Chapter 23 Pure Competitionhttp://www.youtube.com/watch?v=aFBGsad_qE0

FOUR MARKET MODELS:Industries typically operate within one of four distinct market structures:1. Pure Competition

large number of sellers, standardized product, no/low barriers to entrye.g. wheat, corn, gold, foreign currency, NYSE

2. Monopolistic Competitionlarger # of sellers, differentiated product, low entry barriers, non-price competitione.g. restaurants, casual clothing, some retail stores

3. Oligopoly few sellers of similar products, significant entry barriers, price competitione.g. Maytag/GE/Whirlpool refrigerator, Coke/Pepsi, airlines

4. Pure Monopolyone firm as sole seller, complete barriers to entrye.g. certain electricity, water, phone, cable providers

the Four Market Models

A firms control over Price?

• Pure Competition (e.g. wheat)– none; market sets the price; “price takers”

• Monopolistic Competition (e.g. restauraunts)– some but within limits … market forces apply

• Oligopoly (automobiles or airlines)– significant but limited by mutual interdependence

• Pure Monopoly (a town’s cable TV or electricity provider)– considerable (… but must consider demand & elasticity of demand)

the Four Market Models

An industry’s non-price competition? (e.g. advertising, product differentiation)

• Pure Competition (e.g. corn for ethanol production)– none

• Monopolistic Competition (e.g. fiction books)– considerable; emphasis on “branding”, trademarks, advertising

• Oligopoly (automobiles or airlines)– considerable; to differentiate relatively standard product (FF miles)

• Pure Monopoly (a town’s electricity provider) – an attempt to increase demand (consumer tastes/preferences)

– enough to create/maintain barriers to entry

p460 #1. Briefly indicate the basic characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Under which of these market classifications does each of the following most accurately fit? In each case justify your classification.

(a) a supermarket in your home town; Oligopoly- few in number, relatively standard products, price is interdependent w/ competition

(b) the steel industry; Oligopoly- few in number, relatively standard products, significant obstacles to entry

(c) a Kansas wheat farm; Pure Competition- Large number of firms, standardized product, no control over price

(d) the commercial bank in which you or your family has an account; Monopolistic Competition (or maybe Oligopoly)- Monopolistic: Relatively large #, some control over price (fees, interest, etc.), branding- Oligopoly: Products fairly standardized, price interdependent, branding/advertising

(e) the automobile industry. Oligopoly- few in number, relatively standard products, attempts to differentiate, high entry barriers

Introduction to Pure Competition

• Very large numbers • Standardized Product• “Price Takers”

-- the competitive firm cannot set market price, but will adjust to it

• Free entry and exit (i.e. low barriers to entry)

Relevance of Pure Competition• a benchmark for evaluating the efficiency of the real-world economy

• pure competition would result in long-run productive efficiency, where price equals minimum LRATC

• pure competition would result in long-run allocative efficiency, where price equals MC

PURE COMPETITIONQuestions to answer when analyzing pure competition:

1. What is demand from the seller’s viewpoint?2. How does a competitive firm respond to market price (in the short run)?3. In the long run, what adjustments are made in a competitive industry? Why?4. How efficient are perfectly competitive industries? Why/how?

1. Demand in a competitive industry is downward sloping. (Law of demand.) The demand curve for an individual firm is perfectly elastic. (Price-taker.)

2. It “accepts” the price (but will change quantity supplied in response to a change in price).

PURE COMPETITIONQuestions to answer when analyzing pure competition:

1. What is demand from the seller’s viewpoint?2. How does a competitive firm respond to market price (in the short run)?3. In the long run, what adjustments are made in a competitive industry? Why?4. How efficient are perfectly competitive industries? Why/how?

3. Entry/exit of firms. When profits exist, new firms will enter. When losses occur, some firms will exit.

4. Perfectly competitive markets are the most efficient (productive and allocative efficiency) and preferred whenever possible by economists.

p460 #3. Use the following demand schedule to determine total and marginal revenues for each possible level of sales:

a. What can you conclude about the structure of the industry in which thisfirm is operating? Explain.Purely competitive market; the firm is a price-taker; as the “quantity demanded”of the supplier increases, there is no change in price paid by the buyer.

b. Graph the demand, total revenue, and marginal revenue curves for this firm.

c. Why do the demand and marginal revenue curves coincide?Demand is perfectly elastic; MR is constant and equals Price. MR = P

d. “Marginal revenue is the change in total revenue.” Explain verbally and graphically, using the data in the table.

Product Price ($)

Quantity Demanded

Total Revenue

($)

Marginal Revenue

($)

2 0 2 1 2 2 2 3 2 4 2 5

Product Price ($)

Quantity Demanded

Total Revenue

($)

Marginal Revenue

($)

2 0 $ 0 --2 1 2 22 2 4 22 3 6 22 4 8 22 5 10 2

Given a price & the short-run cost structure:a. will this firm produce in the short run? b. Why, or why not? c. If it does produce, what will be the output?d. What will be the economic profit or loss?

To solve:• Is price greater than at least one level of AVC?• If no, shut down. (zero production; loss = TFC)• If yes, apply MR “=“ MC rule to find output.• Find the difference between price and ATC to

determine per unit profit or loss.• Multiply per unit profit or loss by output to

determine total profit/loss.

Potential prices:1. product price of $382. product price of $453. product price of $504. product price of $68

TP AFC AVC ATC MC0 x x x x1 50.00 48.00 98.00 482 25.00 46.00 71.00 443 16.67 42.67 59.33 364 12.50 40.50 53.00 345 10.00 40.40 50.40 406 8.33 41.67 50.00 487 7.14 44.29 51.43 608 6.25 46.88 53.13 659 5.56 50.00 55.56 7510 5.00 54.00 59.00 90

Short Run Profit Maximization

1. Total Revenue minus Total Cost Approach

2. MR = MC. Marginal Revenue equals Marginal Cost Approach• Law of DR explains first decreasing then increasing marginal costs• In lower stages of output, MR > MC; in higher stages of output, MC > MR• To maximize profit, a firm will produce output at the point where MR = MC

(this allows a firm to earn the cumulative profit of all output where MR > MC)

The MR = MC rule:• only applies when producing is preferred to shutting down

(a firm will shut down when its loss at all levels of output exceeds fixed costs)

• applies to pure competition (and oligopoly, monopoly, & monopolistic comp.)

Four scenarios after applying MR = MC:1. Shut Down (P < AVC)2. Minimize Losses (AVC < P < ATC)3. Break Even (P = ATC)4. Maximize Profits (P > ATC)

p460 #4. i. will this firm produce in the short run? ii. Why, or why not? iii. If it does produce, what will be the profit maximizing or loss minimizing output? iv. Explain. v. What economic profit or loss will the firm realize per unit of output.

a. product price of $56 P > AVC (not shutdown) at $56, MR “=” MC at 8 units

MR > ATC (earning profit) Profit per unit is ≈ $7.87 ($56.00 – $48.13)

(x 8 ≈ $63 total profit)

b. product price of $41 P > AVC (not shutdown) at $41, MR “=” MC at 2 and 6 units AC @ 2 units > AC @ 6 units

MR < ATC (loss minimization) Loss per unit is ≈ $6.50 ($41.00 – $47.50)

(x 6 ≈ $39 total loss… < $60 fixed costs)

c. product price of $32 P < AVC at all levels of output (shutdown!!!)

Loss equal to total fixed costs: loss of $60 incurred

P460 #4 d – g. Part d. Part f.

e. The firm will not produce if P < AVC. When P > AVC, the firm will produce in the short run at the quantity where P = MC. The MC curve – above the AVC curve – shows the quantity of output the firm will supply at each price level. (That schedule is the short run supply curve.)

g. The equilibrium price is $46; equilibrium output = 10,500. Each firm will produce 7 units. Loss per unit = $1.14, or $8 per firm. The industry will contract in the long run.

LONG RUN PROFIT MAXIMIZATION

Assumptions (remember: Perfect Competition):• The only long run change is the entry and exit of firms• The “representative” firm; identical costs for all firms

Entry Eliminates Profits• When short run economic profits are earned, new

firms enter (long run) increase in supply

Exit Eliminates Losses• When short run economic losses exist, firms exit

the market (long run) decrease in supply

Long run equilibrium established by entry/exit of firms.

PURE COMPETITION AND EFFICIENCY

Productive Efficiency: P = Minimum ATC-- market forces this behavior in the long run -- entry eliminates profit; loss eliminates firms (i.e. causes exit)

Productive Efficiency is reached when price is equal to minimum average total costs.

Allocative Efficiency : P = MCP = MB…why?

when P > MC, resources have been underallocated and more resources should be used to produce that good

when P < MC, resources have been overallocated and fewer resources should be used to produce that good

Allocative Efficiency is reached when price is equal to marginal cost.