this is a powerpoint presentation on pure competition

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R. Larry Reynolds 1997

Fall ‘ 97 Principles of Microeconomics Slide -- 2

Pure Competition· The word “competition” may be used in two

ways;· rivalry - {synonym; opposition, antagonism}· structural competition or “pure competition”

· large number of sellers and buyers, none of whom can influence the market,

· homogeneous or identical products products,· relatively free entry and exit from the market.

There are no major Barriers to Entry.· [Perfect competition includes complete

infromation]


Price Takers· Because there is a large number of sellers with

identical products, no seller can charge a price above the prevailing market price.

· There is no reason to sell below the market price.

· Result: firms are “price takers,” they have no control over the price at which they sell. They may adjust the method and level of output, not the selling price.

· The market sets the price. Sellers and buyers react.


Firm’s Output· The firm’s choice of method and

level of output is dependent on costs and revenue associated with each output alternative.

· The costs of production are reflected in the supply side of the model.

· the revenue of the firm is reflected in the demand functions.


Markets and Firms· The role of a market is to coordinate the

activities of all the producers and buyers of a good.

· A firm is an organization that controls the operations of the plant(s) or the physical units of production.

· For purposes of simplification we will consider a firm that has a single plant and one good that they produce.


$

QX(millions)utIn the market there are a large number of firms that produce

and offer for sale a large output. Each firm’s output is small.

Market

The market demand and supply functions determine theequilibrium price and quantity.

Dmarket

S

QME

PE

A single firm produces a small portion of the market outputand must sell at the market price.

QX/ut

$ Firm

PEThe demand functionfaced by the firm is perfectly elastic!

Dfirm


$

QX(millions)ut

QME

PE

QX/ut

$ Firm

Dmarket

S

PEDfirm

As a price taker, the firm cannot raise price above PE. Thereis no reason to sell for less. The firm can sell all it wants andcan produce at PE .

Market

Since each unit can be sold at the price [PE ], the Dfirm is also the average revenue [AR]. PE = AR = Demand

Average revenuePE

DfirmAR =


Average and Marginal Revenue

· Total revenue is Price times Q: TR =PQ· AR is total revenue divided by Q; it is

the revenue per unit of output. TR divided by Q is P, so AR = P. AR , price and the demand function are the same thing.

· MR is the change in Total revenue associated with a change in quantity sold.


TR = PQ

AR and TR Revenue Functions:

AR = TRQ = PQ

Q

[cancel Q’s]

= PAR = P

Consider a purely competitive firm thatfaces a P = $5.

Q/ut

$

P= 5Since it can sell all itwants at $5/unit,AR = 5.

AR

The demand faced by thefirm is P =f(Q), P=5 for any Q.

D =

For Q = 1, TR = PQ = 5X1 = 5

1

.

For Q = 2, TR = PQ = 5X2 = 10

2

.10

For Q = 6, TR = PQ = 5X6 = 30

6

.30

TR is a straight line with a slope equal to price. This istrue only in pure comp. where demand isperfectly elastic.

TR


TR = PQMR, AR and TR Revenue Functions:

AR = PMR = TR

QConsider a purely competitive firm thatfaces a P = $5.TR is a straight linewith a slope equal toprice* [in this example $5].

ARD =

Q/ut

$

P= 5

1 2

10

6

30 TR

{* only in pure comp}

Since MR = TRQ , MR is the slope of the TR which is the

price. Because it is a purely comp. firm,each additional unit can be sold at thesame price. P = MR.

The s

lope o

f TR =

MR =

P

P = MR =[When Demand is perfectly elastic!]


$

QX(millions)ut

Dmarket

S

QME

PE

QX/ut

$ Firm

PEDfirm

Market

An increase in the demand in the market

D*market

causes an increasein both the output and equilibrium price [to PH].

Q

PH PH

The demand function [or AR, MR] faced by the firm increasesto D*.

D*firm

Pure Competition


$

QX(millions)ut

Dmarket

S

QME

PE

QX/ut

$ Firm

PEDfirm

Market

A decrease in supply in the market

S*

causes a decreasein output and increase in equilibrium price [to PH].

Q

PH

The demand function [or AR] faced by the firm increasesto D*.

PHD*firm


$

QX(millions)ut

Dmarket

S

QME

PE

QX/ut

$ Firm

An increase in supply lowers the equilibruim price in the marketand the price, AR of the firm.

S*PL PL

PEDfirm

Market

D*firm

A decrease in demand would have the same result in price.

D*

D*firm

PL

Pure Competition


Short Run Profit Maximization· Profits [] = TR - TC. [ are often the objective or goal of firm.]· The firm will choose to produce and offer for sale all

additional units of output that they can produce for a cost [MC] that is less than the additional revenue [MR] that they collect.

· Maximum profits [or minimum loses] for a firm occur when MR = MC.

· Ideally, the market will “signal” the costs of sellers and benefits to buyers with the market price; P = MR = MC


Q/ut

$In pure comp, eachfirm can sell entireoutput at marketprice. TR is linear withslope = P.

TRTC

TR = TC at Q1 & Q4. These are the levels of output where thefirm “breaks even.”

Q1

TR =TC

Q4

TR =TC

A firm producing at Q1would increase outputto Q* because the TCwould increase by lessthan the TR.

Q*

QTC

TR

At output Q*, the vertical distance between TR and TC is the greatest. Since TR - TC = this is maximum .

Notice that the slope of TC,[MC] is the same as theslope of TR [MR] at Q*.MC = MR!

slope o

f TC=MC


Q/ut

$TR

TC

Q1

TR =TC

Q4

TR =TC

Q*At output Q*, the vertical distance between TR and TC is the greatest.Since TR - TC = this is maximum .

slope o

f TC=MC

The firm would notincrease productionabove Q* becauseTC will increase by morethan TR. MC > MR

QTC

Q

TR

Since TR [MR] isless than TC [MC], would fall if outputwere expanded to Q4 .

At Q* MR = MC;Maximum .


QX/ut

$ Firm

PED = AR = MR

Short Run Profit MaximizationIn the short run the firm is a price taker. Given the price inthe market and the fixed input(s), the firm’s only alternativesare the amount of the variable input and consequently, the output [Q].

ATCMCAt output levels Q1 & Q4,

the firm “breakseven.” AR = ATCand TR = TC.* [Includes “normal

[* (AR)Q=TR=TC=(ATC)Q]

Q1 Q4

The firm’s minimum cost per unit [C3 ] is at Q3. This is the maximum perunit, not maximum .

Q3

C3The MC of producing theoutput between Q3 and Q*is less than the market price[ MR = P]: TR increases

“faster” than TC,Maximum profits at Q*!Q*


QX/ut

$ Firm

PED = AR = MR

Short Run Profit Maximization

ATCMC

Q1 Q4Q3

[At Q3 the cost per unit [ATC] is a minimum.]

C3

At Q3 the TC is C3 Q3;

0

TC

TR is PE Q3. is TR - TC, so (PE -C3)Q3 =

By increasing production from Q3 to Q*, the TC will increase;

Q*

TC

TR increases;

TR

The is the area above MC and below MR.

MAXIMUM IS WHEREMC = MR !

.


COSTQ FC VC TC AVC ATC MC

At Q = 0, the only cost isFC.

0 $10 $0 $10 -- -- -- FC is a constant and remains unchanged in the short run.

123456789

10

$10$10$10$10$10$10$10$10$10$10

Variable Cost [VC] increases as output increases.$5

$8$9

$12$18$27$39$54$73$99

Total cost [TC] = VC + FC

$15$18$19$22$28$37$49$64$83

$109

VC/Q = AVC. AVC first decreases,

5.004.003.00

then increases.3.003.604.505.576.758.119.90

ATC = TC/Q. ATC decreases,

15.

9.006.335.50

then increases.

5.606.177.008.00

9.2210.90

MC is the change in TC [or VC] that is associated with change in output [Q].

MC = TCQ

$5$3$ 1$3$6$9$12$15$19$26


The most “efficient” use of the variable input is betweenthe 3rd and 4rth units of Q.*[min AVC and max AP are same.]

{*Remember MC = AVC and ATC at their minimums !}

The lowest cost per unit,[min ATC] is between the 4rthand 5th units of output.*

If the objective is to MAX , the firm will produce and offeroutput for sale so long as the additional unit cost [MC] is lessthan the price at which it can besold [MR = P in pure competition].


0 $10 $0 $10 -- -- --123456789

10

$10$10$10$10$10$10$10$10$10$10

$5$8$9

$12$18$27$39$54$73$99

$15$18$19$22$28$37$49$64$83

$109

5.004.003.003.003.604.505.576.758.119.90

15.

9.006.335.505.606.177.008.00

9.2210.90

$5$3$ 1$3$6$9$12$15$19$26


Given the cost structure of thefirm in our example and a market price of $13;The most “efficient” use of thevariable does not max .

Q = 3; TR = PQ= ($13)3 = $39TC = $19, = TR-TC = $39-$19 = $20

$20

Q = 4; TR = PQ= ($13)4 = $52TC = $22, = TR-TC = $52-$22 = $30

$30

At the least cost per unit [min ATC], = $65-$28=$37

$37

The 6th unit can be produced for a cost [MC] of $9 and sold for $13, that would add $4 to .

Q = 6; TR = PQ= ($13)6 = $78TC = $37, = TR-TC = $78-$37 = $41

$41

Should the 7th unit be produced?


0 $10 $0 $10 -- -- --123456789

10

$10$10$10$10$10$10$10$10$10$10

$5$8$9

$12$18$27$39$54$73$99

$15$18$19$22$28$37$49$64$83

$109

5.004.003.003.003.604.505.576.758.119.90

15.

9.006.335.505.606.177.008.00

9.2210.90

$5$3$ 1$3$6$9$12$15$19$26


$20$30$37$41

Should the 7th unit be produced?The MC of the 7th unit is $12, it can be sold for $13, that would increase by $1.

Q = 7; TR = PQ= ($13)7 = $91TC = $49, = TR-TC = $91-$49 = $42

$42

As long as MR [P in pure comp]exceeds MC {and AVC},produce & sell if max is the goal.

The 8th unit will increasecosts by $15 [MC=15] andcan be sold for $13. Do youwant to produce it?

Q = 8; TR = PQ= ($13)8 = $104, TC = $64, = TR-TC = $104-$64 = $40

$40

NO !

$ 8<-$2><-$10>

$34$21


0 $10 $0 $10 -- -- --123456789

10

$10$10$10$10$10$10$10$10$10$10

$5$8$9

$12$18$27$39$54$73$99

$15$18$19$22$28$37$49$64$83

$109

5.004.003.003.003.604.505.576.758.119.90

15.

9.006.335.505.606.177.008.00

9.2210.90

$5$3$ 1$3$6$9$12$15$19$26


Loss minimization

Due to market conditions,the price falls to $5.

Profits are calculated: = TR - TC = PQ -TC.

<-10><-10><- 8><- 4><- 2><- 3><- 7><-14><-24><-38><-59>

If the firm “shuts down”the loss is $10.

If the firm will produces aslong as MR = P > MC and isgreater than AVC, they canreduce their losses. Lossis $2.


0 $10 $0 $10 -- -- --123456789

10

$10$10$10$10$10$10$10$10$10$10

$5$8$9

$12$18$27$39$54$73$99

$15$18$19$22$28$37$49$64$83

$109

5.004.003.003.003.604.505.576.758.119.90

15.

9.006.335.505.606.177.008.00

9.2210.90

$5$3$ 1$3$6$9$12$15$19$26


QX/ut

$ Firm

Short Run Loss Minimization

ATCMC

Q3

PP

0 QL

AVC

PL

When the price is greater than PP , the firm can make aneconomic . At a price, PP, the firm “breaks even.” Thiscovers a “normal profit,” [ATC > P = MR > AVC ]

Between a price of PL and PP, the firm will lose money but can minimizelosses by producing where MC = MR between output levels QL & Q3.

If the price falls belowPL , the firm should“shut down” to minimizelosses. [ P = MR < AVC]


LONG RUN PROFIT MAXIMIZATION

$

QIn the long run, the envelope curve represented LRAC. All costs are variable in the long run.

ATC!

ATC2ATC3 ATC*

ATC5

ATC6

LRMC

LRACATC*

Plant ATC* is the optimal size!

Q*

Cmin

[firm in long run]

At a price of PP , the firm can make above normal if they have plant size ATC3 or greater and smaller than ATC6 .

PP

Plants ATC!, ATC2 & ATC6 have costs per unit [ATC] that are greater than the price PP. They will not earn normal . These firms must adjust or close.

Firms with Plant size ATC*earn economic , this attractsentry causing the market price fall.

PM=

When price falls to PM , entry ceases.


LONG RUN PROFIT MAXIMIZATION

$

Q

Envelope curve:

ATC*

ATC!

ATC2

ATC3ATC5

ATC6

LRAC

LRMC

ATC*

MC*

Q*

Cmin

So long as P > LRACmin, firms enter [attracted by econ ] driving price down. When P < LRACmin , firms will exit the industry causing an increase in price.. Long run equilibrium [no entry or exit and price is stable] is at a price where it is equal to minimum of the LRAC. Tangent to bottom of LRAC.

P=

In long run equilibrium:

.

P = AR = MR = LRAC = LRMC = ATC* = MC*


P = AR = MR = LRAC = LRMC = ATC* = MC*

LONG RUN EQUILIBRIUM:

1. AR = ATC* {CONDITION FOR NORMAL IN THE SHORT RUN.}2. AR = LRAC {CONDITION FOR NORMAL IN THE LONG RUN.}3. LRAC = LRMC {CONDITION THAT INSURES MINIMUM COST PER UNIT AND OPTIMAL SIZE OR SCALE OF PLANT.}4. ATC* = MC* {CONDITION INSURES THAT THE OPTIMAL SIZE

PLANT IS OPERATED AT ITS MOST EFFICIENT LEVEL OF output.}

5. MR = MC* {CONDITION INSURES FIRM IS MAXIMIZING IN THE SHORT RUN.}

6. P = MR = LRMC {CONDITION INSURES FIRM IS MAXIMIZING IN THE LONG RUN RUN.}

7. P = MR = MC [both long and short run] INSURES THAT THEFIRMS’ BEHAVIOR IS CONSISTENT WITH MAXIMUM SOCIAL WELFARE !

this is a powerpoint presentation on pure competition

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