McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 9 Lecture 11 AND 12 PURE COMPETITION

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

Four Market Models Industries with defining characteristics are grouped into four market models: Pure competition Pure monopoly Monopolistic competition Oligopoly Market Structure Continuum Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Imperfect Competition 9-3

Pure Competition: Characteristics and Occurrence A very large number of independently acting producers. Firms produce a standardized product Individual firms are “Price takers” in that no firm has control over the market price. Free entry and exit Perfectly elastic demand Average revenue Marginal revenue Price 9-4

Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Demand as seen by a Purely Competitive seller Price and Revenue $1179 Quantity Demanded (Sold) D = MR = AR TR PQDQD MR $ $ $ ] ] ] ] ] ] ] ] ] ] 9-5

Average, Total & Marginal Revenue

Short Run: Profit Maximization Since purely competitive firms are price takers, they can maximize profit only by adjusting output. There are two ways to determine the level of output at which a competitive firm will realize maximum profit or minimum loss. total-revenue—total cost approach marginal revenue—marginal cost approach 9-7

Total Revenue and Total Cost approach to Profit Maximization Confronted with market price of its product, the competitive producer asks three questions: Should the product be produced? If so, in what amount? What economic profit (loss) will be realized? 9-8

Total Revenue Total Cost Approach (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 (-) Price = $ $ $ $ $ $ Now Let’s Graph The Results… Do You See Profit Maximization? Perfectly competitive firms will produce when the market Price exceeds per unit cost of production 9-9

9-10 Total Revenue Total Cost Approach

Marginal Revenue Marginal Cost Approach to Profit Maximization The firm compares the amount each additional unit of output would add to total revenue (marginal revenue) and the additional cost each unit of output adds (marginal cost). The output determining rule: the firm will maximize profit or minimize loss by producing the output at which MR = MC.

Features of the MR = MC rule The firm should produce the last complete unit of output for which MR exceeds MC. The MC = MR rule only applies when producing is preferable to shutting down The rule applies to all market structure types. For purely competitive firms, the rule can be restated as P = MC.

Profit Maximizing Case (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) $

9-14 Short run Profit Maximization Case for a Purely Competitive Firm

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 9-15

Short Run Loss Minimizing Case 9-16

Short Run Loss Minimization For A Purely Competitive Firm

Short Run Shutdown Case For A Purely Competitive Firm 9-18

Short-Run Supply Curve Continuing the Same Example… Supply Schedule of a Competitive Firm Price Quantity Supplied Maximum Profit (+) or Minimum Loss (-) $ $ The schedule shows the quantity a firm will produce at a variety of prices 9-19

The P=MC Rule and the Competitive Firms Short run Supply Curve 9-20

Diminishing Returns, Production Costs, and Product supply Because of the law of diminishing returns, marginal costs eventually rise as more units of output are produced. As output rises, marginal costs increase. A purely competitive firm must get successively higher prices to motivate it to produce additional units of output. 9-21

Firm and Industry: Equilibrium Price 9-22

Short Run Competitive Equilibrium For The Firm And The Industry 9-23 Competitive firm must take the price that is Established by industry supply and demand

Output Determination in Pure Competition in the Short run

Long Run Profit Maximization Assumptions Entry and exit only Identical costs Constant-cost industry Goal of the analysis: after all long run adjustments are completed, product price will be exactly equal to, and production will occur at, each firms min average total cost. In the long run, P = min ATC Entry eliminates profits Exit eliminates losses 9-25

Long run Equilibrium Economic profit is zero for individual firms and the industry in the long run equilibrium. There is no tendency for firms to enter or leave the industry, and all existing firms are earning normal profits. Existing firms are earning normal profits.

Single Firm Industry p P p P ,00080,000100,000 New Firm Entry Eliminates Profits ATC MR MC $ D1D1 S1S1 An increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium D2D2 $ S2S2 9-27

Single Firm Industry p P p P ,00080,000100,000 Exit Eliminates Losses ATC MR MC $ D3D3 S3S3 A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium D1D1 $ S1S1 9-28

Long Run Supply Constant 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 9-29

P 0 Q Long-Run Supply Curve Constant-Cost Industry 90,000100,000110,000 Q3Q3 Q1Q1 Q2Q2 $50 P1P2P3P1P2P3 S Z1Z1 Z2Z2 Z3Z3 D3D3 D1D1 D2D2 9-30

P 0 Q Long-Run Supply Curve Increasing-Cost Industry 90,000100,000110,000 Q3Q3 Q1Q1 Q2Q2 $50 P1P1 S Y1Y1 Y2Y2 Y3Y3 D3D3 D1D1 D2D2 $40 $55 P2P2 P3P3 9-31

How would a decreasing-cost industry look? In decreasing-cost industries, firms experience lower costs as the industry expands and higher costs as the industry contracts. As a result, the long-run supply curve of a decreasing-cost industry is downward-sloping. The personal computer industry represents one such example. As the demand for personal computers increased, new manufacturers of computers and computer components expanded output and realized substantial economies of scale which led to lower per unit prices for finished products.

Pure Competition and Efficiency Productive efficiency P = minimum ATC Allocative efficiency P = MC Maximum consumer and producer surplus Dynamic adjustments “Invisible Hand” revisited 9-33

Single FirmMarket Price Quantity 0 0 Long-Run Equilibrium 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 9-34

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 9-35

Price Quantity P1P1 P2P2 D S Q1Q1 Q2Q2 f a d c b Initial Patent Price Result: Greater Quantity at Lower Prices as Predicted by the Competitive Model New Producers Enter Market 9-36 The Case of Generic Drugs As price decreases to f, Consumer surplus abc increases to adf. Producer and consumer surplus is maximized as shown by the gray triangle.

Key Terms pure competition pure monopoly 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 9-37

Next Chapter Preview… Pure Monopoly 9-38