Pure Competition in the Short Run & Long Run 08 and 09 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2008 The McGraw-Hill Companies 9-2 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Chapter Objectives Names and Main Characteristics of the Four Basic Market Models Conditions for Perfect Competition How Do Purely Competitive Firms Maximize Profits or Minimize Losses Why the Marginal Cost and Supply Curves For Competitive Firms Are Identical How Industry Entry and Exit Create Economic Efficiency Differences Between Constant- Cost, Increasing-Cost, and Decreasing-Cost Industries

Copyright 2008 The McGraw-Hill Companies 9-3 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Four Market Models Pure Competition Pure Monopoly Monopolistic Competition Oligopoly Market Structure Continuum Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Imperfect Competition

Four Market Models LO1 Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic CompetitionOligopolyMonopoly Number of firmsA very large number ManyFewOne Type of productStandardizedDifferentiatedStandardized or differentiated Unique; no close subs. Control over price NoneSome, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easySignificant obstacles Blocked Nonprice Competition NoneConsiderable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising ExamplesAgricultureRetail trade, dresses, shoes Steel, auto, farm implements Local utilities 8-4

Pure Competition: Characteristics Very large numbers of sellers Standardized product “Price takers” Easy entry and exit Perfectly elastic demand Firm produces as much or little as they want at the price Demand graphs as horizontal line LO2 8-5

Average, Total, and Marginal Revenue Average Revenue Revenue per unit AR = TR/Q = P Total Revenue TR = P X Q Marginal Revenue Extra revenue from 1 more unit MR = ΔTR/ΔQ LO3 8-6

Copyright 2008 The McGraw-Hill Companies 9-7 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data Pure Competition Price and Revenue $1179 Quantity Demanded (Sold) D = MR = AR TR PQDQD MR $ $ $ ] ] ] ] ] ] ] ] ] ]

Copyright 2008 The McGraw-Hill Companies 9-8 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Profit Maximization in the Short Run Total Revenue-Total Cost Approach Consider: –Should Product Be Produced? –If So, In What Amount? –What Economic Profit (Loss) Will Be Realized?

3 Production Questions LO3 Output Determination in Pure Competition in the Short Run QuestionAnswer Should this firm produce?Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost. What quantity should this firm produce?Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Will production result in economic profit? Yes, if price exceeds average total cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR). 8-9

Copyright 2008 The McGraw-Hill Companies 9-10 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Total Revenue-Total Cost Approach Profit Maximization in the Short Run (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?

Copyright 2008 The McGraw-Hill Companies 9-11 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Total Revenue-Total Cost Approach Profit Maximization in the Short Run $ $ Total Revenue and Total Cost Total Economic Profit Quantity Demanded (Sold) Total Revenue, (TR) Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) Maximum Economic Profit $299 Total Economic Profit $299 P=$131 Total Cost, (TC) W 9.1 G 9.1

Copyright 2008 The McGraw-Hill Companies 9-12 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run Important Features: Firm Will max profits or min loss where MR = MC Profit Maximization in All Market Structures Can Be Restated P = MC

Copyright 2008 The McGraw-Hill Companies 9-13 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run (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) $

Copyright 2008 The McGraw-Hill Companies 9-14 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Cost and Revenue $ Output Economic Profit Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run MR = P MC MR = MC AVC ATC P=$131 A=$97.78 W 9.2

Copyright 2008 The McGraw-Hill Companies 9-15 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Lower the Price to $81 and Observe the Results! Cost and Revenue $ Output Loss Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run MR = P MC AVC ATC Loss Minimizing Case P=$81 A=$91.67 V = $75

Fixed Costs: Digging Out of a Hole Shutting down in the short run does not mean shutting down forever Low prices can be temporary Some firms switch production on and off depending on the market price Examples: oil producers, resorts, and firms that shut down during a recession 8-16

Copyright 2008 The McGraw-Hill Companies 9-17 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Lower the Price Further to $71 and Observe the Results! Cost and Revenue $ Output Marginal Revenue-Marginal Cost Approach MR = MC Rule Profit Maximization in the Short Run MR = P MC AVC ATC Short-Run Shut Down Case P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 V = $74

Copyright 2008 The McGraw-Hill Companies 9-18 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Marginal Cost and Short-Run Supply Continuing the Same Numeric 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 and Results

Copyright 2008 The McGraw-Hill Companies 9-19 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use 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

Copyright 2008 The McGraw-Hill Companies 9-20 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use 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)

Copyright 2008 The McGraw-Hill Companies 9-21 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Changes in Supply Firm and Industry –Equilibrium Price –Market Price and Profits –Firm Versus Industry Graphically…

Copyright 2008 The McGraw-Hill Companies 9-22 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Single Firm Industry p P p P 0 0 Changes in Supply Economic Profit d ATC AVC s = MC $111 D S = ∑ MC’s Competitive Firm Must Take the Price that is Established By Industry Supply and Demand W 9.3

Pure Competition in the Long Run 09 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Note to Students: The following material will not be covered, nor is it required reading: –Long Run Supply: Constant-Cost Industry –Long Run Supply: Increasing-Cost Industry –Long Run Supply: Decreasing-Cost Industry

Copyright 2008 The McGraw-Hill Companies 9-25 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Profit Maximization in the Long Run Assumptions –Entry and Exit Only –Identical Costs –Constant-Cost Industry Goal of the Analysis Long-Run Equilibrium –Entry Eliminates Profits –Exit Eliminates Losses

Copyright 2008 The McGraw-Hill Companies 9-26 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Single Firm Industry p P p P ,00080,000100,000 Supply Readjustment 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

Copyright 2008 The McGraw-Hill Companies 9-27 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Single Firm Industry p P p P ,00080,000100,000 Supply Readjustment 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

Copyright 2008 The McGraw-Hill Companies 9-28 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show 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

Copyright 2008 The McGraw-Hill Companies 9-29 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show 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 How Would a Decreasing-Cost Industry Look?

Copyright 2008 The McGraw-Hill Companies 9-30 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Pure Competition and Efficiency Productive Efficiency P = Minimum ATC Allocative Efficiency P = MC Maximum Consumer and Producer Surplus Dynamic Adjustments “Invisible Hand” Revisited O 9.1

Copyright 2008 The McGraw-Hill Companies 9-31 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Single FirmMarket Price Quantity 0 0 Long-Run Equilibrium Competitive Firm and Market 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

Copyright 2008 The McGraw-Hill Companies 9-32 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Efficiency Gains From Entry: Competitive Model Predicts Lower Price and Greater Output With Increased Efficiency When New Producers Enter Market Example is Patented Drugs Patents Enable Greater Profits in Support of R&D and Accelerated Cost Recovery After Patent Period Generics Enter Market Profits Decrease and Quantities Increase Combined Consumer and Producer Surpluses Increase The Case of Generic Drugs

Copyright 2008 The McGraw-Hill Companies 9-33 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Price Quantity Efficiency Gains From Entry: The Case of Generic Drugs P1P1 P2P2 D S Q1Q1 Q2Q2 f a d c b As Price Decreases to f, Consumer Surplus abc Increases to adf Producer and Consumer Surplus is Maximized Together as Shown by the Gray Triangle Initial Patent Price Results: Greater Quantity at Lower Prices as Predicted by the Competitive Model New Producers Enter Market

Copyright 2008 The McGraw-Hill Companies 9-34 Four Market Models Pure Competition Profit Maximization in the Short-Run Marginal Cost and Short-Run Supply Changes in Supply Profit Maximization in the Long Run Supply Readjustment Pure Competition and Efficiency Long-Run Equilibrium Last Word Key Terms End Show Key Terms pure competition pure monopoly monopolistic competitionmonopolistic competition oligopoly imperfect competitionimperfect competition price taker average revenue total revenue marginal revenue break-even point MR=MC short-run supply curveshort-run supply curve long-run supply curvelong-run supply curve constant-cost industryconstant-cost industry increasing-cost industryincreasing-cost industry decreasing-cost industrydecreasing-cost industry productive efficiencyproductive efficiency allocative efficiencyallocative efficiency consumer surplus producer surplus