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Pure Competition
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Four Market Models Pure Competition: Very Large Numbers
Standardized Product “Price Taker” Free Entry and Exit Pure Competition Monopolistic Competition Pure Monopoly Oligopoly Market Structure Continuum
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Market Demand P Downward Sloping Obeys Law of Demand D Q
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Firm's Demand Curve Firm Price Taking
Because a firm produces the same thing as so many other firms, if an individual firm increases its price, it will lose ALL of it’s business. So it has to sell the product at the market price. Note that it can sell as much as it wants at that price. The firm’s output does not alter Market Supply. 4
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Supply & Demand Determine Price
DF = MR D Q Q Market Firm
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Firm’s Demand Curve $ PM DF = MR Q 5
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Firm’s Total Revenue Curve
P TR Price Quantity (sold)
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Marginal Revenue Marginal Revenue is the increase in revenue from selling one more unit If the firm gets price p* for every unit it sells, then p* is the marginal revenue at all quantities. MR = TR Q Horizontal Demand Curve means MR = P
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Total-Revenue-Total Cost Approach
Product Price Quantity Demanded (Sold) Total Revenue Marginal Revenue $131 131 1 $ 0 131 ] $131 MR = TR Q = $131
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Total-Revenue-Total Cost Approach
Product Price Total-Revenue-Total Cost Approach Quantity Demanded (Sold) Total Revenue Marginal Revenue $131 131 1 2 3 4 5 6 7 8 9 10 $ 0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 ] ] ] ] ] ] ] ] ]
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Perfect Competition Demand, Marginal Revenue, and Total Revenue TR TR
1179 1048 917 786 655 524 393 262 131 TR Price, average and marginal revenue, total revenue (dollars) TR Firm’s Demand P = MR Q Quantity Demanded (sold)
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Profit Maximization We assume that the firm is profit maximizing.
Profit = Total Revenue - Total Cost Total Revenue is P*Q. We know what the Total Cost curve looks like, so let’s graph both
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Total Revenue and Total Cost
TC TR $ MR = Slope of TR MC = Slope of TC Maximum Profit Q* Q
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Profit Maximizing Since the perfectly competitive firm cannot choose the price, the only choice left for the firm is to choose how much to produce. The firm will choose the quantity where TR-TC is the largest, in other words - where the difference between the TR and TC curves is the biggest
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Total-Revenue-Total Cost Approach
Fixed Cost Total Variable Cost Price: $131 Total Product Total Cost Total Revenue Profit 1 2 3 4 5 6 7 8 9 10 $ 100 100 $ 0 90 170 240 300 370 450 540 650 780 930 $ 100 190 270 340 400 470 550 640 750 880 1030 $ 0 131 262 393 524 655 786 917 1048 1179 1310 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280
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Total-Revenue-Total Cost Approach
Fixed Cost Total Variable Cost Price: $131 Total Product Total Cost Total Revenue Profit 1 2 3 4 5 6 7 8 9 10 $ 100 100 $ 0 90 170 240 300 370 450 540 650 780 930 $ 100 190 270 340 400 470 550 640 750 880 1030 $ 0 131 262 393 524 655 786 917 1048 1179 1310 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280
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{ Total-Revenue-Total Cost Approach P Total Revenue Maximum Economic
1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 P Total Revenue Maximum Economic Profits $299 Break-Even Point (Normal Profit) { Total revenue and total costs (dollars) Total Cost Break-Even Point (Normal Profit) Q
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Total Revenue and Total Cost
TC TR $ MR = MC Maximum Profit Q* Q
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Marginal-Revenue-Marginal Cost Approach
Average Fixed Cost Average Variable Cost Average Total Cost Price = Marginal Revenue Total Profit or Loss Total Product Marginal Cost 1 2 3 4 5 6 7 8 9 10 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280 ] 90 80 70 60 110 130 150 $ 131 131 100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 90.00 85.00 80.00 75.00 74.00 77.14 81.25 86.67 93.00 190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 ] ] ] ] ] ] ] ] ]
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How to Find Cost Areas Revenue & Cost P MC ATC AVC Q 200 150 100 50 81
MC ATC Revenue & Cost AVC TFC 81 TVC Q
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Marginal-Revenue = Marginal Cost
150 100 50 P MC 131 MR TR = $1,179 (131 X 9) ATC Revenue and Costs (dollars) 94.78 Q
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Marginal-Revenue = Marginal Cost
150 100 50 P Economic Profit MC 131 MR ATC Revenue and Costs (dollars) 97.78 TC = $880 (97.78 X 9) Q
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The Profit Maximizing Rule
A profit maximizing firm will always produce where MC = MR. In the case of Perfect Competition, we know MR = P, so we could also say that a profit maximizing firm produces where P = MC.
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Profit Maximization MC Revenue & Cost Q p* MR MR = MC Q* MR < MC
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Firm’s Supply Curve In other words, given a price, the firm looks to the MC curve and produces that quantity. This is a supply curve. The Perfectly Competitive firm’s MC curve (the upward sloping portion of it, at least) is its Supply Curve
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Profit We can also determine exactly how much profit the firm is making. We know profit = total revenue - total cost Since ATC=TC/Q, we know ATC*Q =Total Cost We also know that total revenue = price*Q So Profit = (p*Q) - (ATC*Q) = (p- ATC)*Q graphically...
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Profit p MC ATC D C p* MR AVC B A O Q Q 21
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Profit p MC ATC AVC Q MR Profit C D B A AREA: TR = OQCD TC = OQBA
Profit = ABCD Profit/unit = CB O Q Q
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Profit p MC ATC p* MR AVC atc Q* Q 22
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Loss Note that as long as p>ATC at Q*, there will be a profit.
But it may be possible that no matter how much is produced, the firm will still lose money In this case the Q* is the quantity where the firm loses the least amount of money For example...
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Loss p MC ATC AVC atc p* MR Q Q* 24
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Loss p MC ATC AVC atc TC p* MR Q Q*
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Loss p MC ATC AVC atc p* MR TR Q Q*
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Loss P MC ATC AVC atc Loss p* MR Q* Q 25
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Maximixed Loss P MC ATC AVC atc Loss MR P* =AVC Q Q* 25
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Normal profit P MC ATC AVC MR P* =ATC Q* Q 25
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The decision of whether to stay open
Just because a firm is losing money in the short run doesn’t mean it should close its doors. Often we hear of major firms like IBM posting a loss, but they stay open When does a firm shut down? If P < or = AVC 26
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Short-run loss minimization
If the Market Price is lowered from: $131 to $81
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Total-Revenue-Total Cost Approach
Fixed Cost Total Variable Cost Price: $81 Total Product Total Cost Total Revenue Profit 1 2 3 4 5 6 7 8 9 10 $ 100 100 $ 0 90 170 240 300 370 450 540 650 780 930 $ 100 190 270 340 400 470 550 640 750 880 1030 $ 0 81 162 243 324 405 486 567 648 729 810 - $100 - 109 - 108 - 97 - 76 - 65 - 64 - 73 - 102 - 151 - 220
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Loss Minimization P > AVC
200 150 100 50 MC ATC Revenue & Cost AVC Loss 81 MR Q
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Loss Minimization P > AVC
200 150 100 50 MC ATC Revenue & Cost AVC TFC 81 MR Q
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The decision of whether to stay open
If AVC<P*<ATC, then the firm is losing money, BUT they are getting enough revenue to pay all of the variable cost and some of the fixed cost. If they shut down, they will have to pay all of the fixed cost with no revenue. So they are better off staying open and being able to pay some of the fixed costs.
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Total-Revenue-Total Cost Approach
Fixed Cost Total Variable Cost Price: $71 Total Product Total Cost Total Revenue Profit 1 2 3 4 5 6 7 8 9 10 $ 100 100 $ 0 90 170 240 300 370 450 540 650 780 930 $ 100 190 270 340 400 470 550 640 750 880 1030 $ 0 71 142 213 284 355 426 497 568 639 710 - $100 - 119 - 128 - 127 - 116 - 115 - 124 - 143 - 182 - 241 - 320
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Loss Minimization P < AVC
200 150 100 50 MC Revenue & Cost ATC TFC AVC 71 MR At no point is P > AVC Therefore Shut-down! Q
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Loss Minimization P < AVC
200 150 100 50 MC Economic Loss Revenue & Cost ATC AVC 71 MR When price is inadequate to meet minimum AVC, the firm should shut down Q
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The Shut Down Point Shut-down Point - P = min AVC Firm Supply Curve
Firm is indifferent between staying in business and going out of business. Firm Supply Curve MC curve at or above the Shut-down Point
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Firm’s Short-run Supply Line
MC Costs and revenues (dollars) ATC AVC P3 MR3 P2 MR2 This is the lowest price that any units will be supplied Q Q2 Q3
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Firm’s Short-run Supply Line
Break-even (normal profit) point MC Costs and revenues (dollars) ATC P4 MR4 AVC P3 MR3 P2 MR2 At a higher price a greater quantity will be supplied Q Q2 Q3 Q4
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Firm’s Short-run Supply Line
Making Economic Profit MC P5 MR5 Costs and revenues (dollars) ATC P4 MR4 AVC P3 MR3 P2 MR2 Q Q2 Q3 Q4 Q5
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Cost Curve at points above AVC represent the short-run
Firm’s Short-run Supply Line P Short-run Supply Curve MC P5 MR5 Costs and revenues (dollars) ATC P4 AVC MR4 P3 MR3 P2 MR2 The Marginal Cost Curve at points above AVC represent the short-run supply curve Q Q2 Q3 Q4 Q5
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Profit Maximizing in the Short Run
In the short run, the firm takes the market price, given by the intersection of the market supply and demand curves. The firm then produces where MC=MR and takes a profit or loss as long as P>AVC
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Profit Maximizing in Short Run
MR p* D Q Q Market Firm 33
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Profit Maximizing in Short Run
MC P MR p* D Q Q Market Firm 34
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Profit Maximizing in Short Run
MC P MR p* ATC D Q Q Market Firm 35
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Profit Maximizing in Short Run
MC P P MR p* ATC AVC D Q Q Q* Market Firm 36
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Profit Maximizing in Short Run
MC P P MR p* ATC AVC D Q Q Firm Q* Market 37
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Profit Maximizing in Short Run
MC P MR p* Profit ATC AVC D Q Q Firm Q* Market 38
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Profit Maximizing in Short Run
It is also possible that the market price is so low (of the ATC is so high) that the firm will lose money
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Profit Maximizing in Short Run (Losses - not shut-down)
MC P ATC AVC Loss p* MR D Q Q Q* Market Firm 40
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The Long Run Recall that the long run is defined as the time it takes for fixed costs to change. In other words - all costs are variable. The ATC curve equals the AVC curve Also recall that Perfect Competition assumes that there is free entry and exit.
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Perfect Comp. in the Long Run
If there are profits being made in an industry, firms will enter. If there are losses in an industry, firms will leave But what happens to the market when things like this happen? Consider the previous example where the firm was making profits in the short run 42
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Profit Maximizing in Short Run
MC P MR p* Profit ATC D Q Q Q* Market Firm 43
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Profit Maximizing in Long Run
Firms see this profit and enter the industry More firms in an industry means market supply increases This drive price down and profits down Firms continue to enter until the price is driven down so low that profits are zero. Then no more firms want to enter and there is a long run equilbrium
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Profit Maximizing in Long-Run
S S S’ P MC P ATC p* MR Note: price is driven down to the bottom of the ATC curve MR D Q Q Q* Q* Market Firm 45
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Losses in the Long Run But what if there are losses in the long run?
If there are any losses in the long run, firms will want to leave the industry When firms leave, market supply decreases This drives up price and drives down losses Firms leave as long as there are losses. Once profits hit zero, firms stop leaving. Consider the example from earlier...
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Losses Long-Run Adjustment
P MC P ATC Loss p* MR D Q Q Q* Market Firm 48
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Losses in the Long Run S’ S P MC P ATC MR p* MR D Q Q Q* Market Firm
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In the Long Run... In the Long Run in a perfectly competitive market... there are ALWAYS zero profits P = MC = ATC The firm produces at the lowest possible cost at the minimum ATC both in the Short-run and the Long-run.
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Long-Run Equilibrium MC ATCSR LRAC Revenue & Cost p* MR Q* Q
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Constant Cost Industries
Suppose an increase in demand expands an industry This will increase profit in the short-run As firms enter the market, if costs do not change. Then the zero profit price will not change as quantity supplied in the long run expands. In this case the Long Run Supply Curve is flat
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Constant Cost Industry
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Long Run Supply If there are profits being made, firms enter and drive profits down. But as firms enter the industry, what is happening to the industry? Demand for inputs is rising and the cost of inputs is rising.
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Long Run Supply If the input costs are rising, all of the cost curves in the industry will rise Which means the bottom of the ATC curve is rising Which, in turn, means that the zero profit price has gone up
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Increasing Cost Industries
Thus the industry is called an increasing cost industry, because as more firms enter the industry and the market quantity rises, the zero profit price rises We can draw a Long Run Supply Curve which demonstrates the relationship between the long run quantity supplied and the zero profit price
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S*
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Decreasing Cost Industries
What if more firm enter the industry and that allows input suppliers to take advantage of economies of scale and make inputs at lower cost. Then as the long run quantity supplied increases, costs for the firms go down and thus the zero profit price is going down. This means the long run supply curve will be downward sloping
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The Benefits of Perfect Competition
Recall in the beginning of the semester we discussed Productive Efficiency and Allocative Effeciency. Productive Effeciency - producing as much as possible with a given amount of resources. In order to do that the firm must produce at its lowest cost level of production.
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Productive Efficiency
Therefore, a perfectly competitive market, in the long run, will always be productively efficient This is because, in the long run, a perfectly competitive firm always produces at the bottom of the ATC curve
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MB = MC Q*
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Allocative Efficiency
In the context of perfect competition, we are asking if, given the quantity produced is the amount people are willing to pay (the demand curve) equal to the amount people are willing to sell for (the Supply and the MC curve)? The answer is yes, so a perfectly competitive market is allocatively efficient as well.
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Allocative Efficiency
Note that at any quantity less than the equilibrium Q*, the amount people are willing to pay is more than the MC. If the market produces less than Q*, it is then inefficient. This is because we could take resources away from other goods and put them in this market because MC < MB.
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MB = MC Q*
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Allocative Efficiency
Note that at any quantity more than the equilibrium Q*, the amount people are willing to pay is less than the MC. If the market produces more than Q*, it is then inefficient. If we would take resources away from other products, it would not be justified because the MC > MB.
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KEY TERMS pure competition Freedom of Entry Homogenous products
Price takers total revenue marginal revenue Market Demand Firm’s Demand Curve Perfectly Elastic Shut-down rule Slope of TR and TC break-even point MR = MC rule short-run supply curve long-run equilibrium constant-cost industry increasing-cost industry decreasing-cost industry productive efficiency allocative efficiency
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