Chapter 7:Pure Competition

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What is a Pure Competition?

Pure competition is one of four market structures in which thousands of firms each produce a tiny fraction of market supply in their respective industries. Examples: farm commodities (wheat,

soybean, strawberries, milo), the stock market, and the foreign exchange market

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Four Market Models

Economists group industries into four distinct market structures based on their characteristics. The four market models are: Pure competition Monopolistic competition Oligopoly Pure monopoly

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Four Market Models

Pure competition involves a very large number of firms producing a standardized product and there are no restrictions on entry.

Monopolistic competition is characterized by a relatively large number of firms producing differentiated products and entry into and exit from the market are relatively easy.

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Four Market Models

Oligopoly involves only a few large producers of homogeneous or differentiated products, so each firm is affected by the decisions of its rival and must take those decisions into consideration when setting its own price and quantity.

Pure monopoly involves one firm which is the sole seller of a good or service for which there are no good substitutes.

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Characteristics of Pure Competition

Very large numbers – a large number of independently acting sellers who offer their products in large markets.

Standardized product – firms produce a product that is identical or homogenous.

“Price taker” – the firm cannot change the market price, but can only accept it as “given” and adjust to it.

Free entry and exit – no barriers to entry exist.

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Demand as Seen by aPurely Competitive Seller

The demand schedule and demand curve faced by the individual firm in a purely competitive industry is perfectly elastic at the market price. Recall that the firm is a price taker and cannot

influence the market price. However, the industry as a whole, which

determines the market demand curve, can affect price by changing industry output.

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Demand as Seen by aPurely Competitive Seller

INDUSTRY (ORMARKET) DEMAND

AND SUPPLY

INDIVIDUALFIRM DEMAND

Price

P

Q Quantity Quantity

PriceS

D

D

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Demand as Seen by aPurely Competitive Seller

MARKET DEMAND AND SUPPLY FIRM DEMANDPrice

P1

Q1 Q2 Quantity Quantity

PriceS1

D

D1

S2

If market supply increases, the market price falls. Since each firm isa price taker, it has no choice but to charge the lower price for its product.

P2 D2

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Average and Total Revenue

Average revenue (AR) is total revenue from the sale of a product divided by the quantity of the product sold. AR = TR ÷ Q

Total revenue (TR) is the total number of dollars received by a firm from the sale of a product. TR = P x Q

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Marginal Revenue

Marginal revenue (MR) is the change in total revenue that results from selling 1 more unit of output. MR = (change in TR) ÷ (change in Q) MR is constant at the market determined price

—each additional unit of output produced adds the same amount to total revenue.

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Average, Total, andMarginal Revenue

Example: Suppose the market price, P, is $4. Average revenue and marginal revenue are equal to the price.

Output Price TR AR

0 $4 $0

1 $4 $4 $4

2 $4 $8 $4

3 $4 $12 $4

4 $4 $16 $4

MR

$4

$4

$4

$4

Since TR = P x Q and AR = TR ÷ Q,AR = (P x Q) ÷ Q

or AR = P

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Average, Total, andMarginal Revenue

Graphically, total revenue is a straight line that slopes upward to the right.

The demand, marginal revenue, and average revenue curves are horizontal at the market price P. All three curves coincide.

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Average, Total, andMarginal Revenue

TR

D = AR = MR$4

Price

Quantity1 2 3 4

$8

$12

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Profit Maximizationin the Short Run

Because the purely competitive firm is a price taker, it can maximize its economic profit (or minimize its economic loss) only by adjusting its output.

In the short run, the firm can adjust its variable resources (but not its fixed resources) to achieve the output level that maximizes profit.

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Profit Maximizationin the Short Run

In deciding how much to produce, the firm will compare the marginal revenue and marginal cost of each successive unit of output.

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Profit Maximizationin the Short Run

As long as producing is preferable to shutting down, the firm should produce any unit of output whose marginal revenue exceeds its marginal cost.

If the marginal cost of a unit of output exceeds its marginal revenue, the firm should not produce that unit.

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Profit Maximizationin the Short Run

A method of determining the total output at which economic profit is at a maximum (or losses at a minimum) is known as the MR = MC rule. This rule only applies if producing is preferable

to shutting down. In pure competition only, we can restate this

rule as P = MC. A firm will adjust output until marginal revenue

is equal to marginal cost.

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Profit Maximizationin the Short Run

Profit MaximizationIf price exceeds ATC at the MR = MC output (q*), the firm will realize an economic profit equal to q*(P – ATC).

Loss MinimizationIf price exceeds the minimum AVC but is less than ATC, the MR = MC output will permit the firm to minimize losses equal to q*(P – ATC).

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MC

MR

P

Q

ATC

AVC

A Profitable Firm inPure Competition

P*ATC

q*

ECONOMICPROFIT

Using the MR = MC rule, output is q*. Since price is greaterthan ATC at q*, the firm is earning an economic profit.

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The price is less than ATC at q* so the firm is making a loss.Since price is greater than the minimum AVC at q*, the firm continuesto operateat a loss.

MC

MR

P

Q

ATC

AVC

A Firm in Pure Competitionthat Continues to Operate

P*

ATC

q*

AVC

LOSS

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Profit Maximizationin the Short Run

Shutdown If price falls below the minimum AVC, the

competitive firm will minimize its losses in the short run by shutting down.

A firm shuts down if the total revenue that it would get from producing is less than the variable costs of production.

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Marginal Cost andShort-Run Supply

P1

P2

P4

P3

Break-even(normal profit)

point

Shutdown point (if P is below)

MC

quantity

ATC

AVC

Price

MR1

MR2

MR3

MR4

MR5P5

Q2 Q3Q4 Q5

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Marginal Cost andShort-Run Supply

Generalized Depiction Price P1 is below the firm’s minimum AVC; the

firm will not operation and quantity supplied will be zero.

Price P2 is just equal to the minimum AVC. The firm will produce at a loss equal to its fixed cost.

Between price P2 and P4, the firm will minimize its losses by producing and supplying the MR = MC quantity.

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Marginal Cost andShort-Run Supply

Generalized Depiction At price P4, the firm will just break even and

earns a normal profit. At price P5, the firm will realize an economic

profit by producing to the point where MR (=P) = MC.

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Marginal Cost andShort-Run Supply

The competitive firm’s short-run supply curve tells us the amount of output the firm will supply at each price in a series of prices. It is the portion of the MC curve above the

shutdown point. It slopes upward because of the law of

diminishing returns.

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Firm and Industry:Equilibrium Price

Equilibrium price is determined by the intersection of total, or market, supply and total demand. The individual supply curve of each of the

identical firms in an industry are summed horizontally to get the total supply curve.

The market supply together with market demand will determine the equilibrium price in a competitive industry.

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Profit Maximizationin the Long Run

The long-run assumptions in a competitive industry are: The only adjustment is the entry or exit of

firms. All firms in the industry have identical cost

curves. The industry is a constant cost industry.

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Goal of Our Analysis

After all long-run adjustments are completed, product price will be exactly equal to, and production will occur at, each firm’s minimum average total cost. Firms seek profit and shun losses Firms are free to enter and leave the industry

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Long-Run Equilibrium

In long-run equilibrium, firms earn zero economic profit. There is no tendency for firms to enter or leave and the existing firms earn a normal profit. P (=MR) = MC = minimum ATC

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Long-Run Equilibrium

INDUSTRY SINGLE FIRM

Price

$50

10,000 Quantity Quantity

PriceS

D

MR$50

MC

ATC

Q1

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Long-Run Equilibrium

Suppose the market demand for the product increases. Product price will rise, each firm’s marginal-revenue curve will shift upward, price will exceeds ATC at the MR = MC output, and firms will realize an economic profit.

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Long-Run Equilibrium

INDUSTRY SINGLE FIRM

Price

$50

10,000 Quantity Quantity

PriceS1

D1

MR1$50

MC

ATC

Q1Q2

D2

$60 $60 MR2

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Long-Run Equilibrium

When existing firms are earning economic profit, new firms are lured into the industry and will enter, the market supply curve will shift right, and there will be downward pressure on equilibrium price. (If firms are making losses, the opposite will occur.)

Long-run equilibrium will be restored as price and minimum ATC equalize once again.

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Long-Run Equilibrium

INDUSTRY SINGLE FIRM

Price

$50

Quantity Quantity

PriceS1

D1

MR1$50

MC

ATC

Q1

D2

$60 $60 MR2

S2

15,000

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Long-Run Supply in aConstant-Cost Industry

In a constant-cost industry, the long-run supply curve is horizontal. The entry of new firms has no effect on

resource prices and thus no effect on production costs.

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Long-Run Supply in aIncreasing-Cost Industry

An increasing-cost industry is an industry in which the entry of new firms raise the prices for resources and thus increases their production costs. As the industry expands (or contracts), it

produces a larger (smaller) output at a higher (lower) product price. The result is a long-run supply curve that is upsloping.

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Long-Run Supply: Constant-Cost versus Increasing-Cost Industry

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Long-Run Supply in aDecreasing-Cost Industry

In decreasing-cost industries, firms experience lower costs as the industry expands.

Thus, the long-run supply curve of a decreasing-cost industry is downsloping.

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Pure Competitionand Efficiency

In long-run equilibrium, the triple equality of P = MC = minimum ATC tells us that: Firms will only earn a normal profit Firms in a competitive industry use the limited

resources in a way to maximize the satisfaction of consumers This leads to allocative and productive

efficiency