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R. Larry Reynolds ã 1997

2. Principles of Microeconomics
Pure Competition
The word “competition” may be used in two ways;
rivalry - {synonym; opposition, antagonism}
structural competition or “pure competition”
large number of sellers and buyers, none of whom can influence the market,
homogeneous or identical products products,
relatively free entry and exit from the market. There are no major Barriers to Entry.
[Perfect competition includes complete infromation]
Fall ‘ 97
Principles of Microeconomics

3. Principles of Microeconomics
Price Takers
Because there is a large number of sellers with identical products, no seller can charge a price above the prevailing market price.
There is no reason to sell below the market price.
Result: firms are “price takers,” they have no control over the price at which they sell. They may adjust the method and level of output, not the selling price.
The market sets the price. Sellers and buyers react.
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Principles of Microeconomics

4. Principles of Microeconomics
Firm’s Output
The firm’s choice of method and level of output is dependent on costs and revenue associated with each output alternative.
The costs of production are reflected in the supply side of the model.
the revenue of the firm is reflected in the demand functions.
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Principles of Microeconomics

5. Principles of Microeconomics
Markets and Firms
The role of a market is to coordinate the activities of all the producers and buyers of a good.
A firm is an organization that controls the operations of the plant(s) or the physical units of production.
For purposes of simplification we will consider a firm that has a single plant and one good that they produce.
Fall ‘ 97
Principles of Microeconomics

6. Principles of Microeconomics$
QX(millions) ut
QX/ut $
Firm
In the market there are a large number of firms that produce and offer for sale a large output. Each firm’s output is small.
Market S
Dmarket
Dfirm PE PE
The demand function faced by the firm is perfectly elastic!
QME
The market demand and supply functions determine the equilibrium price and quantity.
A single firm produces a small portion of the market output
and must sell at the market price.
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Principles of Microeconomics

7. Principles of Microeconomics$
QX(millions) ut
QME PE
QX/ut
Firm
Market
Dmarket S PE
Dfirm
Dfirm
AR = PE
Average revenue
As a price taker, the firm cannot raise price above PE. There is no reason to sell for less. The firm can sell all it wants and can produce at PE .
Since each unit can be sold at the price [PE ], the Dfirm is also the average revenue [AR]. PE = AR = Demand
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Principles of Microeconomics

8. Average and Marginal Revenue
Total revenue is Price times Q: TR =PQ
AR is total revenue divided by Q; it is the revenue per unit of output. TR divided by Q is P, so AR = P. AR , price and the demand function are the same thing.
MR is the change in Total revenue associated with a change in quantity sold.
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Principles of Microeconomics

9. Principles of Microeconomics
AR and TR Revenue Functions: .
Q/ut $
TR = PQ
[cancel Q’s] TR 30
AR = TR Q = PQ 6
= P
AR = P
Consider a purely competitive firm that faces a P = $5. . 10 .
Since it can sell all it wants at $5/unit, AR = 5. 2 AR
D =
P= 5 1
The demand faced by the firm is P =f(Q), P=5 for any Q.
TR is a straight line with a slope equal to price. This is true only in pure comp. where demand is perfectly elastic.
For Q = 1, TR = PQ = 5X1 = 5
For Q = 2, TR = PQ = 5X2 = 10
For Q = 6, TR = PQ = 5X6 = 30
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Principles of Microeconomics

10. Principles of MicroeconomicsAR
D =
Q/ut $
P= 5 1 2 10 6 30 TR
MR, AR and TR Revenue Functions:
TR = PQ
AR = P
DTR DQ
MR =
The slope of TR = MR = P
Consider a purely competitive firm that faces a P = $5.
P = MR =
TR is a straight line with a slope equal to price* [in this example $5].
[When Demand is perfectly elastic!]
DTR DQ
Since
MR =
, MR is the slope of the TR which is the price. Because it is a purely comp. firm, each additional unit can be sold at the same price. P = MR.
{* only in pure comp}
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Principles of Microeconomics

11. Principles of Microeconomics
Pure Competition
D*market $
QX(millions) ut
Market
QX/ut $
Firm S
Dmarket
D*firm PH PH
Dfirm PE PE
QME Q
An increase in the demand in the market
causes an increase in both the output and equilibrium price [to PH].
The demand function [or AR, MR] faced by the firm increases to D*.
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Principles of Microeconomics

12. Principles of Microeconomics$
QX(millions) ut
Market
QX/ut $
Firm S
Dmarket
D*firm PH PH
Dfirm PE PE Q
QME
causes a decrease in output and increase in equilibrium price [to PH].
A decrease in supply in the market
The demand function [or AR] faced by the firm increases to D*.
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Principles of Microeconomics

13. Principles of Microeconomics
Pure Competition $
QX(millions) ut
Market
QX/ut $
Firm S
Dmarket S*
Dfirm PE D* PE PL PL PL
D*firm
D*firm
QME
An increase in supply lowers the equilibruim price in the market and the price, AR of the firm.
A decrease in demand would have the same result in price.
Fall ‘ 97
Principles of Microeconomics

14. Short Run Profit Maximization
Profits [p] = TR - TC. [p are often the objective or goal of firm.]
The firm will choose to produce and offer for sale all additional units of output that they can produce for a cost [MC] that is less than the additional revenue [MR] that they collect.
Maximum profits [or minimum loses] for a firm occur when MR = MC.
Ideally, the market will “signal” the costs of sellers and benefits to buyers with the market price; P = MR = MC
Fall ‘ 97
Principles of Microeconomics

15. Principles of Microeconomics$
In pure comp, each
firm can sell entire
output at market price. TR is linear with
slope = P. TC TR
TR =TC
Notice that the slope of TC, [MC] is the same as the slope of TR [MR] at Q*. MC = MR!
slope of TC=MC
TR = TC at Q1 & Q4. These are the levels of output where the firm “breaks even.”
DTR
DTC
TR =TC
A firm producing at Q1 would increase output to Q* because the TC would increase by less than the TR. DQ Q1 Q* Q4
Q/ut
At output Q*, the vertical distance between TR and TC is the greatest. Since TR - TC = p, this is maximum p.
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Principles of Microeconomics

16. Principles of Microeconomics
Q/ut $ TR TC Q1
TR =TC Q4 Q*
At output Q*, the vertical distance between TR and TC is the greatest. Since TR - TC = p, this is maximum p.
slope of TC=MC
The firm would not increase production above Q* because TC will increase by more than TR. MC > MR
DTR DQ
DTC
Since DTR [MR] is less than DTC [MC], p would fall if output were expanded to Q4 . DQ
At Q* MR = MC; Maximum p.
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Principles of Microeconomics

17. Principles of Microeconomics
Short Run Profit Maximization
In the short run the firm is a price taker. Given the price in the market and the fixed input(s), the firm’s only alternatives are the amount of the variable input and consequently, the output [Q].
At output levels Q1 & Q4, the firm “breaks even.” AR = ATC and TR = TC.* [Includes “normal p.]
Firm MC $
ATC
[* (AR)Q=TR=TC=(ATC)Q]
D = AR = MR PE
The MC of producing the output between Q3 and Q* is less than the market price [ MR = P]: TR increases “faster” than TC, Maximum profits at Q*! C3
QX/ut Q1 Q3 Q* Q4
The firm’s minimum cost per unit [C3 ] is at Q3. This is the maximum p per unit, not maximum p.
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Principles of Microeconomics

18. Principles of Microeconomics
Short Run Profit Maximization
p is TR - TC, so (PE -C3)Q3 = p.
At Q3 the TC is C3 Q3;
TR is PE Q3.
By increasing production from Q3 to Q*, the TC will increase;
TR increases;
The Dp is the area above MC and below MR.
Firm MC $
ATC . Dp
D = AR = MR PE p
MAXIMUM p IS WHERE MC = MR ! C3
DTR TC
DTC
QX/ut Q1 Q3 Q* Q4
[At Q3 the cost per unit [ATC] is a minimum.]
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Principles of Microeconomics

19. Principles of Microeconomics
COST Q FC VC TC
AVC
ATC MC
At Q = 0, the only cost is FC.
FC is a constant and remains unchanged in the short run.
$10 $0 --
Variable Cost [VC] increases as output increases. 1 2 3 4 5 6 7 8 9 10
$10 $5 $8 $9
$12
$18
$27
$39
$54
$73
$99
$15
$18
$19
$22
$28
$37
$49
$64
$83
$109
5.00
4.00
3.00
15.
9.00
6.33
5.50 $5 $3
$ 1 $6 $9
$12
$15
$19
$26
Total cost [TC] = VC + FC
VC/Q = AVC. AVC first decreases,
3.00
3.60
4.50
5.57
6.75
8.11
9.90
then increases.
5.60
6.17
7.00
8.00
9.22
10.90
ATC = TC/Q. ATC decreases,
then increases.
MC is the change in TC [or VC] that is associated with change in output [Q].
MC =
DTC DQ
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Principles of Microeconomics

20. Principles of Microeconomics
COST Q FC VC TC
AVC
ATC MC
$10 $0 -- 1 2 3 4 5 6 7 8 9 10 $5 $8 $9
$12
$18
$27
$39
$54
$73
$99
$15
$19
$22
$28
$37
$49
$64
$83
$109
5.00
4.00
3.00
3.60
4.50
5.57
6.75
8.11
9.90
15.
9.00
6.33
5.50
5.60
6.17
7.00
8.00
9.22
10.90 $3
$ 1 $6
$26
The most “efficient” use of the variable input is between the 3rd and 4rth units of Q.* [min AVC and max AP are same.]
The lowest cost per unit, [min ATC] is between the 4rth and 5th units of output.*
If the objective is to MAX p, the firm will produce and offer output for sale so long as the additional unit cost [MC] is less than the price at which it can be sold [MR = P in pure competition].
{*Remember MC = AVC and ATC at their minimums !}
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Principles of Microeconomics

21. Principles of Microeconomics
COST Q FC VC TC
AVC
ATC MC
$10 $0 -- 1 2 3 4 5 6 7 8 9 10 $5 $8 $9
$12
$18
$27
$39
$54
$73
$99
$15
$19
$22
$28
$37
$49
$64
$83
$109
5.00
4.00
3.00
3.60
4.50
5.57
6.75
8.11
9.90
15.
9.00
6.33
5.50
5.60
6.17
7.00
8.00
9.22
10.90 $3
$ 1 $6
$26
Given the cost structure of the firm in our example and a market price of $13; p
The most “efficient” use of the variable does not max p.
Q = 3; TR = PQ= ($13)3 = $39 TC = $19, p = TR-TC = $39-$19 = $20
$20
$30
Q = 4; TR = PQ= ($13)4 = $52 TC = $22, p = TR-TC = $52-$22 = $30
$37
$41
At the least cost per unit [min ATC], p = $65-$28=$37
Q = 6; TR = PQ= ($13)6 = $78 TC = $37, p = TR-TC = $78-$37 = $41
The 6th unit can be produced for a cost [MC] of $9 and sold for $13, that would add $4 to p .
Fall ‘ 97
Principles of Microeconomics
Should the 7th unit be produced?

22. Principles of Microeconomics
Should the 7th unit be produced?
COST Q FC VC TC
AVC
ATC MC
$10 $0 -- 1 2 3 4 5 6 7 8 9 10 $5 $8 $9
$12
$18
$27
$39
$54
$73
$99
$15
$19
$22
$28
$37
$49
$64
$83
$109
5.00
4.00
3.00
3.60
4.50
5.57
6.75
8.11
9.90
15.
9.00
6.33
5.50
5.60
6.17
7.00
8.00
9.22
10.90 $3
$ 1 $6
$26
The MC of the 7th unit is $12, it can be sold for $13, that would increase p by $1. p
<-$10>
Q = 7; TR = PQ= ($13)7 = $91 TC = $49, p = TR-TC = $91-$49 = $42
<-$2>
$ 8
As long as MR [P in pure comp] exceeds MC {and AVC}, produce & sell if max p is the goal.
$20
$30
$37
$41
$42
The 8th unit will increase costs by $15 [MC=15] and can be sold for $13. Do you want to produce it?
$40
$34
$21
NO !
Q = 8; TR = PQ= ($13)8 = $104, TC = $64, p = TR-TC = $104-$64 = $40
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Principles of Microeconomics

23. Principles of Microeconomics
Loss minimization
COST Q FC VC TC
AVC
ATC MC
$10 $0 -- 1 2 3 4 5 6 7 8 9 10 $5 $8 $9
$12
$18
$27
$39
$54
$73
$99
$15
$19
$22
$28
$37
$49
$64
$83
$109
5.00
4.00
3.00
3.60
4.50
5.57
6.75
8.11
9.90
15.
9.00
6.33
5.50
5.60
6.17
7.00
8.00
9.22
10.90 $3
$ 1 $6
$26 p
Due to market conditions, the price falls to $5.
<-10>
<-10>
Profits are calculated: p = TR - TC = PQ -TC.
<- 8>
<- 4>
<- 2>
If the firm “shuts down” the loss is $10.
<- 3>
<- 7>
<-14>
If the firm will produces as long as MR = P > MC and is greater than AVC, they can reduce their losses. Loss is $2.
<-24>
<-38>
<-59>
Fall ‘ 97
Principles of Microeconomics

24. Principles of Microeconomics
Short Run Loss Minimization
When the price is greater than PP , the firm can make an economic p . At a price, PP, the firm “breaks even.” This covers a “normal profit,” [ATC > P = MR > AVC ] MC $
Firm
ATC
AVC
If the price falls below PL , the firm should “shut down” to minimize losses. [ P = MR < AVC] PP PL
QX/ut QL Q3
Between a price of PL and PP, the firm will lose money but can minimize losses by producing where MC = MR between output levels QL & Q3.
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Principles of Microeconomics

25. Principles of Microeconomics
LONG RUN PROFIT MAXIMIZATION
[firm in long run]
Plant ATC* is the optimal size!
LRMC
ATC!
ATC2
ATC3
ATC*
ATC5
ATC6 $
LRAC
ATC* PP
Firms with Plant size ATC* earn economic p, this attracts entry causing the market price fall.
PM=
Cmin Q* Q
When price falls to PM , entry ceases.
In the long run, the envelope curve represented LRAC. All costs are variable in the long run.
At a price of PP , the firm can make above normal p if they have plant size ATC3 or greater and smaller than ATC6 .
Plants ATC!, ATC2 & ATC6 have costs per unit [ATC] that are greater than the price PP. They will not earn normal p. These firms must adjust or close.
Fall ‘ 97
Principles of Microeconomics

26. Principles of Microeconomics
LONG RUN PROFIT MAXIMIZATION
Envelope curve:
LRMC $
ATC*
ATC!
ATC2
ATC3
ATC5
ATC6
LRAC
MC* .
ATC* P=
Cmin Q* Q
So long as P > LRACmin, firms enter [attracted by econ p] driving price down. When P < LRACmin , firms will exit the industry causing an increase in price..
Long run equilibrium [no entry or exit and price is stable] is at a price where it is equal to minimum of the LRAC. Tangent to bottom of LRAC.
In long run equilibrium:
P = AR = MR = LRAC = LRMC = ATC* = MC*
Fall ‘ 97
Principles of Microeconomics

27. Principles of Microeconomics
LONG RUN EQUILIBRIUM:
P = AR = MR = LRAC = LRMC = ATC* = MC*
1. AR = ATC* {CONDITION FOR NORMAL p IN THE SHORT RUN.}
2. AR = LRAC {CONDITION FOR NORMAL p IN THE LONG RUN.}
3. LRAC = LRMC {CONDITION THAT INSURES MINIMUM COST PER UNIT AND OPTIMAL SIZE OR SCALE OF PLANT.}
4. ATC* = MC* {CONDITION INSURES THAT THE OPTIMAL SIZE PLANT IS OPERATED AT ITS MOST EFFICIENT LEVEL OF output.}
5. MR = MC* {CONDITION INSURES FIRM IS MAXIMIZING p IN THE SHORT RUN.}
6. P = MR = LRMC {CONDITION INSURES FIRM IS MAXIMIZING p IN THE LONG RUN RUN.}
7. P = MR = MC
[both long and short run] INSURES THAT THE FIRMS’ BEHAVIOR IS CONSISTENT WITH MAXIMUM SOCIAL WELFARE !
Fall ‘ 97
Principles of Microeconomics