but not all of its fixed costs by producing
Loss is minimized at MR=MC (P=MC)

24. Loss-Minimizing Case

25. Loss Minimizing Case Graph

26. Shut Down Case

27. Shut Down Case Graph

28. Marginal Cost and Short-Run Supply

29. Diminishing Returns, Productions Costs and Product Supply
Because of the law of diminishing returns, marginal costs eventually rise as more units of output are produced.
A purely competitive firm must get successively higher prices to motivate it to produce additional units of output

30. Firm and Industry: Equilibrium Price
For a competitive firm, the short-run supply curve is drawn by applying the MR=(P=)MC rule
Market equilibrium price is the price at which the total quantity supplied of the product equals the total quantity demanded.

31. Market Price and Profit Graph

32. Firm and Market S/D

33. Market Price and Profit
Market equilibrium is where total quantity demand = total quantity supplied
Does total revenue exceed total cost?
TR-TC= economic profit of each firm
Product price – ATC = economic profit of each firm
Remember, individual firms are price takers
The supply plans of the competitive producers as a group is a determinant of product price

34. PC output Determination in the Short-Run

35. Profit Maximization in the Long Run
Assumptions:
The only long-run adjustment is the entry or exit of firms
Ignore all short-run adjustments
Identitcal costs
Constant cost industry
Two basic facts
Firms seek profits and shun losses
Under pure competition, firms are free to enter and leave an industry

36. Long-Run Equilibrium For a single firm, long –run equilibrium occurs:
MR=MC=P
P= minimum ATC
No firms have the incentive to enter or exit
Industry in equilibrium (at rest)

37. Entry Eliminates Economic Profit

38. Exit Eliminates Economic Losses

39. Long-Run Supply Curve for a Constant Cost Industry
Industry expansion or contraction will not affect resource prices or production costs
Entry and exit does not shift the long-run ATC curves of individual firms
Industry demand for resources is small relative to the amount of resources available
Long run supply curve is perfectly elastic

40. LR Supply Curve – Constant Cost

41. Long-Run Supply: Increasing Cost Industry
Firms’ ATC curves shift upwards as the indsutry expands (downwards when it contracts)
Entry of new firms will increase resource prices
Specialized inputs or limited supply

42. Long-Run Supply for Increasing Cost Industry

43. Long-Run Supply: Decreasing Cost Industry
Firms experience lower costs as the industry expands
Personal computers
Economies of scale
Downsloping long-run supply curve

44. Pure Competition and Effficiency

45. Productive Efficiency
P= Minimum ATC
Goods must be produced in the least costly way
Consumers benefit by paying the lowest product price possible under prevailing technology and cost conditions

46. Allocative Efficiency
P= MC
Resources are aportioned among firms and industries to yield the mix of products and services that is most wanted by society
Cannot simply alter the combination of goods and services and achieve any net gains for society
The price of any product is society’s measure of the relative worth of additional unit (P=MB)
MC of a good is the opportunity cost of another good sacrificed

47. Maximum Consumer and Producer Surplus
At market equilibrium both consumer and producer surplus are maximized
Any output beyond Qe would lead to a deadweight loss
Short run economic profits and losses encourage entry and exit allowing the industry to adjust