1. Chapter 7: Pure Competition

2. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. What is a Pure Competition? Pure competition is one of four market structures in which thousands of firms each produce a tiny fraction of market supply in their respective industries. Examples: farm commodities (wheat, soybean, strawberries, milo), the stock market, and the foreign exchange market

3. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Four Market Models Economists group industries into four distinct market structures based on their characteristics. The four market models are: Pure competition Monopolistic competition Oligopoly Pure monopoly

4. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Four Market Models Pure competition involves a very large number of firms producing a standardized product and there are no restrictions on entry. Monopolistic competition is characterized by a relatively large number of firms producing differentiated products and entry into and exit from the market are relatively easy.

5. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Four Market Models Oligopoly involves only a few large producers of homogeneous or differentiated products, so each firm is affected by the decisions of its rival and must take those decisions into consideration when setting its own price and quantity. Pure monopoly involves one firm which is the sole seller of a good or service for which there are no good substitutes.

6. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Characteristics of Pure Competition Very large numbers – a large number of independently acting sellers who offer their products in large markets. Standardized product – firms produce a product that is identical or homogenous. “Price taker” – the firm cannot change the market price, but can only accept it as “given” and adjust to it. Free entry and exit – no barriers to entry exist.

7. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Demand as Seen by a Purely Competitive Seller The demand schedule and demand curve faced by the individual firm in a purely competitive industry is perfectly elastic at the market price. Recall that the firm is a price taker and cannot influence the market price. However, the industry as a whole, which determines the market demand curve, can affect price by changing industry output.

8. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Demand as Seen by a Purely Competitive Seller INDUSTRY (OR MARKET) DEMAND AND SUPPLY INDIVIDUAL FIRM DEMAND Price P Q Quantity Price S D D

9. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Demand as Seen by a Purely Competitive Seller MARKET DEMAND AND SUPPLYFIRM DEMAND Price P1P1 Q 1 Q 2 Quantity Price S1S1 D D1D1 S2S2 If market supply increases, the market price falls. Since each firm is a price taker, it has no choice but to charge the lower price for its product. P2P2 D2D2

10. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Average and Total Revenue Average revenue (AR) is total revenue from the sale of a product divided by the quantity of the product sold. AR = TR ÷ Q Total revenue (TR) is the total number of dollars received by a firm from the sale of a product. TR = P x Q

11. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Marginal Revenue Marginal revenue (MR) is the change in total revenue that results from selling 1 more unit of output. MR = (change in TR) ÷ (change in Q) MR is constant at the market determined price—each additional unit of output produced adds the same amount to total revenue.

12. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Average, Total, and Marginal Revenue Example: Suppose the market price, P, is $4. Average revenue and marginal revenue are equal to the price. OutputPriceTRAR 0$4$0 1$4 2 $8$4 3 $12$4 4 $16$4 MR $4 Since TR = P x Q and AR = TR ÷ Q, AR = (P x Q) ÷ Q or AR = P

13. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Average, Total, and Marginal Revenue Graphically, total revenue is a straight line that slopes upward to the right. The demand, marginal revenue, and average revenue curves are horizontal at the market price P. All three curves coincide.

14. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Average, Total, and Marginal Revenue TR D = AR = MR $4 Price Quantity 1234 $8 $12

15. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Short Run Because the purely competitive firm is a price taker, it can maximize its economic profit (or minimize its economic loss) only by adjusting its output. In the short run, the firm can adjust its variable resources (but not its fixed resources) to achieve the output level that maximizes profit.

16. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Short Run In deciding how much to produce, the firm will compare the marginal revenue and marginal cost of each successive unit of output.

17. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Short Run As long as producing is preferable to shutting down, the firm should produce any unit of output whose marginal revenue exceeds its marginal cost. If the marginal cost of a unit of output exceeds its marginal revenue, the firm should not produce that unit.

18. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Short Run A method of determining the total output at which economic profit is at a maximum (or losses at a minimum) is known as the MR = MC rule. This rule only applies if producing is preferable to shutting down. In pure competition only, we can restate this rule as P = MC. A firm will adjust output until marginal revenue is equal to marginal cost.

19. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Short Run Profit Maximization If price exceeds ATC at the MR = MC output (q*), the firm will realize an economic profit equal to q*(P – ATC). Loss Minimization If price exceeds the minimum AVC but is less than ATC, the MR = MC output will permit the firm to minimize losses equal to q*(P – ATC).

20. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. MC MR P Q ATC AVC A Profitable Firm in Pure Competition P* ATC q* ECONOMIC PROFIT Using the MR = MC rule, output is q*. Since price is greater than ATC at q*, the firm is earning an economic profit.

21. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. The price is less than ATC at q* so the firm is making a loss. Since price is greater than the minimum AVC at q*, the firm continues to operate at a loss. MC MR P Q ATC AVC A Firm in Pure Competition that Continues to Operate P* ATC q* AVC LOSS

22. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Short Run Shutdown If price falls below the minimum AVC, the competitive firm will minimize its losses in the short run by shutting down. A firm shuts down if the total revenue that it would get from producing is less than the variable costs of production.

23. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Marginal Cost and Short-Run Supply P1P1 P2P2 P4P4 P3P3 Break-even (normal profit) point Shutdown point (if P is below) MC quantity ATC AVC Price MR 1 MR 2 MR 3 MR 4 MR 5 P5P5 Q 2 Q 3 Q 4 Q 5

24. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Marginal Cost and Short-Run Supply Generalized Depiction Price P 1 is below the firm’s minimum AVC; the firm will not operation and quantity supplied will be zero. Price P 2 is just equal to the minimum AVC. The firm will produce at a loss equal to its fixed cost. Between price P 2 and P 4, the firm will minimize its losses by producing and supplying the MR = MC quantity.

25. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Marginal Cost and Short-Run Supply Generalized Depiction At price P 4, the firm will just break even and earns a normal profit. At price P 5, the firm will realize an economic profit by producing to the point where MR (=P) = MC.

26. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Marginal Cost and Short-Run Supply The competitive firm’s short-run supply curve tells us the amount of output the firm will supply at each price in a series of prices. It is the portion of the MC curve above the shutdown point. It slopes upward because of the law of diminishing returns.

27. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Firm and Industry: Equilibrium Price Equilibrium price is determined by the intersection of total, or market, supply and total demand. The individual supply curve of each of the identical firms in an industry are summed horizontally to get the total supply curve. The market supply together with market demand will determine the equilibrium price in a competitive industry.

28. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Profit Maximization in the Long Run The long-run assumptions in a competitive industry are: The only adjustment is the entry or exit of firms. All firms in the industry have identical cost curves. The industry is a constant cost industry.

29. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Goal of Our Analysis After all long-run adjustments are completed, product price will be exactly equal to, and production will occur at, each firm’s minimum average total cost. Firms seek profit and shun losses Firms are free to enter and leave the industry

30. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Equilibrium In long-run equilibrium, firms earn zero economic profit. There is no tendency for firms to enter or leave and the existing firms earn a normal profit. P (=MR) = MC = minimum ATC

31. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Equilibrium INDUSTRYSINGLE FIRM Price $50 10,000 Quantity Price S D MR $50 MC ATC Q1Q1

32. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Equilibrium Suppose the market demand for the product increases. Product price will rise, each firm’s marginal-revenue curve will shift upward, price will exceeds ATC at the MR = MC output, and firms will realize an economic profit.

33. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Equilibrium INDUSTRYSINGLE FIRM Price $50 10,000 Quantity Price S1S1 D1D1 MR 1 $50 MC ATC Q1Q2Q1Q2 D2D2 $60 MR 2

34. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Equilibrium When existing firms are earning economic profit, new firms are lured into the industry and will enter, the market supply curve will shift right, and there will be downward pressure on equilibrium price. (If firms are making losses, the opposite will occur.) Long-run equilibrium will be restored as price and minimum ATC equalize once again.

35. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Equilibrium INDUSTRYSINGLE FIRM Price $50 Quantity Price S1S1 D1D1 MR 1 $50 MC ATC Q1Q1 D2D2 $60 MR 2 S2S2 15,000

36. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Supply in a Constant-Cost Industry In a constant-cost industry, the long-run supply curve is horizontal. The entry of new firms has no effect on resource prices and thus no effect on production costs.

37. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Supply in a Increasing-Cost Industry An increasing-cost industry is an industry in which the entry of new firms raise the prices for resources and thus increases their production costs. As the industry expands (or contracts), it produces a larger (smaller) output at a higher (lower) product price. The result is a long-run supply curve that is upsloping.

38. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Supply: Constant-Cost versus Increasing-Cost Industry

39. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Long-Run Supply in a Decreasing-Cost Industry In decreasing-cost industries, firms experience lower costs as the industry expands. Thus, the long-run supply curve of a decreasing-cost industry is downsloping.

40. McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Pure Competition and Efficiency In long-run equilibrium, the triple equality of P = MC = minimum ATC tells us that: Firms will only earn a normal profit Firms in a competitive industry use the limited resources in a way to maximize the satisfaction of consumers This leads to allocative and productive efficiency