Chapter 9 Pure Competition McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives The four basic market models Conditions for pure competition Profit maximization for competitive firms The competitive firm supply curve Industry entry and exit Industry cost structure Economic efficiency 9-2

Market Structure Continuum Four Market Models Pure competition Pure monopoly Monopolistic competition Oligopoly Imperfect Competition Pure Competition Monopolistic Competition Pure Monopoly Oligopoly Market Structure Continuum 9-3

Pure Competition Very large numbers Standardized product “Price takers” Free entry and exit Perfectly elastic demand Average revenue Marginal revenue Price 9-4

Pure Competition P QD TR MR TR Price and Revenue ] D = MR = AR 2 4 6 8 10 12 131 262 393 524 655 786 917 1048 $1179 Quantity Demanded (Sold) Firm’s Demand Schedule (Average Revenue) Revenue Data TR P QD TR MR $131 131 1 2 3 4 5 6 7 8 9 10 $0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 D = MR = AR 9-5

Short Run Profit Maximization Market price is given Three questions: Should the product be produced? If so, in what amount? What economic profit (loss) will be realized? 9-6

Profit Maximization Two approaches Total revenue and total cost approach Produce where TR-TC is greatest Marginal revenue and marginal cost approach Produce where MR=MC 9-7

Total Revenue Total Cost Approach Price = $131 (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) 1 2 3 4 5 6 7 8 9 10 $100 100 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 $0 131 262 393 524 655 786 917 1048 1179 1310 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization? Now Let’s Graph The Results… 9-8

Total Revenue Total Cost Approach 1 2 3 4 5 6 7 8 9 10 11 12 13 14 $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum Economic Profit $299 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) Total Economic Profit $299 9-9

Marginal Revenue Marginal Cost Approach (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (1) Total Product (Output) (5) Marginal Cost (MC) (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) 1 2 3 4 5 6 7 8 9 10 $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 $90.00 85.00 80.00 75.00 74.00 77.14 81.25 86.67 93.00 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 $90 80 70 60 90 110 130 150 $131 131 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization Now? No Surprise - Now Let’s Graph It… 9-10

Marginal Revenue Marginal Cost Approach $200 150 100 50 MR = MC MC P=$131 Economic Profit MR = P ATC Cost and Revenue AVC A=$97.78 1 2 3 4 5 6 7 8 9 10 Output 9-11

Short Run Profit Maximization Produce where MR (=P) = MC Suffer loss, still produce? Yes if loss is less than fixed cost Cover variable cost Shut down if loss greater than fixed cost Produce if P > min AVC 9-12

Short Run Loss Minimizing Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Lower the Price to $81 and Observe the Results! MC Loss A=$91.67 ATC AVC P=$81 MR = P V = $75 9-13

Short Run Shut Down Case Cost and Revenue $200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Lower the Price Further to $71 and Observe the Results! MC ATC V = $74 AVC MR = P P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 9-14

Short-Run Supply Curve Continuing the Same Example… Supply Schedule of a Competitive Firm Quantity Supplied Maximum Profit (+) or Minimum Loss (-) Price $151 131 111 91 81 71 61 10 9 8 7 6 $+480 +299 +138 -3 -64 -100 The schedule shows the quantity a firm will produce at a variety of prices 9-15

Short-Run Supply Curve Firms produce where MR=MC Cost and Revenues (Dollars) Quantity Supplied MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5 9-16

Short-Run Supply Curve Firms produce where MR=MC Examine the MC for the Competitive Firm Cost and Revenues (Dollars) Quantity Supplied MC Above AVC Becomes the Short-Run Supply Curve S Break-even (Normal Profit) Point MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 9-17

Firm and Industry Supply Changes in firm supply Shifts in marginal cost Input price or technology The industry (total) supply curve Sum of individual supply Industry supply and demand Determine market price 9-18

Firm and Industry Supply Single Firm Industry p P S = ∑ MC’s s = MC Economic Profit ATC d $111 $111 AVC D 8 8000 Competitive firm must take the price that is Established by industry supply and demand 9-19

Long Run Profit Maximization Assumptions Entry and exit only Identical costs Constant-cost industry Goal of the analysis In the long run, P = min ATC Entry eliminates profits Exit eliminates losses 9-20

Entry Eliminates Profits Single Firm Industry p P 100 90,000 80,000 100,000 S1 MC $60 50 40 ATC $60 50 40 S2 MR D2 D1 An increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium 9-21

Exit Eliminates Losses Single Firm Industry p P 100 90,000 80,000 100,000 S3 MC $60 50 40 ATC $60 50 40 S1 MR D1 D3 A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium 9-22

Long Run Supply Constant cost industry Increasing cost industry Entry/exit does not affect LR ATC Constant resource price Special case Increasing cost industry Most industries LR ATC increases with expansion Specialized resources Decreasing cost industry 9-23

Long-Run Supply Curve Constant-Cost Industry S P P1 P2 P3 Q $50 Z3 Z1 Q P1 P2 P3 $50 S Z3 Z1 Z2 D3 D1 D2 Q3 Q1 Q2 90,000 100,000 110,000 9-24

Long-Run Supply Curve Increasing-Cost Industry Q S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 D2 D1 D3 Q3 Q1 Q2 90,000 100,000 110,000 How would a decreasing-cost industry look? 9-25

Pure Competition and Efficiency Productive efficiency P = minimum ATC Allocative efficiency P = MC Maximum consumer and producer surplus Dynamic adjustments “Invisible Hand” revisited 9-26

Long-Run Equilibrium Pure competition has both in Single Firm Market Price Quantity MC P=MC=Minimum ATC (Normal Profit) S ATC P MR P D Qf Qe Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC Pure competition has both in its long-run equilibrium 9-27

The Case of Generic Drugs Efficiency gains from entry Lower price and greater output Purpose of drug patent Encourage R&D Cost recovery Expiration of patent on drugs Generics enter Profits decrease, output increase Combined CS and PS increase 9-28

The Case of Generic Drugs New Producers Enter Market a Price Quantity As price decreases to f, Consumer surplus abc increases to adf Producer and consumer surplus is maximized as shown by the gray triangle S Initial Patent Price b c P1 d P2 f D Q1 Q2 Result: Greater Quantity at Lower Prices as Predicted by the Competitive Model 9-29

Key Terms pure competition pure monopoly long-run supply curve monopolistic competition oligopoly imperfect competition price taker average revenue total revenue marginal revenue break-even point MR=MC rule short-run supply curve long-run supply curve constant-cost industry increasing-cost industry decreasing-cost industry productive efficiency allocative efficiency consumer surplus producer surplus 9-30

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