Copyright McGraw-Hill/Irwin, 2002 Pure Competition 23 C H A P T E R

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 Market Structure Continuum Pure Competition Pure Monopoly Monopolistic Competition Oligopoly FOUR MARKET MODELS 1. Pure Competition: Very Large Numbers Standardized Product “Price Takers” Free Entry and Exit

Copyright McGraw-Hill/Irwin, 2002 Very large numbers Very large number of independently acting sellers, e.g., farm products, stock market, foreign exchange market. 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 Price takers - Individual firms exert 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 to it. - None of the sellers can ask for a higher price - None will sell at a lower price

Copyright McGraw-Hill/Irwin, 2002 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 pure competition model. It is meaningful as a starting point for discussing price and output determination.

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 Revenue Average revenue (AR) Revenue per unit The firms demand schedule is its revenue schedule Price and average revenue are the same Total revenue (TR) The price times the quantity Total revenue increases by a constant amount for each units of sales Marginal revenue (MR) ∆ TR due to ∆ Q (by one unit) MR is constant MR = P

Copyright McGraw-Hill/Irwin, 2002 note In a competitive market: Price = Average revenue = Marginal revenue P = AR = MR

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 ] ] ] ] ] ] ] ] ] ] Graphically Presented…

Copyright McGraw-Hill/Irwin, 2002 Perfectly elastic demand Demand curve faced by the individual competitive firm is perfectly elastic at the market price Note the competitive market demand curve is a down-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 PROFIT MAXIMIZATION IN THE SHORT RUN First: TR -TC Approach The Decision Rule: Produce in the short-run if: 1- make a profit, (or) 2- A loss < fixed costs The Decision Process: Should the firm produce? If so… What quantity should be produced? What profit or loss will be realized?

Copyright McGraw-Hill/Irwin, 2002 SHORT RUN PROFIT MAXIMIZATION First: TR -TC Approach The Decision Rule: Produce in the short-run if: 1- make a profit, (or) 2- A loss < fixed costs The Decision Process: Should the firm produce? If so… What quantity should be produced? What profit or loss will be realized? Applied Graphically …

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 $

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 REVENUE-TOTAL COST APPROACH

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 TOTAL REVENUE-TOTAL COST APPROACH

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 Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) TOTAL REVENUE-TOTAL COST APPROACH

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 Second: MR -MC Approach MR = MC Rule And P = MC

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 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 Graphically

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 P > ATC $ $97.78 MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position

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

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 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 MARGINAL REVENUE-MARGINAL COST APPROACH Short-Run Shut Down Point Minimum AVC is the Shut-Down Point

Copyright McGraw-Hill/Irwin, 2002 Profit maximization Rule P (or MR) =MC If and only if: P ≥ AVC min Otherwise: Shut-Down point

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

Copyright McGraw-Hill/Irwin, 2002 Cost and Revenue, (dollars) MC MR 1 AVC ATC MARGINAL REVENUE-MARGINAL COST APPROACH 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

Copyright McGraw-Hill/Irwin, 2002 Cost and Revenue, (dollars) MC MR 1 MARGINAL REVENUE-MARGINAL COST APPROACH 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

Copyright McGraw-Hill/Irwin, 2002 MARGINAL REVENUE-MARGINAL COST APPROACH 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

Copyright McGraw-Hill/Irwin, 2002 MARGINAL REVENUE-MARGINAL COST APPROACH 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

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 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 How about the long-run?

Copyright McGraw-Hill/Irwin, 2002 Profit maximization in the LR Recall: In the LR, all production factors are variable. No fixed inputs  No fixed costs

Copyright McGraw-Hill/Irwin, 2002 PROFIT MAXIMIZATION IN THE LONG-RUN Assumptions... Entry and Exit Only Identical Costs 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) $ $ LONG-RUN 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 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 P MR Q MC ATC Quantity Price Price = MC = Minimum ATC (normal profit) LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM