Pure/Perfect Competition

Background DiscussionHere are 3 products in the

marketplace:◦Corn◦Restaurant meals◦Mobile phone service◦Electricity

How would an entrepreneur compete?

Know this chart! Perfect/Pure Competition

Monopolistic Competition

Oligopoly

Monopoly

# of Firms

Many, Many

Many A few dominate

One

Variety of goods

None Some Some None

Control over prices

None Little Some Complete

Barriers to entry

Few Low High Complete

Examples

Wheat, Corn, Paper

Jeans, Pizza Cars, Movies

Public water

Perfect/Pure CompetitionThe simplest market structure

is known as Perfect/Pure competition.◦A Perfect/Purely competitive

market is one with a large number of firms all producing essentially the same product

◦Each firm produces so little of the product compared to total supply, no single producer can influence price; they are known as “price takers.”

Conditions for Perfect/Pure CompetitionThere are surprisingly only a few good examples of

Perfect/Pure competition because of the conditions needed for a Perfect/Purely competitive market.

◦ 1. Many Buyers and Sellers - There are many participants on both the buying and selling sides.

◦ 2. Identical Products - There are no differences between the products sold by different suppliers. Typically, commodities!

◦ 3. Informed Buyers and Sellers - The market provides the buyer with full control over the product and its price. The producer is at the mercy of the market.

◦ 4. Free Market Entry and Exit - Firms can enter the market when they can make money and leave it when they can't. Low barrier to entry!

Examples of Perfect/Pure CompetitionIt is difficult to meet all 4 criteria

for Perfect/Pure competition. Examples tend to be

commodities – a product that is the same no matter who produces it◦Roofing nails, paper clips◦Ag products: milk, corn◦Notebook or copy paper

Why isn’t there more Perfect/Pure competition?

barriers to entry are the most common reason we don’t see more examples of Perfect/Pure competition

A barrier to entry is any factor that creates an obstacle for a new firm to enter a market

Barriers to entry result in imPerfect competition

Examples of BarriersStart-up Costs

◦The expenses that a new business must pay before the first product reaches the customer are called start-up costs. Have to buy land, labor, capital

Technology◦Some markets require a high degree

of technological know-how. As a result, new entrepreneurs cannot easily enter these markets. Human and physical capital

Price and OutputOne of the primary characteristics of

Perfect/Purely competitive markets is that they are efficient. In a Perfect/Purely competitive market, price and output reach their equilibrium levels.

Market Equilibrium in Perfect/Pure Competition

Quantity

Pric

e

Supply

Demand

Equilibrium Price

Equ

ilibr

ium

Q

uant

ity

Demand from the competitive seller’s viewpointDemand is perfectly elastic

(horizontal on a graph)See text pg. 402 Fig. 21.1Yet, market demand is a

downward sloping D curve

Average, Total & Marginal RevenueD schedule = AR schedule

because price per unit for the consumer, is also revenue per unit for the producer

TR = Q x P (slopes upward to the right = S curve)

MR= TR/QSince price is constant, MR = D =

AR

Profit Maximization in the Short Run: TR & TC Approach

PC firms maximize profit by changing output

Changes output by changing variable resources◦Compare TR to TC OR MR to MC

TR and TCProducer will ask…

◦Should we produce this product?◦If so, what amount?◦What economic profit/loss will we incur?

Let’s look at textbook pg. 403 Table 21.2

Break-even point: point where TR=TC, obtain normal profit

Profit Maximization: are on graph where TR curve is furthest distance from TC curve

MR & MCAssume that producing is preferable

over shutting down, should continue to produce as long as MR > MC

If MC>MR, stop producing that unit!In the short run, firms will maximize

profit (or minimize loss) by producing the output in which MR=MC (As long as producing is preferred to shutting down)

See textbook pg. 405 Table 21.3

Profit-Maximizing Profit per unit = (P-A) x Q

◦Price - average total cost x quantityOutput at which MR > MC…keep producing

Minimize loss: the price-marginal cost relationship gets better with more production (specialization)◦if the loss is less than the fixed costs,

keep producing or your loss is still the fixed costs

Normal Profit/Economic Profit Firms in a PC market will

eventually operate at equilibrium

This LR equilibrium returns a normal profit to entrepreneurs and occurs at:P= minimum ATC

If the firm is operating above P=minimum ATC they realize an economic profit in the short run

If P > minimum ATC more firms will enter the market to realize the economic profits

Profits will erode away as additional supply lowers the price to LR equilibrium.

When to shutdown?If AVC is greater than the price

(loss is greater than the fixed costs)

A competitive firm will maximize profit (minimize loss) in the short run by producing output at which MR = P = MC, as long as the market price exceeds the minimum AVC

Loss Minimization and Shutdown

Occasionally a firm will choose to operate at a loss in the short run

This occurs when P< ATC and P > AVC

This may be more favorable than shutting down however

If a firm can cover all its variable costs, and a part of its fixed costs, it is better than shutting down

A firm will generally shut down when P < AVC

Practice1. Let us suppose Chuck's, a local supplier of chili and pizza, has the following revenue and cost structure:

    A. Chuck's should stay open in the long run.B. Chuck's should shut down in the short run.C. Chuck's should stay open in the short run.D. Chuck's should shut down in the short run but reopen in the long run.

Practice2. What is the minimum price for this firm to realize a normal profit

A. $2.60B. $4.00C. $4.90D. $6.70E. $2.80

The MC Curve as the Supply Curve The MC curve for a PC

firm also doubles as the short-run supply curve

This is because P=MR and all firms produce at MR=MC

Therefore PC firms produce where P=MC

Each time P shifts, we produce at a new Q.

The supply curve is simply a set of prices and quantities

The MC curve represents those prices and corresponding quantities

Practice…3. In general, the supply curve of a purely competitive firm is:  A. identical to the marginal-cost curve.B. a horizontal line equal to the market price.C. the rising portion of the average-total-cost (ATC) curve.D. the rising portion of the marginal-cost curve above the AVC curve.

Practice…4. If a firm is a price taker, then the demand curve for the firm's product is:  A. equal to the total revenue curve.B. perfectly inelastic.C. perfectly elastic.D. unit elastic.

Long Run Equilibrium for a PC firm

Practice…3. In pure competition, price is determined where the industry:  A. demand and supply curves intersect.B. total cost is greater than total revenue.C. demand intersects the firm's marginal cost curve.D. average total cost equals total variable costs.

Allocative & Productive Efficiency

Productive Efficiency Occurs at the point

whereP= minimum ATC

This means that the firm is producing at the minimum possible cost

Firms use best available production methods and least cost methods

Consumers pay the lowest possible price

Allocative Efficiency Occurs at the point where

P=MC This means that the firm is

providing society with the goods consumers want the most

If a resource is underallocatedP>MC

If a resource if overallocatedP<MC

Practice4. Productive efficiency refers to:  A. cost minimization, where P = minimum ATC.B. production, where P = MC.C. maximizing profits by producing where MR = MC.D. setting TR = TC.

Practice…5. Allocative efficiency refers to:

A. Maximizing profitsB. Producing at the lowest possible

costC. Using resources most efficientlyD. Producing what society most

wants

Practice…6. Refer to the graph at the right. It shows the short-run cost curves for a purely competitive firm together with a number of different prices. At what price is the firm making an economic profit?  A. P1B. P2C. P3D. P4

Practice…7. Which is true for a purely competitive firm in short-run equilibrium?  A. The firm is making only normal profits.B. The firm's marginal cost is greater than its marginal revenue.C. The firm's marginal revenue is equal to its marginal cost.D.  A decrease in output would lead to a rise in profits.

Practice…8. When a firm produces less output, it can reduce:  A. its fixed costs but not its variable costs.B. its variable costs but not its fixed costs.C. average fixed cost.D. marginal revenue.