Chapter 5: Pure Competition
Objectives of chapter 5:
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Pure competition characteristics
Demand as seen by a purely competitive seller
Profit maximization in the short-run
Marginal cost and short-run supply
Profit maximization in the long-run
Pure competition and efficiency
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Introduction
• Market structures can vary in both the theoretical
analysis and real world observation.
• If you want to go to buy Cell-card scratch card, you can
go to thousands of sellers which are present almost
everywhere.
• What happens in the market if one seller stop selling the
scratch cards?
• What happens in the market if you stop buying Cell-card
scratch cards?
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Pure competition characteristics
• Very large numbers of sellers and buyers
• Standardized product: identical products are produced
by firms in the pure competition market.
• Buyers and sellers are price takers: no influence from
any individual buyer and seller on the market.
• Free entry and exit in and out of the market.
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Demand as seen by a purely competitive
seller
• Each purely competitive firm offers only a negligible
fraction of total market supply.
• It must accept the price predetermined by the market.
(sellers are price-takers)
• Perfectly elastic demand
– The demand curve of a competitive firm is perfectly elastic.
Note that the market demand curve is different from the firm
demand curve. The firm demand curve shows the relationship
between the price and quantity demanded of the product the
firm is producing. It is a straight horizontal line a price is fixed
at any quantity demanded.
• Total revenue = Price x Quantity
• Average revenue = Total revenue / Quantity
• Marginal revenue = ∆ Total revenue / ∆ Quantity
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Demand as seen by a purely competitive
seller
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Profit maximization in the short-run
• Because the purely competitive firm is a price take, it
can maximize its economic profit only by adjusting its
output.
• In the short-run, the firm has a fixed plant; therefore,
the firm must adjust the variable resources (materials
and labor) to adjust the level of output.
• There are two ways to determine the level of output at
which a competitive firm will realize maximum profit or
minimum loss (in case of loss).
– Total revenue and total cost comparison
– Marginal revenue and marginal cost comparison
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Total revenue and total cost comparison
• Economic profit = Total revenue – Total cost
• The firm will choose an output level (Q) that makes its
economic profit maximum.
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Marginal revenue and marginal cost
comparison
• The firm will make maximum economic profit when
marginal revenue = marginal cost
• If the marginal revenue is greater than the marginal
cost, this means that producing one more unit of the
product will add economic profit to the firm (economic
profit increases).
• If the marginal revenue is less than the marginal cost,
this means that producing one more unit of the product
will add negative economic profit (or economic loss) to
the firm (economic profit decreases)
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Marginal revenue and marginal cost
comparison
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Short-run equilibrium
MR = P
MR = MC
P = MC
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Shutdown point
• This point is where AVC is at its minimum.
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Marginal cost and short-run supply
• The short-run market supply curve shows the quantity
supplied by all firms in the market at each price when
each firm’s plant and the number of firms remain the
same.
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Market supply curve
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Market equilibrium
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Profit maximization in the long-run
• Entry and exit only: entry and exit of the firm are the
only adjustments for profit maximization in the long-run.
• Identical cost: all the firms have the same cost.
• Constant-cost industry: the entry and exit of the firm
do not affect the prices of the resources.
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Profit maximization in the long-run
• Entry eliminates economic profits.
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Profit maximization in the long-run
• Entry eliminates economic profits.
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Profit maximization in the long-run
• Exit eliminates economic losses.
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Profit maximization in the long-run
• Exit eliminates economic losses.
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A permanent change in demand
• A decrease in demand shifts the market demand curve
leftward. The market price falls, and each firm
decreases the quantity it produces.
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A permanent change in demand
• Economic losses induce some firms to exit in the long
run, which decreases the market supply and the price
starts to rise.
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A permanent change in demand
• A new long-run equilibrium occurs when the price has
risen to equal minimum average total cost. Firms make
zero economic profits, and firms no longer exit the
market.
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A permanent change in demand
• A new long-run equilibrium occurs when the price has
risen to equal minimum average total cost. Firms make
zero economic profits, and firms no longer exit the
market.
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External Economies and Diseconomies
• The change in the long-run equilibrium price following a
permanent change in demand depends on external
economies and external diseconomies.
• External economies are factors beyond the control of
an individual firm that lower the firm’s costs as the
industry output increases.
• External diseconomies are factors beyond the control
of a firm that raise the firm’s costs as industry output
increases.
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The long-run market supply curve
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The long-run market supply curve
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The long-run market supply curve
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Long-run equilibrium
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Long-run equilibrium
P = MC = Minimum ATC
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Pure competition and efficiency
• Efficient Use of Resources
– Resources are used efficiently when no one can be made better
off without making someone else worse off.
• Productive efficiency: P = Minimum ATC
– In the long-run, pure competition forces firms to produce at
minimum average total cost of production. This means that the
minimum amount of resources will be used to produce any
particular output.
• Allocative efficiency: P = MC
– Underallocation: P > MC (the firm is not yet at the maximum
profit point)
– Overallocation: P < MC (the firm is over the maximum profit
point)
• Dynamic adjustment: ability to restore efficiency.
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