1. Pure Competition in the Short Run
Chapter 10
Explanations and characteristics of the four models are outlined at the beginning of this chapter, then the characteristics of a purely competitive industry are detailed. There is an introduction to the concept of the perfectly elastic demand curve facing an individual firm in a purely competitive industry. Next, the total, average, and marginal revenue schedules are presented in numeric and graphic form. Using the cost schedules from the previous chapter, the idea of profit maximization is explored.
The total revenue and total cost approach is analyzed first because of its simplicity. More space is devoted to explaining the MR = MC rule, and to demonstrating how this rule applies in all market structures, not just in pure competition.
Next, the firm’s short run supply curve is shown to be the same as its marginal cost curve at all points above the average variable cost curve. Then the short run competitive equilibrium is discussed at the firm and industry levels.
Finally, this chapter’s Last Word discusses firms’ decisions to shut down in the short run and the losses incurred due to fixed costs.
Pure Competition in the Short Run

2. Four Market Models Market Structure Pure competition
Imperfect competition
Monopolistic competition
Oligopoly
Pure monopoly
Market structure refers to the characteristics of an industry that define the likely behavior and performance of its firms. After beginning with an overview of the four basic market models, the chapter focuses on pure competition. Imperfect competition refers to all market structures except pure competition; the other three market models are examples of imperfect competition and will be discussed in future chapters.
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3. Market Model Characteristics
Characteristics of the Four Basic Market Models
Characteristic
Pure Competition
Monopolistic Competition
Oligopoly
Monopoly
Number of firms
A very large number
Many
Few
One
Type of product
Standardized
Differentiated
Standardized or differentiated
Unique; no close subs.
Control over price
None
Some, but within rather narrow limits
Limited by mutual inter-dependence; considerable with collusion
Considerable
Conditions of entry
Very easy, no obstacles
Relatively easy
Significant obstacles
Blocked
Nonprice Competition
Considerable emphasis on advertising, brand names, trademarks
Typically a great deal, particularly with product differentiation
Mostly public relations
advertising
Examples
Agriculture
Retail trade, dresses, shoes
Steel, auto, farm implements
Local utilities
Pure competition is rare in the real world, but the model is important. The model helps analyze industries with characteristics similar to pure competition and provides a context in which to apply revenue and cost concepts developed in previous chapters. Pure competition also provides a norm or standard against which to compare and evaluate the efficiencies found in the real world.
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4. Pure Competition: Characteristics
Very large numbers of sellers
Standardized product
“Price takers”
Easy entry and exit
Very large numbers of independent sellers each acting alone cannot influence the market price by increasing or decreasing their output because each has such a miniscule part of the entire market.
A standardized product is a product for which all other products in the market are identical and thus are perfect substitutes. The consequence of this is that buyers are indifferent as to whom they buy from.
Price takers are sellers that have no pricing power; in other words, they do not have the ability to price their product.
Easy entry and exit means that there are no obstacles to enter or to exit the industry.
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5. Purely Competitive Demand
Perfectly elastic demand
Firm produces as much or little as they wish at the market price
Demand graphs as horizontal line
Perfectly elastic demand means that firm has no power to influence price so the firm merely chooses to produce a certain level of output at the price that is given. The demand curve is not perfectly elastic for the industry; it only appears that way to the individual firm, since they must take the market price no matter what quantity they produce. The firm faces a perfectly elastic demand because each individual firm makes up such a small part of the total market and the goods are perfect substitutes. Note that this perfectly elastic demand curve is a horizontal line at the price.
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6. Average, Total, and Marginal Revenue Formulas
Average revenue
Revenue per unit
AR = TR/Q = P
Total revenue
TR = P X Q
Marginal revenue
Extra revenue from 1 more unit
MR = ΔTR/ΔQ
When a firm charges the same price for each unit of output, the average revenue is just the price of the good. Total revenue refers to the total amount of money that the firm collects for the sale of all of the units of their good. Marginal revenue reflects the additional revenue that the firm will receive by producing one more unit of output. When the firm is deciding how much to produce, the firm considers the marginal revenue in their decision.
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7. Average, Total, and Marginal Revenue
Firm’s
Demand
Schedule
(Average
Revenue)
Revenue
Data
$1179 TR
1048 QD P TR MR
917 1 2 3 4 5 6 7 8 9 10
$131
131 $0
131
262
393
524
655
786
917
1048
1179
1310
786 ]
$131
131
655
Price and revenue
524
This graph shows a purely competitive firm’s demand curve and revenue curves. The demand curve (D) of a purely competitive firm is a horizontal line (perfectly elastic) because the firm can sell as much output as it wants at the market price (here, $131). Because each additional unit sold increases total revenue by the amount of the price, the firm’s total-revenue (TR) curve is a straight upsloping line and its marginal-revenue (MR) curve coincides with the firm’s demand curve. The average-revenue (AR) curve also coincides with the demand curve.
393
262
D = MR = AR
131 2 4 6 8 10 12
Quantity demanded (sold)
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8. Profit Maximization: TR - TC Approach
The competitive producer will wish to produce at the output level where total revenue exceeds total cost by the greatest amount
Break-even point
When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option. The break-even point is an output at which a firm just makes a normal profit, total revenue = total costs.
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9. Profit Maximization: TR - TC Table
The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131)
(1)
Total Product
(Output) (Q)
(2)
Total Fixed Cost (TFC)
(3)
Total Variable Costs (TVC)
(4)
Total Cost
(TC)
(5)
Total Revenue (TR)
(6)
Profit (+)
or Loss (-)
$100 $0
$-100 1
100 90
190
131
-59 2
170
270
262 -8 3
240
340
393
+53 4
300
400
524
+124 5
370
470
655
+185 6
450
550
786
+236 7
540
640
917
+277 8
650
750
1048
+298 9
780
880
1179
+299 10
930
1030
1310
+280
In this table, total costs are given as well as total revenue. Here we can start identifying where the firm will choose to produce using the total revenue-total cost approach. Based on TR - TC, the firm will produce where the difference between total revenue and total cost is the greatest. Based on this approach, the profit maximizing output is 9 units when the price is $131.
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10. Profit Maximization: TR - TC Graphs1 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)
Total revenue, (TR)
Break-even point
(Normal profit)
Maximum
economic
$299
P=$131
Total cost,
(TC)
The firm’s profit is maximized at an output of 9 units where total revenue, TR, exceeds total cost, TC, by the maximum amount. The vertical distance between TR and TC is plotted as a total economic profit curve.
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11. Profit Maximization: MR = MC Approach
Using the MR = MC rule
For a price taker, price = marginal revenue
The firm considers three questions:
Should the firm produce?
If so, what amount?
What economic profit (loss) will be realized?
The MR = MC rule is the principle that a firm will maximize its profit (or minimize its losses) by producing the output at which marginal revenue and marginal cost are equal, provided product price is equal to or greater than average variable cost. When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. We recognize that part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option.
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12. Profit Maximization: MR = MC Table
The Profit-Maximizing Output for a Purely Competitive Firm: Marginal Revenue = Marginal Cost Approach (Price = $131)
(1)
Total
Product
(Output)
(2)
Average Fixed Cost (AFC)
(3)
Average Variable Costs (AVC)
(4)
Average Total Cost
(ATC)
(5)
Marginal Cost
(MC)
Price = Marginal Revenue
(MR)
(6)
Total Economic Profit (+)
or Loss (-)
$-100 1
$100.00
$90.00
$190
$90
$131
-59 2
50.00
85.00
135 80
131 -8 3
33.33
80.00
113.33 70
+53 4
25.00
75.00
100.00 60
+124 5
20.00
74.00
94.00
+185 6
16.67
91.67
+236 7
14.29
77.14
91.43 90
+277 8
12.50
81.25
93.75
110
+298 9
11.11
86.67
97.78
130
+299 10
10.00
93.00
103.00
150
+280
Compare MC and MR at each level of output. The firm should continue to expand output as long as MR is greater than MC. The firm will maximize profits by producing the last unit of output where MR still exceeds the MC, up to where MR = MC. Since the tenth unit’s MC > MR, 9 units is the profit maximizing output.
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13. Profit Maximization: MR = MC Graph
$200
150
100 50
MR = MC MC
P=$131
Economic profit
MR = P
ATC
Cost and revenue
AVC
A=$97.78
This graph shows the short-run profit maximization for a purely competitive firm. The MR = MC output enables the purely competitive firm to maximize profits or to minimize losses. In this case, MR (=P in pure competition) and MC are equal at an output, Q, of 9 units. At this output, P equals $131 and exceeds the average total cost, and A = $97.78, so the firm realizes an economic profit of P - A per unit. The total economic profit is represented by the green rectangle and is (Price - ATC) * 9. 1 2 3 4 5 6 7 8 9 10
Output
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14. Loss Minimizing Case Loss minimization
Still produce because MR > minimum AVC
Losses at a minimum where MR = MC
Producing adds more to revenue than to costs
In the short run the firm only has two choices: produce or shut-down. There is not enough time in the short run for the firm to go out of business. Given these options, sometimes the firm will produce, but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down so this is the firm’s best choice.
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15. Loss Minimizing Case Graph
Cost and revenue
$200
150
100 50 1 2 3 4 5 6 7 8 9 10
Output MC
Loss
ATC
A=$91.67
AVC
P=$81
MR = P
This graph shows the short run loss minimization for a purely competitive firm. If price, P, exceeds the minimum AVC (here $74 at Q = 5) but is less than ATC at the MR = MC output (here 6 units) then the firm will incur losses, but it will produce. In this instance the loss is P - A per unit, where A is the average total cost at 6 units of output and price equals $81. The total loss is shown by the red area and is equal to (P - ATC)*6.
V = $75
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16. Short-run shut down point
Shutdown Case
Cost and revenue
$200
150
100 50 1 2 3 4 5 6 7 8 9 10
Output MC
ATC
AVC
V = $74
MR = P
Here is a the short-run shutdown case for a purely competitive firm. The MR = MC method yields an output level of 5. If price, P (here equal to $71), falls below the minimum AVC (here $74 at Q = 5), the competitive firm will minimize its losses in the short run by shutting down. There is no level of output at which the firm can produce and incur a loss smaller than its total fixed cost. In other words, the $100 fixed cost is the minimum possible loss.
P=$71
Short-run shut down point
P < minimum AVC
$71 < $74
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17. Short Run Supply Supply graphs as upsloping line
Short run supply curve
As long as P exceeds min. AVC
Firm continues to produce using the
MR (= P) = MC rule
Supply graphs as upsloping line
The segment of the firm’s marginal cost curve that lies above the average variable cost curve is the firm’s short run supply curve.
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18. Marginal Cost and Short Run Supply
The Supply Schedule of a Competitive Firm Confronted with Cost Data from Figure 10.3
Price
Quantity
Supplied
Maximum Profit (+)
Minimum Loss (-)
$151 10
$+480
131 9
+299
111 8
+138 91 7 -3 81 6
-64 71
-100 61
There is a relationship between price and quantity supplied. Since P = MR for the competitive firm, the profit maximization rule MR = MC will yield the short run supply curve. The short run supply curve is the part of the MC that lies above the AVC curve. The schedule shows the quantity a firm will produce at a variety of prices
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19. MC Curve and Short Run Supply
Cost and revenues (dollars)
Quantity supplied MC e P5
MR5 d
ATC P4
MR4 c
AVC P3
MR3 b
This graph displays the quantity a firm will produce at a variety of prices. Firms continue to follow the profit-maximizing rule and produce where MR = MC. They will produce as long as the price is greater than the min AVC. P2
MR2 a P1
MR1 Q2 Q3 Q4 Q5
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20. MC Becomes Short Run Supply Curve
Cost and revenues (dollars)
Quantity supplied S MC e P5
MR5 d
ATC P4
MR4 c
AVC P3
MR3 b P2
MR2
Here is a generalized depiction of how the marginal cost curve becomes the short run supply curve. Examine the MC for the competitive firm. If price is below AVC, then the firm should shut down and produce 0. If the price is equal to or above AVC, the firm should produce. The MC curve that is above the AVC curve becomes the short run supply curve. The break-even point is point d where the firm earns a normal profit because Price = ATC here. a P1
MR1
Shut-down point
(If P is below) Q2 Q3 Q4 Q5
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21. Output Determination
Output Determination in Pure Competition in the Short Run
Question
Answer
Should this firm produce?
Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost.
What quantity should this firm produce?
Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized.
Will production result in economic profit?
Yes, if price exceeds average total cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR).
We must work through these 3 questions sequentially every time we are confronted with a new market price. Here is a table that summarizes the steps that you need to go through to determine profit maximizing output.
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22. Firm and Industry: Equilibrium
Firm and Market Supply and Market Demand
(1)
Quantity
Supplied,
Single
Firm
(2)
Total
1000 Firms
(3)
Product
Price
(4)
Demanded 10
10,000
$151
4000 9
9000
131
6000 8
8000
111 7
7000 91 6 81
11,000 71
13,000 61
16,000
The market equilibrium condition is where quantity demanded equals quantity supplied. This will occur at a price of $111 and this price is the equilibrium, or market clearing price. Notice, the industry demand curve is a typical, downward sloping demand even though, for the firm, the demand curve is perfectly elastic and horizontal.
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23. Firm versus Industry: Equilibrium
S = ∑MCs
s = MC
Economic
profit
ATC d
$111
$111
AVC
Short-run competitive equilibrium for (a) a firm and (b) the industry. The horizontal sum of the 1000 firms’ individual supply curves (s) determines the industry supply curve (S). Given industry demand (D), the short-run equilibrium price and output for the industry are $111 and 8000 units. Taking the equilibrium price as given, the individual firm establishes its profit-maximizing output at 8 units and, in this case, realizes the economic profit represented by the green area.
Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price. D 8
8000
(a) Single firm
(b) Industry
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24. Fixed Costs: Digging Out of a Hole
Shutting down in the short run does not mean shutting down forever
Low prices can be temporary
Some firms switch production on and off depending on the market price
Examples: oil producers, resorts, and firms that shut down during a recession
In the short run, firms must determine whether or not to produce and whether producing will generate a profit, breaking even, or a loss. They have to consider the reality that with the given market price, they may not even be able to cover the firm’s variable costs, making a shut-down of the firm necessary. When firms shut-down, they still have to pay their fixed costs. But the shut-down may be temporary, and the firm may reopen when prices rise again and business conditions improve. In fact, many industries regularly switch production on and off depending on the market price for their product.