1. Pure Competition Chapter 7
Explanations and characteristics of the four models are outlined at the beginning of this chapter, then the characteristics of a purely competitive industry are detailed. There is an introduction to the concept of the perfectly elastic demand curve facing an individual firm in a purely competitive industry. Next, the total, average, and marginal revenue schedules are presented in numeric and graphic form. Using the cost schedules from the previous chapter, the idea of profit maximization is explored.
The total-revenue—total-cost approach is analyzed first because of its simplicity. More space is devoted to explaining the MR = MC rule, and to demonstrating how this rule applies in all market structures, not just in pure competition.
Next, the firm’s short‑run supply schedule is shown to be the same as its marginal-cost curve at all points above the average-variable-cost curve. Finally, the short‑run competitive equilibrium is discussed at the firm and industry levels.
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved

2. Monopolistic competition Oligopoly
Four Market Models
Pure competition
Pure monopoly
Monopolistic competition
Oligopoly
We will be discussing all four of these market models, but first we will start with pure competition. The other market models will be discussed in future chapters. Pure competition involves a very large number of firms producing a standardized product and there is easy entry and exit. Pure monopoly is a market structure in which one firm is the sole seller of a product or service and the entry of additional firms is blocked. Monopolistic competition consists of a relatively large number of sellers producing differentiated products. Oligopoly involves only a few sellers of a standardized or differentiated product.
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3. 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
Very large numbers of independent sellers each acting alone cannot influence the market price by increasing or decreasing their output because each has such a miniscule part of the entire market.
A standardized product is a product for which all other products in the market are identical and thus are perfect substitutes. The consequence of this is that buyers are indifferent as to whom they buy from.
Price takers have no pricing power; in other words, no ability to price their product.
Easy entry and exit means that there are no obstacles to enter or exit the industry.
Perfectly elastic demand means that the firm has no power to influence price so the firm merely chooses to produce a certain level of output at the price that is given. The demand curve is not perfectly elastic for the industry; it only appears that way to the individual firm since they must take the market price no matter what quantity they produce. The firm faces a perfectly elastic demand because each individual firm makes up such a small part of the total market and the goods are perfect substitutes. Note that this perfectly elastic demand curve is a horizontal line at the price.
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4. Average, Total, and Marginal Revenue
Firm’s
Demand
Schedule
(Average
Revenue)
Revenue
Data TR P QD TR MR 1 2 3 4 5 6 7 8 9 10
$131
131 $0
131
262
393
524
655
786
917
1048
1179
1310 ]
$131
131
This graph shows a purely competitive firm’s demand and revenue curves. The demand curve (D) of a purely competitive firm is a horizontal line (perfectly elastic) because the firm can sell as much output as it wants at the market price (here, $131). Because each additional unit sold increases total revenue by the amount of the price, the firm’s total-revenue (TR) curve is a straight upsloping line and its marginal-revenue (MR) curve coincides with the firm’s demand curve. The average-revenue (AR) curve also coincides with the demand curve.
D = MR = AR
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5. Average, Total, and Marginal Revenue
Average revenue
Revenue per unit
AR = TR/Q = P
Total revenue
TR = P × Q
Marginal revenue
Extra revenue from 1 more unit
MR = ΔTR/ΔQ
When a firm charges the same price for each unit of output, the average revenue is just the price of the good. Total revenue refers to the total amount of money that the firm collects for the sale of all of the units of their good. Marginal revenue reflects the additional revenue that the firm will receive by producing one more unit of output. When the firm is deciding how much to produce, the firm considers the marginal revenue in their decision.
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6. Profit Maximization: TR-TC Approach
Three questions:
Should the firm produce?
If so, what amount?
What economic profit (loss) will be realized?
When looking at profit maximization, there are essentially three questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option.
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7. Profit Maximization: MR-MC Approach
The Profit-Maximizing Output for a Purely Competitive Firm: Marginal Revenue– Marginal Cost Approach (Price = $131)
(1)
Total
Product
(Output)
(2)
Average Fixed Cost (AFC)
(3)
Average Variable Cost (AVC)
(4)
Average Total Cost
(ATC)
(5)
Marginal Cost
(MC)
Price = Marginal Revenue
(MR)
(6)
Total Economic Profit (+)
or Loss (-)
$-100 1
$100.00
$90.00
$190
$90
$131
-59 2
50.00
85.00
135 80
131 -8 3
33.33
80.00
113.33 70
+53 4
25.00
75.00
100.00 60
+124 5
20.00
74.00
94.00
+185 6
16.67
91.67
+236 7
14.29
77.14
91.43 90
+277 8
12.50
81.25
93.75
110
+298 9
11.11
86.67
97.78
130
+299 10
10.00
93.00
103.00
150
+280
Compare MC and MR at each level of output. The firm should continue to expand output as long as MR is greater than MC. The firm will maximize profits by producing the last unit of output where MR still exceeds the MC, or where MR = MC. At the tenth unit MC exceeds MR. Therefore, the firm should produce only nine units to maximize profits.
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved
LO3
7-7

8. Profit Maximization: MR-MC Approach
$200
150
100 50
MR = MC MC
P=$131
Economic Profit
MR = P
ATC
Cost and Revenue
AVC
A=$97.78
This figure shows the short-run profit maximization for a purely competitive firm. The MR =MC output enables the purely competitive firm to maximize profits or to minimize losses. In this case, MR (= P in pure competition) and MC are equal at an output, Q, of nine units. At this output, P equals $131 and exceeds the average total cost, and A = $97.78, so the firm realizes an economic profit of P - A per unit. The total economic profit is represented by the green rectangle and is (Price - ATC) * 9. 1 2 3 4 5 6 7 8 9 10
Output
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9. Still produce because P > min AVC Losses at a minimum where MR = MC
Loss-Minimizing Case
Loss minimization
Still produce because P > min AVC
Losses at a minimum where MR = MC
In the short run the firm only has two choices: produce or shut down. There is not enough time in the short run for the firm to get out of the business. Given these options, sometimes the firm will produce but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down, so this is the firm’s best choice.
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10. Profit Minimization: MR-MC Approach
The Profit-Minimizing Output for a Purely Competitive Firm: Marginal Revenue– Marginal Cost Approach (Price = $81)
(1)
Total
Product
(Output)
(2)
Average Fixed Cost (AFC)
(3)
Average Variable Cost (AVC)
(4)
Average Total Cost
(ATC)
(5)
Marginal Cost
(MC)
Price = Marginal Revenue
(MR)
(6)
Total Economic Profit (+)
or Loss (-)
$-100 1
$100.00
$90.00
$190
$90
$81
-109 2
50.00
85.00
135 80 81
-108 3
33.33
80.00
113.33 70
-97 4
25.00
75.00
100.00 60
-76 5
20.00
74.00
94.00
-65 6
16.67
91.67
-64 7
14.29
77.14
91.43 90
-73 8
12.50
81.25
93.75
110
-102 9
11.11
86.67
97.78
130
-151 10
10.00
93.00
103.00
150
-220
Compare MC and MR at each level of output. The firm should continue to expand output as long as MR is greater than MC. The firm will minimize losses by producing the last unit of output where MR still exceeds the MC, or where MR = MC. At the seventh unit MC exceeds MR. Therefore, the firm should produce only six units to minimize profits.
LO3
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11. Loss-Minimizing Case Loss Cost and Revenue $200 150 100 50 1 2 3 4 5 61 2 3 4 5 6 7 8 9 10
Output MC
Loss
ATC
A=$91.67
AVC
P=$81
MR = P
This figure shows the short-run loss minimization for a purely competitive firm. If price, P, exceeds the minimum AVC (here $74 at Q = 5) but is less than ATC at the MR = MC output (here 6 units), then the firm will earn losses, but it will produce. In this instance the loss is P - A per unit, where A is the average total cost at 6 units of output and price equals $81. The total loss is shown by the red area and is equal to (P – ATC)*6.
V = $75
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12. Shutdown Case: MR-MC Approach
The Profit-Minimizing Output for a Purely Competitive Firm: Marginal Revenue– Marginal Cost Approach (Price = $71)
(1)
Total
Product
(Output)
(2)
Average Fixed Cost (AFC)
(3)
Average Variable Cost (AVC)
(4)
Average Total Cost
(ATC)
(5)
Marginal Cost
(MC)
Price = Marginal Revenue
(MR)
(6)
Total Economic Profit (+)
or Loss (-)
$-100 1
$100.00
$90.00
$190
$90
$71
-119 2
50.00
85.00
135 80 71
-128 3
33.33
80.00
113.33 70
-127 4
25.00
75.00
100.00 60
-116 5
20.00
74.00
94.00
-115 6
16.67
91.67
-124 7
14.29
77.14
91.43 90
-143 8
12.50
81.25
93.75
110
-182 9
11.11
86.67
97.78
130
-241 10
10.00
93.00
103.00
150
-320
In some cases the market price will not support any production. In this case, the firm will minimize its losses by shutting down as there is no level of output at which the firm can produce and realize a loss smaller than its total fixed cost.
LO3
7-12 12

13. Short-Run Shutdown Point
Shutdown Case
Cost and Revenue
$200
150
100 50 1 2 3 4 5 6 7 8 9 10
Output MC
ATC
V = $74
AVC
MR = P
P=$71
Short-Run Shutdown Point
P < Minimum AVC
$71 < $74
This figure shows the short-run shutdown case for a purely competitive firm. If price, P (here equal to $71), falls below the minimum AVC (here $74 at Q = 5), the competitive firm will minimize its losses in the short run by shutting down. There is no level of output at which the firm can produce and incur a loss smaller than its total fixed cost. In other words, the $100 fixed cost is the minimum possible loss.
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14. Marginal Cost and Short-Run Supply
The Supply Schedule of a Competitive Firm Confronted with Cost Data
Price
Quantity
Supplied
Maximum Profit (+)
Minimum Loss (-)
$151 10
+ $480
131 9
+299
111 8
+138 91 7 -3 81 6
-64 71
-100 61
There is a relationship between price and quantity supplied. Since P = MR for the competitive firm, the profit maximization rule MR = MC will yield the short-run supply curve. The short-run supply curve is the part of the MC that lies above the AVC curve. The schedule shows the quantity a firm will produce at a variety of prices.
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15. Marginal Cost and Short-Run Supply
Cost and Revenues (Dollars)
Quantity Supplied S MC e P5
MR5 d
ATC P4
MR4 c
AVC P3
MR3 b P2
MR2 a P1
MR1
Here is a generalized depiction of how the marginal-cost curve becomes the short-run supply curve. Examine the MC for the competitive firm. If price is below AVC, then the firm should shut down and produce 0. If the price is equal to or above AVC, the firm should produce. The MC curve that is above the AVC curve becomes the short-run supply curve. The break-even point is point d, where the firm earns a normal profit because Price = ATC here.
Shut-Down Point
(If P is Below) Q2 Q3 Q4 Q5
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16. 3 Production Questions
Output Determination in Pure Competition in the Short Run
Question
Answer
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).
We must work through these three questions sequentially every time we are confronted with a new market price. This is a great table that summarizes the steps that you need to go through to determine profit-maximizing output.
LO4
7-16

17. Firm and Industry: Equilibrium
Firm and Market Supply and the Market Demand
(1)
Quantity
Supplied,
Single
Firm
(2)
Total
1,000 Firms
(3)
Product
Price
(4)
Demanded 10
10,000
$151
4,000 9
9,000
131
6,000 8
8,000
111 7
7,000 91 6 81
11,000 71
13,000 61
16,000
The market equilibrium condition is where quantity demanded equals quantity supplied. This will occur at a price of $111 and this price is the equilibrium, or market-clearing price. We can see that the industry demand curve is a typical, downward-sloping demand even though, for the firm, the demand curve is perfectly elastic and horizontal.
LO4
7-17

18. Firm and Industry: Equilibrium
S = ∑ MCs
s = MC
Economic
profit
ATC d
$111
$111
AVC D
Short-run competitive equilibrium for (a) a firm and (b) the industry. The horizontal sum of the 1,000 firms’ individual supply curves (s) determines the industry supply curve (S). Given industry demand (D), the short-run equilibrium price and output for the industry are $111 and 8,000 units. Taking the equilibrium price as given, the individual firm establishes its profit-maximizing output at eight units and, in this case, realizes the economic profit represented by the green area.
Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price. 8
8000
(a) Single Firm
(a) Industry
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19. Profit Maximization in the Long Run
Easy entry and exit
The only long-run adjustment we consider
Identical costs
All firms in the industry have identical costs
Constant-cost industry
Entry and exit do not affect resource prices
In our model all firms have identical costs. Therefore, they will all make the same production decisions since they also all face the same market price. The goal of the firm is to make profits and avoid losses. This is easy to do in pure competition due to the easy entry into the industry and easy exit out of the industry.
7-19 19

20. Long-Run Equilibrium Entry eliminates profits Firms enter
Supply increases
Price falls
Exit eliminates losses
Firms exit
Supply decreases
Price rises
Profits attract firms from less profitable industries and losses cause them to leave the unprofitable industry to find another more profitable one. This reflects the supply determinant, a change in the number of sellers.
7-20 20

21. Entry Eliminates Economic Profits
Single firm
(b)
Industry P q Q
100
90,000
80,000
100,000 S1 MC
$60 50 40
ATC
$60 50 40 S2 MR D2 D1
These graphs show temporary profits and the reestablishment of long-run equilibrium in (a) a representative firm and (b) the industry. A favorable shift in demand (D1 to D2) will upset the original industry equilibrium and produce economic profits. As a result, those profits will entice new firms to enter the industry, increasing supply (S1 to S2) and lowering product price until economic profits are once again zero. In other words, an increase in demand temporarily raises price. Higher prices draw in new competitors. Increased supply returns price to equilibrium.
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22. Exit Eliminates Losses
Single Firm
(b)
Industry P q Q
100
90,000
80,000
100,000 S3 MC
$60 50 40
$60 50 40
ATC S1 MR D1 D3
Temporary losses and the reestablishment of long-run equilibrium in (a) a representative firm and (b) the industry. A decrease in demand temporarily lowers price. Lower prices drive away some competitors and the decrease in supply returns price to equilibrium
7-22 22

23. 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
In this first scenario, the constant-cost industry, the number of firms entering or leaving the industry does not affect costs.
In this second scenario, entry or exit of firms does affect costs. When firms enter the industry, input costs will increase; input costs will fall as firms exit the industry. The long-run supply curve is upsloping.
In the decreasing-cost industry, as the number of firms increase or decrease due to entry or exit, the industry costs change inversely. If demand for their product falls, firms will leave the industry, causing input costs to rise. If demand for their product increases, firms will enter the industry, causing input costs to fall. The long-run supply curve is downsloping.
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24. LR Supply: Constant-Cost IndustryQ P1 P2 P3
$50 S Z3 Z1 Z2
In a constant-cost industry, entry and exit of firms do not affect resource prices and therefore do not affect per-unit costs, so an increase in demand raises output but not price. Similarly, a decrease in demand reduces output but not price. Therefore, the long-run supply curve is horizontal. D3 D1 D2 Q3 Q1 Q2
90,000
100,000
110,000
LO6
7-24 24

25. LR Supply: Increasing-Cost IndustryQ S P2
$55 Y2 P1
$50 Y1 P3
$40 Y3 D2
The long-run supply curve for an increasing-cost industry is upsloping. In an increasing-cost industry, the entry of new firms in response to an increase in demand (D3 to D1 to D2) will bid up resource prices and thereby increase unit costs. As a result, an increased industry output (Q3 to Q1 to Q2) will be forthcoming only at higher prices ($55 > $50 > $45). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2. D1 D3 Q3 Q1 Q2
90,000
100,000
110,000
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26. Pure Competition and Efficiency
In the long run, efficiency is achieved
Productive efficiency
Producing where P = min ATC
Allocative efficiency
Producing where P = MC
Productive efficiency is producing goods in the least costly way. Allocative efficiency is producing the mix of goods most desired by society. Another bonus is that consumer surplus and producer surplus are maximized in the long run in pure competition.
Note: P = min ATC = MC does not occur in decreasing-cost industries.
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27. Purely competitive markets will automatically adjust to
Dynamic Adjustments
Purely competitive markets will automatically adjust to
Changes in consumer tastes
Resource supplies
Technology
Recall the “invisible hand”
Dynamic adjustments will occur automatically in pure competition when changes in demand, resource supplies, or technology occur. Disequilibrium will cause expansion or contraction of the industry until the new equilibrium at P = MC occurs.
“The invisible hand” works in a competitive market system since no explicit orders are given to the industry to achieve the P = MC result. The profit motivation brings about highly desirable economic outcomes.
7-27 27