McGraw-Hill/Irwin Chapter 7: Pure Competition Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved

Four Basic Market Models  Economists group industries into four market structures:  Perfect competition: large number of sellers, standardized product, easy entry and exit  Monopolistic competition: large number of sellers, differentiated product, easy entry and exit  Oligopoly: small number of sellers, standardized or differentiated product, limited entry  Pure monopoly: one seller, unique product, no entry LO:

Characteristics of Pure Competition  Very large numbers of independently acting sellers who offer their products in large markets.  Standardized product: firms produce a product that is identical or homogenous.  Firms are “price takers”: 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. LO:

Demand as Seen by A Purely Competitive Firm  A purely competitive firm sees its demand as perfectly elastic (horizontal demand curve).  Thus, average revenue (AR) is equal to price (P).  Total revenue (TR) is equal to price times quantity sold (Q).  Because the price is constant, marginal revenue (MR) is also equal to price. LO: 7-3 TR = P x Q AR=TR ÷ Q MR=change in TR ÷ change in Q Graphically… 7-4

Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Price and Revenue $1179 Quantity Demanded (Sold) D = MR = AR TR PQDQD MR $ $ $ ] ] ] ] ] ] ] ] ] ] LO:

Profit Maximization in the Short Run  A purely competitive firm is a price taker, thus it can maximize its economic profit only by adjusting its output.  In the short run, the firm can adjust its variable resources to achieve the output level that maximizes profit.  In deciding how much to produce, the firm will compare the marginal revenue and marginal cost of each successive unit of output. LO:

MR=MC Rule  MR=MC rule is used to determine the total output at which economic profit is at a maximum (or losses are at a minimum) - label this output level q*.  In perfect competition, because P=MR, we can restate this rule as P=MC. LO: 7-3 MR=MC Rule: If producing is preferable to shutting down, the firm should produce any unit of output for which 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. 7-7

Profit Maximization If P>ATC at q* (where MR=MC), the firm will realize an economic profit equal to q*(P – ATC)>0. Loss Minimization If P<ATC but exceeds the minimum AVC, q* output level will minimize losses, equal to q*(P – ATC)<0. Firm Shutdown If P falls below the minimum AVC, the competitive firm will minimize its losses in the short run by shutting down, because the total revenue that it would get from producing is less than the variable costs of production. LO: 7-3 Profit Maximization and Loss Minimization in the Short Run 7-8

(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 (-) $ $ $ $ $ No Surprise - Now Let’s Graph It… Do You See Profit Maximization Now? (5) Marginal Cost (MC) $ LO: 7-3 Applying MR=MC Rule 7-9

Cost and Revenue $ Output Economic Profit MR = P MC MR = MC AVC ATC P=$131 ATC=$97.78 LO: 7-3 Applying MR=MC Rule 7-10

Price Quantity Supplied Maximum Profit (+) or Minimum Loss (-) $ $ The schedule shows the quantity a firm will produce at a variety of prices LO: 7-4 Supply Schedule of a Competitive Firm Continuing the Same Example… 7-11

Firms produce where MR=MC P1P1 0 Cost and Revenues (Dollars) Quantity Supplied MR 1 P2P2 MR 2 P3P3 MR 3 P4P4 MR 4 P5P5 MR 5 MC AVC ATC Q2Q2 Q3Q3 Q4Q4 Q5Q5 This Price is Below AVC So Firm will not be Producing a b c d e LO: 7-4 Short-Run Supply Curve 7-12

P1P1 0 Cost and Revenues (Dollars) Quantity Supplied MR 1 P2P2 MR 2 P3P3 MR 3 P4P4 MR 4 P5P5 MR 5 MC AVC ATC Q2Q2 Q3Q3 Q4Q4 Q5Q5 This Price is Below AVC And Will Not Be Produced 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) LO: 7-4 Short-Run Supply Curve 7-13

 The individual supply curves of each of the identical firms in an industry are summed horizontally to get the total (market) supply curve.  Industry equilibrium price and quantity are determined by the intersection of total; market, supply, and total; or market and demand. Industry Equilibrium LO:

 Assume that in the long run in a competitive industry  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  Then, in the long run, 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 LO: 7-5 Profit Maximization in the Long Run 7-15

Single FirmMarket Price Quantity 0 0 P MR D S QeQe QfQf 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 LO: 7-5 Long-Run Equilibrium 7-16

Long-Run Supply Curve  In a constant cost industry, resource prices are not affected by the number of firms, thus  Long-run supply curve is horizontal.  In an increasing-cost industry the entry of new firms raise the prices for resources and thus increases their production costs, thus  As the industry expands, it produces a larger output at a higher product price. The result is a long-run supply curve that is upward-sloping.  In a decreasing-cost industry, firms experience lower costs as the industry expands, thus  Long-run supply curve is downward-sloping. LO: