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CHAPTER 21

PURE

COMPETITION

4 Market Structures

Economists group industries into four distinct market structures based on:

* the number of firms in the industry

* Whether those firms produce a standardized product or try to differentiate from each other

* How easy or difficult it is for firms to enter the industry

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The 4 market structures are:

•1. Pure (Perfect) Competition – a large number of usually smaller firms producing a product identical to other producers (ex. farmers)

•2. Pure Monopoly – one firm is the sole seller of a product or service (MLB, satellite radio)

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4 Market Structures

• 3. Oligopoly – a middle ground between capitalism and monopoly; only a few sellers of a standardized or differentiated product so each firm is affected by the decisions of its rivals (steel, film, cell phone industries)

• 4. Monopolistic Competition – a larger number of sellers producing differentiated products (clothing, furniture, books)

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4 Market Structures

PerfectCompetition

PureMonopoly

MonopolisticCompetition Oligopoly

FOUR MARKET STRUCTURES

Every product is sold in a market that can be considered one of the above market structures.

What is the market structure for each?1. Fast Food Market2. The Market for Cars3. Microsoft Operating Systems 4. Strawberry Market5. Cereal Market

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Monopolistic Competition

Oligopoly

Monopoly

Perfect Competition

Oligopoly (a few main producers)

Perfect Competition

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PerfectCompetition

PureMonopoly

MonopolisticCompetition Oligopoly

FOUR MARKET STRUCTURES

Characteristics of Perfect Competition:

• Many small firms• Identical products (perfect substitutes)• Easy for firms to enter and exit the industry• Seller has no need to advertise • Firms are “Price Takers”

The seller has NO control over price.

Examples of Perfect Competition: Avocado farmers, sunglass huts, and hammocks in Mexico

Imperfect Competition

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Law of One Price

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In an efficient market, all identical goods must have only one price.

Result: Each firm is a price taker. Firms have no control of the price

Traffic AnalogyWhen there is heavy traffic,

why do all lanes seem to go the same speed?

Cars leave slower lanes and enter faster lanes.

Similarly, what happens in perfectly competitive markets if firms earn excessive profit?

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Perfectly Competitive FirmsExample:

• Say you go to Mexico to buy a hammock.• After visiting at few different shops you find that

the buyers and sellers always agree on $15.• This is the market price (where demand and

supply meet)1. Is it likely that any shop can sell hammocks for $20?2. Is it likely that any shop will sell hammocks for $10?3. What happens if a shop prices hammocks too high?4. Do you think that these firms make a large profit off

of hammocks? Why? These firms are “price takers” because the sell their

products at a price set by the market.10

Demand for Perfectly Competitive Firms

Why are they Price Takers?•If a firm charges above the market price, NO ONE will buy. They will go to other firms•There is no reason to price low because consumers will buy just as much at the market price.

Since the price is the same at all quantities demanded, the demand curve for each firm is…

Perfectly Elastic (A Horizontal straight line)

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P

Q

Demand

P

Q5000

D

S

Industry Firm(price taker)

$15 $15

The Competitive Firm is a Price TakerPrice is set by the Industry

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13

What is the additional revenue for selling an

additional unit? 1st unit earns $152nd unit earns $15Marginal revenue is constant at $15Notice:

• Total revenue increases at a constant rate

• MR equal Average Revenue

P

Q

Demand

Firm(price taker)

$15

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MR=D=AR=P

The Competitive Firm is a Price TakerPrice is set by the Industry

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What is the additional revenue for selling an

additional unit? 1st unit earns $152nd unit earns $15Marginal revenue is constant at $15Notice:

• Total revenue increases at a constant rate

• MR equal Average Revenue

P

Q

Demand

Firm(price taker)

$15

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MR=D=AR=P

The Competitive Firm is a Price TakerPrice is set by the Industry

For Perfect Competition:Demand = MR

(Marginal Revenue)

MaximizingPROFIT!

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Short-Run Profit MaximizationWhat is the goal of every business?

To Maximize Profit!!!!!!•To maximize profit firms must make the right output •Firms should continue to produce until the additional revenue from each new output equals the additional cost.

Example (Assume the price is $10) • Should you produce…

…if the additional cost of another unit is $5…if the additional cost of another unit is $9…if the additional cost of another unit is $11

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Short-Run Profit MaximizationWhat is the goal of every business?

To Maximize Profit!!!!!!•To maximum profit firms must make the right output •Firms should continue to produce until the additional revenue from each new output equals the additional cost.

Example (Assume the price is $10) • Should you produce…

…if the additional cost of another unit is $5…if the additional cost of another unit is $9…if the additional cost of another unit is $11

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Profit Maximizing Rule

MR=MC

Lets put costs and revenue together on a graph to calculate profit.

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Total Revenue =$63

$9

8

7

6

5

4

3

2

1

1 2 3 4 5 6 7 8 9 10

MC

AVCATC

•How much output should be produced?•How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much?

MR=D=AR=P

Total Cost=$45

Profit = $18

Don’t forget that averages

show PER UNIT COSTS

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Q

P

Suppose the market demand falls. What would happen if the price is lowered from

$7 to $5? The MR=MC rule still applies but now the firm will make an economic loss.

The profit maximizing rule is also the loss minimizing rule!!!

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Total Revenue=$35

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVC

ATC

•How much output should be produced?•How much is Total Revenue? How much is Total Cost? •Is there profit or loss? How much?

MR=D=AR=P

Total Cost = $42

Loss =$7

$9

8

7

6

5

4

3

2

1

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Q

Assume the market demand falls even more. If the price is lowered from $5 to $4

the firm should stop producing.

Shut Down Rule:•A firm should continue to produce as long as the price is above the AVC •When the price falls below AVC then the firm should minimize its losses by shutting down •Why? If the price is below AVC the firm is losing more money by producing than they would have to pay to shut down.

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Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVC

ATC

SHUT DOWN! Produce Zero

$9

8

7

6

5

4

3

2

1

Minimum AVC is shut down

point

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Q

TC=$35

TR=$20

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

AVC

ATC

P<AVC. They should shut down Producing nothing is cheaper than staying open.

MR=D=AR=P

Fixed Costs=$10

$9

8

7

6

5

4

3

2

1

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Q

Three Characteristics of MR=MC Rule:1. Rule applies to ALL markets

structures (PC, Monopolies, etc.)2. The rule applies only if price is

above AVC 3. Rule can be restated P = MC for

perfectly competitive firms (because MR = P)

Profit Maximizing RuleMR = MC

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Practice

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$20

15

10

5

0

Cos

t an

d R

even

ue

MC

AVC

ATC14

Should the firm produce?What output should the firm produce?What is TR at that output? What is TC?How much profit or loss?

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MR=D=AR= P

Yes10

TR=$140

Profit=$40 TC=$100

#1

27Q6 7 10

$20

15

10

5

0

Cos

t an

d R

even

ue

5 7

MC

MR=D=AR=P

AVCATC

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What output should the firm produce?What is TR at MR=MC point?What is TC at MR=MC point?How much profit or loss?

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Loss=Only Fixed Cost $5

Zero Shutdown (Price below AVC)$45

$55#2

28Q

$40

30

20

10

0

Cos

t an

d R

even

ue

6 8

MC

MR=D=AR=P

AVC

ATC

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What output should the firm produce?What is TR at that output?What is TC?How much profit or loss?

6$90

$120Loss= $30

#3

29Q