Lecture notes March 4 & 17
Chapter 9: Pure Competition
We want to understand firm decision making in a perfectly competitive market. Before studying
this market, we will first consider the differences among market types.
4 basic Market models:
Model
# of firms
Pure
Competition
(ex/
agriculture)
Monopolistic
Competition
(ex/ retail
trade)
Oligopoly
(ex/ car
companies)
Monopoly
(ex/ local
utilities)
Type of
Control over
product
price
Standardized
None
(homogeneous)
Conditions
of entry
Easy
Non-price
competition
None
Many
Differentiated
Some (but not
much)
Fairly easy
A lot
(advertising,
etc.)
Few
Standardized
or
differentiated
Unique (no
close
substitutes)
Some, but
High
mutually
obstacles
interdependent
A lot
Blocked
Large
number of
fims
One
A lot (product
differentiation)
Public
relations and
advertising
Pure Competition Characteristics:
•
•
•
•
Large number of firms
Standardized product -> consumers indifferent as to which firm they buy from
Price taker -> since there are a large number of firms, each selling the same product, if you
raise your price, no customer will buy from you. If you lower your price you make less
profit. Therefore, you take the price of the industry.
Free Entry and Exit -> no significant legal, financial or technical barriers prevent new firms
from starting up, or old firms from closing down.
Demand for a Purely Competitive Seller:
Because the firm is a price taker, demand for its goods is perfectly elastic.
Note: market demand for the product is NOT perfectly elastic. Market demand is the standard
downward sloping curve. A firm’s individual demand is perfectly elastic only because the firm is
a price taker.
Demand and Revenue Schedule for 1 perfectly competitive firm
Price
131
131
131
131
131
131
131
131
131
131
131
Quantity
demanded
0
1
2
3
4
5
6
7
8
9
10
TR
MR=Demand
0
131
262
393
524
655
786
917
1084
1179
1310
131
131
131
131
131
131
131
131
131
131
AR=P*Q = P
Q
0
131
131
131
131
131
131
131
131
131
131
What the firm needs to decide is: at the market price of $131, how many units do they want to
supply?
They decide this by producing quantities which will maximize their profit.
Short Run Profit Maximization
Recall: in the SR, plant size is fixed. So wee need to look at TC, TVC and TFC to get a picture of
what the firms costs are.
Q
TFC
TVC
TC
TR
Profit=TR-TC
5
6
7
8
9
10
100
100
100
100
100
100
370
450
540
650
780
930
470
550
640
750
880
1030
655
786
917
1048
1179
1310
185
236
277
298
299
280
So it appears the firm would maximize profit, and therefore wish to produce at 9 units.
Note: TC includes normal profit. So the point where TR=TC is the quantity in which the firm
makes a normal profit, but not an economic profit. This is called the break even point. (see text
book illustration)
Another, easier way to find the quantity at which a firm should produce is to produce that quantity
at which MR=MC.
MR=MC rule – method of determining the total output at which economic profit is at a maximum.
1. This rule only applies if producing is preferable to shutting down
2. this rule is an accurate guide to profit maximization for ANY type of firm
3. for purely competitive firms MR=P, so the rule is the same as P=MC
We can revisit the previous example and look at Average costs to see a clearer picture.
Q
AFC
AVC
ATC
MC
P=MR
Profit=Q*MR-Q*TC
5
6
7
8
9
10
20
16.67
14.29
12.50
11.11
10
74
75
77
81
86.67
93
94
91.67
91.43
93.75
97.78
103
70
80
90
110
130
150
131
131
131
131
131
131
185
236
277
298
299
280
Graphically:
$
MC
Price=131
PROFITS
ATC
AVC
9
Note that profit = P*Q – ATC*Q, this is the shaded area.
Now what would happen if price fell to $81?
Quantity
Graphically:
$
MC
ATC
Price=81
losses
AVC
6
Quantity
Should the firm produce at this price if it is making losses? Yes. Because if it didn’t produce, it
would still lose it’s fixed cost of $100, here, the loss is only $64.
What if the price fell to $71?
Graphically:
$
MC
ATC
losses
AVC
Price=71
Quantity
Should the firm produce at this price? No, the Average cost is always above the price. That means,
no matter how many units they could produce, they will lose money on every unit they produce.
That means, profits (losses) will fall (rise) with each unit. So losing the $100 fixed cost is better
than producing and losing more than $100.
Any time the price is below the minimum of the AVC, the firm’s best decision is to shut down.
We can think of it as the shut down price.
So what does a firm’s short run supply curve look like? Well, at any price above the shut down
price, the firm will supply quantity where P=MC. Thus, their supply curve is their MC curve.
Graphically:
$
MC ( supply)
ATC
AVC
Shut down Price
Quantity
What would cause a firm’s short run supply curve to shift? A change in costs. If costs rise, the
supply curve will shift, along with the MC curve, up and to the right.
Firm and industry equilibrium price
What determines the price of the product in equilibrium? Consider: 1000 firms in the market. All
with identical costs. Then we can generate market supply.
Q single firm
10
9
8
7
6
0
Q single * 1000 firms
10000
9000
8000
7000
6000
0
Price
150
131
111
91
81
71
Remember, in the market, equilibrium occurs where supply = demand.
Quantity Demanded
4000
6000
8000
9000
11000
13000
Here we see total Quantity supplied = Quantity Demanded at a price of $111, so the equilibrium
price is $111 and the equilibrium quantity is 8000, or 8 per firm.
Price
S
111
D
8
Quantity
Long Run Profit Maximization
In the short run, firms may “shut down” by not producing. They don’t have time to liquidate
assets.
In the long run, a firm can expand or contract their plant size. ALSO, in the long run, firms may
enter or exit the industry, thereby changing the number of firms in the industry, thereby shifting
the market supply curve.
How do these long run adjustments affect our short run analysis?
Before we answer that, we make 3 assumptions:
1. We focus on long run decisions and adjustment (entry/exit) rather than short run decisions
2. All firms have identical costs
3. The industry is a constant cost industry (price of inputs doesn’t change with entry/exit of
firms)
The basic conclusion of the Long Run analysis:
Production will occur at the minimum of the firm’s Long Run ATC curve.
Why?
1. Because firms seek profit and avoid losses.
2. Firms can enter and exit the market at will.
Visually, we see that if there are profits in an industry, more firms will wish to enter and reap those
profits. As more firms enter, the market supply curve shifts out and price falls.
If there are losses in an industry, some firms will exit. As firms exit, the market supply curve
shifts in and price rises.
Equilibrium (no more entry/exit) occurs at the price that equals min ATC.
Case of Profits
Price
$
S1
MC
S2
P1
P2
profits
ATC
D
Qlr
Quantity
Qlr
Quantity
Case of losses
Price
$
MC
S2
S1
ATC
P2
P1
losses
D
Qlr
Quantity
Qlr
Quantity
As we see above, entry eliminates profits, exit eliminates losses. Note that if demand increases,
Firms will temporarily (short run) make profits. But in the long run, new firms will enter the
industry and profits will disappear. All that competitive firms make in the long run are normal
profits (which are included in their cost curves).
So, in the long run, there is no economic profit, but there is normal profit.
Note that the ATC curves above are long run ATC curves
So, given that the long run price is established where P=min ATC, we will have a long run supply
that is perfectly elastic.
Price
S1
S2
S3
P(long run)
S (long run –constant cost ind)
D1
D2
D3
Quantity
Note: this is for a constant cost industry. What would happen if we were in an increasing costs
industry? This would mean that as more firms entered, the cost of inputs would be higher.
If this is the case, than the LR ATC curve will increase when more firms enter. And we’d have an
increasing long run supply curve that looks something like this:
Price
S1 S2 S3
S(long run- increasing cost ind)
D1
D2
D3
Quantity
Decreasing cost industry implies that if more firms enter, the costs of production decrease. This
would imply a slightly downward sloping supply curve in the long run.
Efficiency
Is pure competition allocatively and productively efficient?
As we saw above, in the long run P=MR=MC=min ATC long run
Productive Efficiency- producing a set of goods the least costly way. Since we are producing at
min ATC in the long run, then it is clear that Perfect Competition is productively efficient.
Allocative Efficiency- producing the set of goods which best satisfies society’s wants. Note that
money measures the relative worth of a product compared with other goods.
Since MB=P, and P=MC, then MB=MC. This implies that the relative worth of the last unit
produced of the good is equal to the marginal cost of producing it. This means, we are allocating
as best for society. Hence, perfect competition is allocatively efficient. If we were to reallocate
resources and produce less of this good and more of another, then P>MC and we would be under
allocating resources to this good. The desire for the good is greater than the cost of the resources
which are used elsewhere. Over allocation would occur if P<MC, this means that firms should
decrease the number of resources allocated to making this good (decrease quantity), until MC rises
to meet P.
So, we can conclude that the long run equilibrium in a purely competitive industry is efficient.
Note also, purely competitive markets adjust to demand shocks quickly, as seen above, and restore
equilibrium, P=MC, in the long run.
Pure Monopoly
An industry in which only one firm is the sole seller of a product or service.
Characteristics of this market are:
1.
2.
3.
4.
Single seller
No close substitutes
High control over price
High barriers to entry
Barriers to entry include Economies of scale, Legal Barriers, Ownership, and pricing/strategy
barriers.
Economies of scale: New firms entering the market would have a hard time competing with the
older large firm because the large firm will be producing at a lower ATC position.
Legal Barriers: Patents –give exclusive rights of production to the inventor for a number of years
Liscences-government may limit entry of firms by requiring liscenses
Ownership of Resources: one firm/country may own all/most of world’s natural resource
Pricing/strategic barriers: one firm may slash prices and up advertising to make it very difficult for
a new firm to make a profit and thereby discourage entry.
How does a monopolist decide price and quantity?
First we make 3 assumtions: 1. firm is the sole producer; 2. firm is not gov’t regulated; 3. firm
charges same price to all customers.
Because the monopolist is the sole producer, its demand curve IS the market demand curve.
1. Because the market demand curve is downward sloping, the monopolist can increase sales by
decreasing price. Therefore, MR<P, unlike in perfect competition. In perfect competition, there is
one price and you can sell the quantity you want at that price. If you charge above that price, no
one will buy, so MR=0, if you charge below that price, all you will do is lower profit, so why
charge below? For a monopolist, if you lower the price, you will sell more. If you raise the price,
you will sell less. But the lower price refers to all units, not just the last unit sold, while MR refers
only to the last unit sold. As such, MR will always be lower than P for the monopolist.
2. Monopolist is price maker: by changing market supply, the monopolist determines price.
3. The monopolist will always set prices in the elastic portion of the demand curve, because it
is in this area when a price decrease will raise TR. Elsewhere, they would only be
decreasing TR.
Equilibrium: Profit Maximization is found by producing enough quantity such that MR=MC
Why? If MR>MC the firm could make more profit by producing more. If MR<MC the firm could
make more profit by producing less.
Lets look at an example. Keep in mind that Profit= TR-TC, and AR=(P*Q)/Q = P
Q
0
1
2
3
4
5
6
7
8
9
10
P
172
162
152
142
132
122
112
102
92
82
72
TR
0
162
304
426
528
610
672
714
736
738
720
MR
162
142
122
102
82
62
42
22
-2
-18
ATC
Na
190
135
113
100
94
91.67
91.43
93.75
97.78
103.33
TC
100
190
270
340
400
470
550
640
750
880
1030
MC
Profit
-100
-28
34
86
128
140
122
74
-14
-142
-310
90
80
70
60
70
80
90
110
130
150
Where should the monopolist produce? At 5 units. Then P=$122
Graphically, we can see the monopolist’s decision is at the intersection of the MC and MR curves,
and that price is determined by drawing a vertical line up from the MR=MC point. Profit is the
geometric area P*Q – ATC*Q.
$
MC
P=122
Profit
ATC
ATC
D
5
Myths of Monopolist Pricing:
1. Monopolists charge the highest price they can (false)
2. Monopolists want to maximize per unit profits (false)
3. Pure monopoly guarantees profit (false)
8
Quantity
MR
Monopolists seek to maximize total profits. This implies they likely charge a price lower than the
highest possible price. Moreover, if the demand curve is low enough, and costs are high enough,
the monopolist may not be able to make a profit no matter what price they charge.
Efficiency
Is a pure monopolist efficient?
Productive efficiency- Monopolist produces at a point where ATC> minATC. This implies that
they are not productively efficient. They find it profitable to sell smaller amounts at higher prices
than a competitive firm and thus are not at lowest ATC.
Price
S
Pm
Pc
Qm
D = MR(competitive)
MR(monopolist)
Qc
Quantity
Allocative Efficiency- since MB=P>MC then there is underallocation of resources to this product
(not enough is being produced)
Therefore Monopolies are not efficient.
It is said that Monopolists are rent seekers. Rent Seeking is action by persons, firms or unions to
gain special benefits from the government at tax payers or someone else’s expense.
However, some people argue that if a monopolist wishes to keep his/her monopoly power, he/she
is more likely than the competitive firm to stay on top of more efficient production techniques and
technological advances over time. Therefore the inefficiency of monopolies may be over stated.
In the basic model, we assumed that unit costs would be the same for a competitive firm as for a
monopolist, but this may not be so. Moreover, the value of the product may differ.
These types of complications to the basic model include:
1. Economies of Scale – when there are large economies of scale, market demand may not be
sufficient to support large numbers of competing firms.
2. Simultaneous consumption – the firm may be able to satisfy large numbers of customers at
the same time with relatively low marginal costs
3. Network effects – the more people use a product, the higher the value of the product,
including the existing ones.
4. X-inefficiency- failure to produce on the ATC curve (produce above it)
Price Discrimination
What would happen if we relaxed the assumption that a monopolist must charge the same price to
each consumer? What if the monopolist could charge a higher price to those who were willing to
pay more (those who want it more)
This behavior is called Price Discrimination – selling a product to different buyers at different
prices when the differences are not justified by differences in prices.
Ex/ airline tickets (student rates, etc)
Consequences of Price Discrimination in our model:
Because each unit is sold at a different price (the price the consumer is willing to pay) MR=D=P
1. Higher profit
2. More production (because MR=D, and production occurs where MR=MC)
We can see these effects by comparing a single price industry to an industry with Perfect price
discrimination:
Single Price:
$
MC
P1
Profits
ATC
D
MR
Quantity
Perfect Price Discrimination
Graphically:
$
MC
Profits
ATC
ATC
D
Quantity
Regulated Monopolies
Many natural monopolies have been regulated by the government. Ex. Hydro, telephone, etc. The
government usually regulates these firms by setting a maximum price which is considered ‘fair’ or
‘optimal’, and the monopolist cannot legally charge more than this price.
Fair Return Price: P=ATC
This price enables the producer to obtain a normal profit and that price is therefore equal to the
average cost of producing the good. Most regulatory agencies in Canada set this kind of price.
Socially Optimal Price: P=MC
This price results in allocative efficiency. However if this price is below the monopolists ATC,
they will not wish to continue producing in the long run, so the government would face a dilemna.
It is possible that at P=MC they might still make a normal profit, if MC>=ATC. Below we see a
graphical example where P<ATC at the socially optimal price:
Graphically:
$
MC
Pm
ATC
Pfr
Pso
D
MR
Qm Qfr
Qso
Quantity