Copyright McGraw-Hill/Irwin, 2002 Chapter 23: Pure Competition

Copyright McGraw-Hill/Irwin, 2002 Very large number of firms, standardized product, new firms can enter or exit from the industry very easily FOUR MARKET MODELS Pure Competition

Copyright McGraw-Hill/Irwin, 2002 One firm is the sole seller of a product, entry of additional producers is blocked, produces a unique product, it makes no effort to differentiate its product. Pure Competition FOUR MARKET MODELS Pure Monopoly

Copyright McGraw-Hill/Irwin, 2002 Pure Competition Pure Monopoly FOUR MARKET MODELS Imperfect Competition

Copyright McGraw-Hill/Irwin, 2002 Relatively large number of sellers, producing different products, widespread non-price competition, product differentiation. Pure Competition Pure Monopoly FOUR MARKET MODELS Monopolistic Competition

Copyright McGraw-Hill/Irwin, 2002 Few sellers of an identical product, each is affected by decisions of others. Pure Competition Pure Monopoly Monopolistic Competition FOUR MARKET MODELS Oligopoly

Copyright McGraw-Hill/Irwin, 2002 Perfect Competition 1.Very large numbers Very large number of independently acting sellers (e.g. farm products, stock market, foreign exchange market. 2.Standardized product Identical or homogeneous product. As long as the price is the same, consumers will be indifferent about which seller they buy the product from

Copyright McGraw-Hill/Irwin, Price takers - Individual firms have no significant control over the market price. Each firm’s quantity is too small to affect the market supply or price. - Competitive firms are price takers, they cannot affect the price, but adjust their own price to it. - None of the sellers can ask for a higher price because it will lose all consumers. - None will sell at a lower price because it will incur a loss.

Copyright McGraw-Hill/Irwin, Free entry and exit New firms can freely enter and existing firms can freely leave the market. No significant legal, technological, financial, or other obstacles prohibit new firms from selling their output in the market. Relevance of pure competition Pure competition is rare. It is highly relevant, we can learn much about markets by studying the pure competition model. It is meaningful as a starting point for discussing price and output determination. Useful to compare with other markets with regard to efficiency, price and output.

Copyright McGraw-Hill/Irwin, 2002 Revenue Total Revenue (TR) Equals the price times the quantity (TR=P x Q). Total revenue increases by a constant amount for each unit sold. Average Revenue (AR) Revenue per unit sold (AR = TR/Q). The firm’s demand schedule is its revenue schedule. Price and average revenue are the same (P=AR). Marginal Revenue (MR) The change in total revenue due to the change in the quantity sold by one unit (MR = ΔTR/ Δ Q). Marginal revenue is constant because price is constant. Marginal revenue equals the price.

Copyright McGraw-Hill/Irwin, 2002 Note Only in a competitive market: Price = Average revenue = Marginal revenue

Copyright McGraw-Hill/Irwin, 2002 $131 0$ 0 Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER

Copyright McGraw-Hill/Irwin, 2002 $ $ $131 Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER ]

Copyright McGraw-Hill/Irwin, 2002 $ $ $ Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER ] ]

Copyright McGraw-Hill/Irwin, 2002 $ $ $ Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER ] ] ]

Copyright McGraw-Hill/Irwin, 2002 $ $ $ Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER ] ] ] ]

Copyright McGraw-Hill/Irwin, 2002 $ $ $ Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER ] ] ] ] ] ] ] ] ] ]

Copyright McGraw-Hill/Irwin, 2002 $ $ $ Product Price (P) (Average Revenue) Total Revenue (TR) Marginal Revenue (MR) Quantity Demanded (Q) DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER ] ] ] ] ] ] ] ] ] ]

Copyright McGraw-Hill/Irwin, 2002 Perfectly elastic demand A firm cannot obtain a higher price by restricting its output, nor does it need to lower its price to increase its sales volume. Demand curve faced by the individual competitive firm is perfectly elastic at the market price Note that competitive market demand curve is a downward sloping curve.

Copyright McGraw-Hill/Irwin, 2002 DEMAND, MARGINAL REVENUE, AND TOTAL REVENUE IN PURE COMPETITION TR D = MR Price and revenue Quantity Demanded (sold)

Copyright McGraw-Hill/Irwin, 2002 SHORT RUN PROFIT MAXIMIZATION Two Approaches... First: Total-Revenue -Total Cost Approach: The Decision Rule: Produce in the short-run if you can realize: 1- A profit (or) 2- A loss less than the fixed cost The Decision Process: Should the firm produce? If YES, What quantity should be produced? and, What profit or loss will be realized?

Copyright McGraw-Hill/Irwin, 2002 Total Cost Total Product Total Fixed Cost Total Variable Cost Total Revenue Profit $ $ $ Price: $131 - $ TOTAL REVENUE-TOTAL COST APPROACH $ Can you see the profit maximization?

Copyright McGraw-Hill/Irwin, 2002 Total Cost Total Product Total Fixed Cost Total Variable Cost Total Revenue Profit $ $ $ Price: $131 - $ TOTAL REVENUE-TOTAL COST APPROACH $ Graphing Total Cost & Revenue

Copyright McGraw-Hill/Irwin, 2002 $1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1, Total revenue and total cost Total Revenue Total Cost Maximum Economic Profits $299 Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) TOTAL REVENUE-TOTAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 SHORT RUN PROFIT MAXIMIZATION Two Approaches... First: Total-Revenue -Total Cost Approach Three Characteristics: The rule applies only if producing is preferred to shutting down (otherwise the firm will shut down) Rule applies to all markets Rule can be restated as: P=MC Second Approach: Marginal-Revenue Marginal-Cost Approach MR = MC Rule

Copyright McGraw-Hill/Irwin, 2002 MR = MC rule In the short run, the firm will maximize profit or minimize losses by producing the output at which marginal revenue equals marginal cost.

Copyright McGraw-Hill/Irwin, 2002 Average Total Cost Total Product Average Fixed Cost Average Variable Cost Price = Marginal Revenue Total Economic Profit/Loss $ $ $ $ MARGINAL REVENUE-MARGINAL COST APPROACH $ Marginal Cost The same profit maximizing result!

Copyright McGraw-Hill/Irwin, 2002 Average Total Cost Total Product Average Fixed Cost Average Variable Cost Price = Marginal Revenue Total Economic Profit/Loss $ $ $ $ MARGINAL REVENUE-MARGINAL COST APPROACH $ Marginal Cost

Copyright McGraw-Hill/Irwin, 2002 Two Ways to Calculate Profit First: Calculate total profit TR = P x Q TC = ATC x Q Π = TR – TC Second: calculate profit per unit Π /Q = TR/Q – TC/Q Π /Q = P (or AR) – ATC Π = (Π /Q) x Q

Copyright McGraw-Hill/Irwin, 2002 $ Cost and Revenue MC MR AVC ATC Economic Profit $ $97.78 MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position

Copyright McGraw-Hill/Irwin, 2002 $ Cost and Revenue MC MR AVC ATC Economic Profit $ $97.78 MARGINAL REVENUE-MARGINAL COST APPROACH MR = MC Optimum Solution Profit Maximization Position

Copyright McGraw-Hill/Irwin, 2002 The MR=MC rule still applies If the price is lowered from $131 to $81 …But the MR = MC point changes Note: π = π per unit x Q MARGINAL REVENUE-MARGINAL COST APPROACH Loss Minimization Position

Copyright McGraw-Hill/Irwin, 2002 $ Cost and Revenue MC MR AVC ATC Economic Loss $81.00 $91.67 MARGINAL REVENUE-MARGINAL COST APPROACH Loss Minimization Position

Copyright McGraw-Hill/Irwin, 2002 $ Cost and Revenue MC MR AVC ATC $71.00 Short-Run Shut Down Point Minimum AVC is the Shut-Down Point MARGINAL REVENUE-MARGINAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 Marginal Cost & Short-Run Supply Price Quantity Supplied Maximum Profit (+) Or Minimum Loss (-) Observe the impact upon profitability as price is changed $ $ MARGINAL REVENUE-MARGINAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 Cost and Revenue, (dollars) MC MR 1 AVC ATC Quantity Supplied MR 2 MR 3 MR 4 MR 5 P1P1 P2P2 P3P3 P4P4 P5P5 Q2Q2 Q3Q3 Q4Q4 Q5Q5 Marginal Cost & Short-Run Supply Do not Produce – Below AVC MARGINAL REVENUE-MARGINAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 Cost and Revenue, (dollars) MC MR 1 Quantity Supplied MR 2 MR 3 MR 4 MR 5 P1P1 P2P2 P3P3 P4P4 P5P5 Q2Q2 Q3Q3 Q4Q4 Q5Q5 Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve Supply No Production Below AVC MARGINAL REVENUE-MARGINAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 Marginal Cost & Short-Run Supply AVC 2 MC 2 Higher Costs Move the Supply Curve to the Left Cost and Revenue, (dollars) MC 1 AVC 1 Quantity Supplied S1S1 S2S2 MARGINAL REVENUE-MARGINAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 Marginal Cost & Short-Run Supply AVC 2 MC 2 Lower Costs Move the Supply Curve to the Right Cost and Revenue, (dollars) MC 1 AVC 1 Quantity Supplied S1S1 S2S2 MARGINAL REVENUE-MARGINAL COST APPROACH

Copyright McGraw-Hill/Irwin, 2002 P Q S=MC AVC ATC 8 D P Q 8000 D S=  MC’s Industry Firm (price taker) Economic Profit $111 SHORT RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” its Price from the Industry Equilibrium

Copyright McGraw-Hill/Irwin, 2002 P Q S=MC AVC ATC 8 D P Q 8000 D S=  MC’s Industry Firm (price taker) Economic Profit $111 SHORT RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” it’s Price from the Industry Equilibrium

Copyright McGraw-Hill/Irwin, 2002 PROFIT MAXIMIZATION IN THE LONG-RUN Assumptions... Entry and Exit Only: the only long run adjustment is the entry and exit of firms. Identical Costs: all firms in the industry have identical cost curves. Constant-Cost Industry: entry and exit does not affect resource prices. Goal... Price = Minimum ATC Zero Economic Profit Model

Copyright McGraw-Hill/Irwin, 2002 Temporary Profits and the Reestablishment Of Long-Run Equilibrium S1S1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN MR D1D1

Copyright McGraw-Hill/Irwin, 2002 An increase in demand increases profits… MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Economic Profits S1S1

Copyright McGraw-Hill/Irwin, 2002 New Competitors increase supply and lower Prices decrease economic profits MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Zero Economic Profits S1S1 S2S2

Copyright McGraw-Hill/Irwin, 2002 Decreases in demand, Losses and the Reestablishment of Long-Run Equilibrium S1S1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D1D1 MR

Copyright McGraw-Hill/Irwin, 2002 A decrease in demand creates losses… MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Economic Losses S1S1

Copyright McGraw-Hill/Irwin, 2002 MR D1D1 MC ATC P Q 100 P Q 100,000 Industry Firm (price taker) $ $ PROFIT MAXIMIZATION IN THE LONG-RUN D2D2 Return to Zero Economic Profits S1S1 S3S3 Competitors with losses decrease supply and prices return to zero economic profits

Copyright McGraw-Hill/Irwin, 2002 LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY Constant Cost Industry Perfectly Elastic Long-Run Supply: entry and exit will set the price back to its original level Graphically...

Copyright McGraw-Hill/Irwin, 2002 P Q =$50 S D1D1 Z1Z1 Q1Q1 D2D2 Z2Z2 Q2Q2 Q3Q3 D3D3 Z3Z3 100,000110,00090,000 LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY P1P2P3P1P2P3

Copyright McGraw-Hill/Irwin, 2002 P Q =$50 S D1D1 Z1Z1 Q1Q1 D2D2 Z2Z2 Q2Q2 Q3Q3 D3D3 Z3Z3 100,000110,00090,000 LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY P1P2P3P1P2P3

Copyright McGraw-Hill/Irwin, 2002 P Q $ S D1D1 Y1Y1 Q1Q1 D2D2 Y2Y2 Q2Q2 Q3Q3 D3D3 Y3Y3 100,000110,00090,000 LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY P1P2P3P1P2P3

Copyright McGraw-Hill/Irwin, 2002 P Q $ S D1D1 Y1Y1 Q1Q1 D2D2 Y2Y2 Q2Q2 Q3Q3 D3D3 Y3Y3 100,000110,00090,000 P1P2P3P1P2P3 LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY

Copyright McGraw-Hill/Irwin, 2002 P Q $ S D1D1 Y1Y1 Q1Q1 D2D2 Y2Y2 Q2Q2 Q3Q3 D3D3 Y3Y3 100,000110,00090,000 P1P2P3P1P2P3 LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY

Copyright McGraw-Hill/Irwin, 2002 P MR Q MC ATC Quantity Price Price = MC = Minimum ATC (normal profit) LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM

Copyright McGraw-Hill/Irwin, 2002 PURE COMPETITION AND EFFICIENCY Productive Efficiency: Price = Minimum ATC Allocative Efficiency: Price = MC Underallocation: Price > MC Overallocation: Price < MC Resources are efficiently allocated Under pure competition