ch09 pure competition[1]
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Chapter Objectives
• The four basic market models • Characteristics of pure competition • Profit maximization for competitive
firms in the short • The competitive firm supply curve • Profit Maximization in the long-run • Pure competition and Efficiency
Four Market Models • Pure competition
• Pure monopoly
• Monopolistic competition
• Oligopoly
Market Structure Continuum
Pure Competition
Monopolistic Competition Oligopoly
Pure Monopoly
Imperfect Competition
• Imperfect competition refers to those market structures
that fall between pure competition and pure monopoly.
The Four Types of Market Structure
Copyright © 2004 South-Western
• Local electric
utility
Pure
Monopoly
• Clothing
• Furniture
Monopolistic
Competition
• Tennis balls
• Crude oil
Oligopoly
Number of Firms?
Pure
• Wheat
• Milk
Competition
Type of Products?
Identical
products
Differentiated
products
One
firm
Few
firms
Many
firms
Characteristics of pure competition
• A perfectly competitive market has the following
characteristics:
– Very large numbers : There are many buyers
and sellers in the market (examples: markets
for farm commodities, the stock market, the
foreign exchange market).
– Standardized product: The goods offered by
the various sellers are largely the same.
Characteristics of pure competition • “Price takers”:
– Each buyer and seller takes the market price as given.
– Buyers and sellers must accept the price determined by the market.
• Free entry and exit: Firms can freely enter or exit the market. There are no obstacles prohibit new firms from selling their output in any competitive market.
Demand of Pure Competition • Perfectly elastic demand
– We need to analyze the demand of a pure competition firm to see how it affects revenue.
– The demand faced by the individual firm in a pure competition market is perfectly elastic at the market price.
– We are not saying that market demand is perfectly elastic.
– All firms acting independently can increase price by reducing output. But individual competitive firm cannot do that.
Demand of Pure Competition
• no individual firm can affect the market price
• demand curve facing each firm is perfectly elastic
The Revenue of a Competitive Firm
• Average revenue (AR) tells us how much revenue a
firm receives for the typical unit sold.
• Average revenue is total revenue divided by the
quantity sold.
Average Revenue =Total revenue
Quantity
Price Quantity
Quantity
Price
The Revenue of a Competitive Firm
• Total revenue (TR) for a firm is the selling price
times the quantity sold.
TR = (P Q)
• Marginal revenue (MR) is the change in total
revenue (or the extra revenue) from selling one
more unit of output.
MR = TR/ Q
The Revenue of a Competitive Firm
• In pure competition, marginal revenue and price
are equal (MR = P).
Firm’s Demand Schedule (Average Revenue)
Firm’s Revenue
Data
Demand, Total Revenue, Average Revenue, and
Marginal Revenue for a Competitive Firm
Pri
ce
an
d R
eve
nu
e
2 4 6 8 10 12
131
262
393
524
655
786
917
1048
$1179
Quantity Demanded (Sold)
D = MR = AR
TR
P QD TR MR
$131
131
131
131
131
131
131
131
131
131
131
0
1
2
3
4
5
6
7
8
9
10
$0
131
262
393
524
655
786
917
1048
1179
1310
$131
131
131
131
131
131
131
131
131
131
] ] ] ] ] ] ] ] ] ]
Demand, Total Revenue, Average Revenue, and
Marginal Revenue for a Competitive Firm
• Total revenue is a straight line.
• The Demand curve is horizontal, indicating perfect price elasticity.
• Marginal revenue curve = demand curve, because the product price is constant.
• Average revenue curve = price = demand curve.
Short Run Profit Maximization
• Because the purely competitive firm is a price
taker, it can maximize its economic profit (or
minimize its loss) only by adjusting its output.
• In the short run, it can adjust its output only
through changes in the amount of variable
resources to achieve the output level that
maximizes its profit.
Short Run Profit Maximization
• Two approaches to determine the level of output
at which a competitive firm will realize maximum
profit or minimum loss.
• Total revenue and total cost approach
– Produce where TR-TC is greatest
• Marginal revenue and marginal cost approach
– Produce where MR=MC
Short Run Profit Maximization
• The competitive producer will ask three questions:
– Should the product be produced?
– If so, in what amount?
– What economic profit (loss) will be realized?
Total-Revenue Total-Cost Approach
• The goal of a competitive firm is to maximize
profit.
• This means that the firm will want to produce
the quantity that maximizes the difference between
total revenue (TR) and total cost (TC).
Total-Revenue Total-Cost Approach
(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 = $131
0 1 2 3 4 5 6 7 8 9
10
$100 100 100 100 100 100 100 100 100 100 100
$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
1 0 2 3 4 5 6 7 8 9 10 11 12 13 14
1 0 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
400
300
200
100
To
tal
Re
ve
nu
e a
nd
To
tal
Co
st
To
tal
Eco
no
mic
P
rofi
t
Quantity Demanded (Sold)
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)
Total-Revenue Total-Cost Approach
Total-Revenue Total-Cost Approach
• Total cost increases with output because more production requires more resources.
• The rate of increase in TC reflects the law of diminishing marginal returns.
• TR and TC are equal where the two curves intersect.
• Break-even point: an output at which a firm makes normal profit but not an economic profit.
• Any output within the 2 break-even points will yield an economic profit.
Marginal-Revenue Marginal-Cost
Approach
• The firm compare MR and MC
• MR: the additional revenue resulting from the
sale of an additional unit of output
• MC: the additional cost resulting from the sale
of an additional unit of output
Marginal-Revenue Marginal-Cost
Approach
• The firm's profits are maximized at the level of
output at which MR ( = P) = MC.
• Produce where MR = MC. The firm has no
incentive to produce either more or less output.
Marginal-Revenue Marginal-Cost
Approach
• If MR > MC, the production of an additional unit of output adds more to revenue than to costs. – In this case, a firm is expected to increase its level of
production to increase its profits.
• If MR < MC, the production of an additional unit of output costs more than the additional revenue generated by the sale of this unit. – In this case, firms can increase their profits by producing less.
• A profit-maximizing firm will produce more output when MR > MC and less output when MR < MC.
Marginal-Revenue Marginal-Cost Approach
(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 (-)
0 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 75.00 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
$131
131 131 131 131 131 131 131 131 131
$-100 -59
-8 +53
+124 +185 +236 +277 +298 +299 +280
(5) Marginal
Cost (MC)
$90
80 70 60 70 80 90
110 131 150
Marginal-Revenue Marginal-Cost
Approach
• Each of the first 9 units adds to the firm’s profit and should be produced (MR > MC).
• The 10th unit should not be produced, it would add more to the cost ($150) than to revenue ($131).
• Profit = (profit per unit) x # of units
= (P – ATC) x Q = (131-97.78) x 9 = $299
• P = MC at the profit-maximizing output of 9 units.
• Note that the firm wants to maximize its total profit,
and not per-unit profit.
Co
st
an
d R
eve
nu
e
$200
150
100
50
0 1 2 3 4 5 6 7 8 9 10
Output
Economic Profit MR = P
MC MR = MC
AVC
ATC
P=$131
A=$97.78
Marginal-Revenue Marginal-Cost Approach
Short Run Loss Minimizing Case
Suppose that P < ATC. Since the firm is experiencing a loss, should it shut down?
• Stay in business if P > AVC.
• Shut down if P < AVC.
Short Run Loss Minimizing Case
• Suppose the market price = $81 rather than $131.
– Should the firm still produced?
– If so, how much?
– And what will be the resulting profit or loss?
• Yes, 6 units, and a loss of $64.
• Why produce? This loss is less than the firm’s $100 of fixed costs, which is the $100 loss the firm would incur in the short run by closing down.
Short Run Loss Minimizing Case
Lower the Price to $81 and Observe the Results!
Co
st
an
d R
eve
nu
e
$200
150
100
50
0 1 2 3 4 5 6 7 8 9 10
Output
Loss
Short Run Loss Minimizing Case: (AVC<P< ATC)
MR = P
MC
AVC
ATC
P=$81
A=$91.67
V = $75
Short Run Shut Down Case
• A shutdown refers to a short-run decision not to
produce anything during a specific period of
time because of current market conditions.
• Exit refers to a long-run decision to leave the
market.
Short Run Shut Down Case
Copyright © 2004 South-Western
MC
Quantity
ATC
AVC
0
Costs
Firm
shuts
down if
P < AVC
If P > AVC, firm will
continue to produce
in the short run.
If P > ATC, the firm
will continue to
produce at a profit.
Short Run Shut Down Case
• Suppose now that the market price = $71 rather
than $131.
• Should the firm still produced?
• No, because at every output the firm’s AVC > P.
• The smallest loss it can incur by producing is
greater than the $100 fixed cost.
Short Run Loss Minimizing Case
Lower the Price Further to $71 and Observe the Results!
Co
st
an
d R
eve
nu
e
$200
150
100
50
0 1 2 3 4 5 6 7 8 9 10
Output
Short Run Shut Down Case: P < AVC
MR = P
MC
AVC
ATC
P=$71
Short-Run Shut Down Point
P < Minimum AVC $71 < $74
V = $74
Short-Run Supply Curve
Continuing the Same Example…
Supply Schedule of a Competitive Firm
Price Quantity Supplied
Maximum Profit (+) or Minimum Loss (-)
$151 131 111
91 81 71 61
10 9 8 7 6 0 0
$+480 +299 +138
-3 -64
-100 -100
The schedule shows the quantity a firm will produce at a variety of prices
Short-Run Supply Curve
From the table we can note that:
• The firm will not produce at price $61 or $71 because both are less than the $74 minimum AVC.
• The quantity supplied increases as price increases.
• The economic profit is higher at a higher price.
Short-Run Supply Curve
Short-Run Supply Curve
• The ATC, AVC, and MC are shown with several MR lines drawn at possible market prices.
• Price P1: is below the firm’s minimum AVC, so at this price the firm won’t operate at all (Qs = 0).
• Price P2: is just equal to the minimum AVC. The firm will supply Q2 units of output (where MR2 = MC). The firm would be indifferent as to shutting down or supplying Q2.
Short-Run Supply Curve
• Price P3: the firm will supply Q3 to minimize its short-run losses (AVC<P< ATC).
• Price P4: the firm will earn a normal profit but not an economic profit (MR = ATC). Total revenue will just cover total cost.
• Price P5: the firm will realize an economic profit b y producing and supplying Q5 units of output.
Short-Run Supply Curve
• The portion of the marginal-cost curve that lies
above average variable cost is the
competitive firm’s short-run supply curve.
Short-Run Supply Curve
Firms produce where MR=MC
P1
0
Co
st
an
d R
eve
nu
es (
Do
lla
rs)
Quantity Supplied
MR1
P2 MR2
P3 MR3
P4 MR4
P5 MR5
MC
AVC
ATC
Q2 Q3 Q4 Q5
This Price is Below AVC And Will Not Be Produced
a
b
c
d
e
Short-Run Supply Curve
P1
0
Co
st
an
d R
eve
nu
es (
Do
lla
rs)
Quantity Supplied
MR1
P2 MR2
P3 MR3
P4 MR4
P5 MR5
MC
AVC
ATC
Q2 Q3 Q4 Q5
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)
Firms produce where MR=MC
Firm and Industry Supply
• Changes in firm supply:
1. Changes in the price of variable inputs or in
technology,
2. Will alter costs and shift the MC (it means
the short-run supply curve).
• For example, a wage increase would increase
MC and shift the supply curve: supply would
decrease.
Firm and Industry Supply
• Changes in firm supply:
Technological progress that increases the
productivity of labor would reduce MC and shift
the MC or supply curve: an increase in supply.
Firm and Industry Supply
• The industry (total) supply curve
– Sum of individual supply
– Market supply equals the sum of the
quantities supplied by the individual firms in
the market.
• Industry supply and demand
– Determine market price
Firm and Industry Supply
Single Firm Industry p P
p P 0 0
Firm and Industry Supply
Economic Profit
d
ATC
AVC
s = MC
$111 $111
D
S = ∑ MC’s
8 8000
Competitive firm must take the price that is Established by industry supply and demand
Long Run Profit Maximization
• Assumptions
– Entry and exit only: the only long-run adjustment is the entry or exit of firms.
– Identical costs: all firms in the industry have identical cost curves.
– Constant-cost industry: the entry and exit of firms does not affect resources prices.
Long Run Profit Maximization
• Goal of the analysis
– In the long run, the product price: P =
min ATC
– Entry eliminates profits
– Exit eliminates losses
Long Run Profit Maximization
• Long-run equilibrium
– In the long run: P=min ATC.
– Economic profit here = 0: Firms will enter or exit the market until profit is driven to zero.
– The industry is in equilibrium because there is no tendency for firms to enter or to leave.
– The market price is determined by market demand and supply.
Long Run Profit Maximization
• Long-run equilibrium
Long Run Profit Maximization • Entry Eliminates Profits (firm enter if P > ATC)
– market supply increases
– price declines
– profit declines until economic profit equals zero (and entry stops)
– Price is brought back down: P = min ATC
• Exit Eliminates Losses (firm exits if P < ATC)
– market supply decreases
– price rises
– losses decline until economic profit equals zero
– Price back up: P = min ATC
Single Firm Industry p P
p P 0 0 100 90,000 80,000 100,000
Entry Eliminates Profits
ATC
MR
MC
$60
50
40
D1
S1
- An increase in demand temporarily raises price - Higher prices draw in new competitors - Increased supply returns price to equilibrium
D2
$60
50
40
S2
Single Firm Industry p P
p P 0 0 100 90,000 80,000 100,000
Exit Eliminates Losses
ATC
MR
MC
$60
50
40
D3
S3
- A decrease in demand temporarily lowers price - Lower prices drive away some competitors - Decreased supply returns price to equilibrium
D1
$60
50
40
S1
Long-Run Supply Curve • What is the character of the long-run supply curve
of a competitive industry?
• The crucial factor here is the effect that changes in the number of firms in the industry will have on costs of the individual firms in the industry.
• Three cases:
– Constant-cost industry
– Increasing-cost industry
– Decreasing-cost industry
Long-Run Supply Curve • Constant-cost industry
– This means that entry and exit of firms does not affect resources prices.
– Entry/exit does not shift the long-run ATC
– The industry’s demand for resources is small in relation to the total demand for those resources.
– Constant resource price
– This is a special case
P
0 Q
Long-Run Supply Curve
Constant-Cost Industry
90,000 100,000 110,000
Q3 Q1 Q2
$50
P1
P2
P3
S Z1 Z2 Z3
D3 D1 D2
• The industry can expand or contract without significantly affecting resource prices and costs.
Long-Run Supply Curve • Increasing cost industry
– Most industries
– Long run ATC increases with expansion
– Long run ATC decreases with contraction
– Specialized resources
P
0 Q
Long-Run Supply Curve
Increasing-Cost Industry
90,000 100,000 110,000
Q3 Q1 Q2
$50 P1
S
Y1
Y2
Y3
D3
D1
D2
$40
$55 P2
P3
Long-Run Supply Curve • Decreasing cost industry
– Firms experience lower costs as their industry
expands.
– The personal computer industry is an
example.
– The supply of personal computers increased
by more than demand, and the price of
personal computers declined.
Pure Competition and Efficiency
• We need to understand the efficiency characteristics of the individual firms and the market.
• Whether the industry is an constant-cost industry or an increasing-cost industry, the final long-run equilibrium positions of all firms have the same basic efficiency characteristics.
Pure Competition and Efficiency
• Two desirable efficiency properties:
– P = MC (marginal benefit = marginal
cost)
– P = minimum ATC
Pure Competition and Efficiency
Productive efficiency P = minimum ATC
• In the long-run, pure competition forces firms to produce at the minimum ATC.
• It means that the minimum amount of resources will be used to produce any particular output.
• Goods produced in the least costly way.
Allocative efficiency P = MC
Pure Competition and Efficiency
Maximum consumer and producer surplus
• Pure competition maximizes the sum of the “benefits surplus”
• Consumer surplus = net gain from trade received by consumers (MB > P for consumers up to the last unit consumed)
• Producer surplus = net gain received by producers (P > MC up to the last unit sold)
Pure Competition and Efficiency
Dynamic adjustments • Many factors can cause MC not equal P:
– Consumer tastes,
– Resources supplies,
– Technology
• This will cause producers in either pursuing profit or avoiding loss, to reallocate resources until product supply is such that P one again equals MC.
• It means it will correct for any inefficiency in the allocation of resource.
Single Firm Market P
rice
Pri
ce
Quantity Quantity
0 0
Pure Competition and Efficiency:
Long-Run Equilibrium
P MR
D
S
Qe Qf
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
Pure Competition and Efficiency: Long-Run Equilibrium
• P = MC = minimum ATC at Qf
• Qf indicates that the firm is achieving productive efficiency and allocative efficiency.
• It is using the most efficient technology, charging the lowest price, and producing the greatest output consistent with its costs.
• It is receiving only a normal profit, which is incorporated into the ATC curve.
• The sum of consumer surplus and producer surplus is maximized.
Why Do Competitive Firms Stay in Business If
They Make Zero Profit?
• Profit = total revenue - total cost.
• Total cost includes all the opportunity costs of
the firm.
• In the zero-profit equilibrium, the firm’s revenue
compensates the owners for the time and money
they expend to keep the business going.