21
Pure
Competition
21-1
Copyright 2008 The McGraw-Hill Companies
Learning objectives – In this chapter students will learn:
A. The names and main characteristics of the four basic
market models.
B. The conditions required for purely competitive markets.
C. How purely competitive firm maximize profits or minimize
losses.
D. Why the marginal cost curve and supply curve of
competitive firms are identical.
E. How industry entry and exit produce economic efficiency.
21-2
Copyright 2008 The McGraw-Hill Companies
Four market models
A. Pure competition
• entails a large number of firms, standardized product, and
easy entry (or exit) by new (or existing) firms.
B. Pure Monopoly
• At the opposite extreme, pure monopoly has one firm that
is the sole seller of a product or service with no close
substitutes; entry is blocked for other firms.
C. Monopolistic competition
• is close to pure competition, except that the product is
differentiated among sellers rather than standardized, and
there are fewer firms.
D. Oligopoly
• is an industry in which only a few firms exist, so each is
affected by the price-output decisions of its rivals.
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Copyright 2008 The McGraw-Hill Companies
Pure Competition: Characteristics and Occurrence
The characteristics of pure competition:
1. Pure competition is rare in the real world, but the model is
important. Pure competition provides a norm or standard
against which to compare and evaluate the efficiency of
the real world.
2. There are many sellers means, that there are enough
numbers so that a single seller has no impact on price by
its decisions alone.
3. The products in a purely competitive market are
homogeneous or standardized; each seller’s product is
identical to its competitor’s (the market for the dollar).
4. Individual firms must accept the market price; they are
price takers and can exert no influence on price.
5. Freedom of entry and exit means that there are no
significant obstacles preventing firms from entering or
leaving the industry.
21-4
Copyright 2008 The McGraw-Hill Companies
Demand from the Viewpoint of a Competitive Seller
• The individual firm will view its demand as perfectly elastic.
a perfectly elastic demand curve is a horizontal line at the
price
• The demand curve is not perfectly elastic for the industry: It
only appears that way to the individual firm, since they
must take the market price no matter what quantity they
produce.
P
P
Industry
Firm
S
D=P=MR
D
Q
21-5
Copyright 2008 The McGraw-Hill Companies
Q
Pure Competition
$1179
P
Firm’s
Revenue
Data
917
QD TR
$131 0
131 1
131 2
131 3
131 4
131 5
131 6
131 7
131 8
131 9
131 10
TR
1048
$0
131
262
393
524
655
786
917
1048
1179
1310
MR
] $131
] 131
] 131
] 131
] 131
] 131
] 131
] 131
] 131
] 131
Price and Revenue
Firm’s
Demand
Schedule
(Average
Revenue)
786
655
524
393
262
D = MR = AR
131
2
4
6
8
10
Quantity Demanded (Sold)
21-6
Copyright 2008 The McGraw-Hill Companies
12
Definitions of average, total, and marginal revenue:
Average revenue
• is the price per unit for each firm in pure competition.
Total revenue
• is the price multiplied by the quantity sold.
Marginal revenue
• is the change in total revenue and will also equal the unit
price in conditions of pure competition.
21-7
Copyright 2008 The McGraw-Hill Companies
• Profit Maximization in the Short-Run: Two Approaches
• In the short run the firm has a fixed plant and maximizes
profits or minimizes losses by adjusting output; profits are
defined as the difference between total costs and total
revenue.
• Three questions must be answered.
1. Should the firm produce?
2. If so, how much?
3. What will be the profit or loss?
21-8
Copyright 2008 The McGraw-Hill Companies
Profit Maximization in the
Short Run
Total Revenue-Total Cost Approach
Price = $131
(1)
Total Product
(Output) (Q)
0
1
2
3
4
5
6
7
8
9
10
(2)
Total Fixed
Cost (TFC)
(3)
Total Variable
Cost (TVC)
$100
100
100
100
100
100
100
100
100
100
100
$0
90
170
240
300
370
450
540
650
780
930
(4)
(5)
(6)
Total Cost Total Revenue Profit (+)
(TC)
(TR)
or Loss (-)
$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
Do
You
SeeGraph
Profit The
Maximization?
Now
Let’s
Results…
21-9
Copyright 2008 The McGraw-Hill Companies
Profit Maximization in the
Short Run
Total Revenue-Total Cost Approach
Total Economic
Profit
Total Revenue and Total Cost
$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
21-10
Break-Even Point
(Normal Profit)
W 21.1
Total Revenue, (TR)
Maximum
Economic
Profit
$299
Total Cost,
(TC)
P=$131
Break-Even Point
(Normal Profit)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)
$500
400
300
200
100
Total Economic
Profit
$299
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)
Copyright 2008 The McGraw-Hill Companies
G 21.1
1. Firm should produce if the difference between total
revenue and total cost is profitable, or if the loss is less
than the fixed cost.
2. In the short run, the firm should produce that output at
which it maximizes its profit or minimizes its loss.
3. The profit or loss can be established by subtracting total
cost from total revenue at each output level.
4. The firm should not produce, but should shut down in the
short run if its loss exceeds its fixed costs. Then, by
shutting down its loss will just equal those fixed costs.
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Copyright 2008 The McGraw-Hill Companies
•
Marginal-revenue—marginal-cost approach
•
MR = MC rule states that the firm will maximize profits or
minimize losses by producing at the point at which
marginal revenue equals marginal cost in the short run.
• Three features of this MR = MC rule are important.
a. Rule assumes that marginal revenue must be equal to or
exceed minimum-average-variable cost or firm will shut
down.
b. Rule works for firms in any type of industry, not just pure
competition.
c. In pure competition, price = marginal revenue, so in
purely competitive industries the rule can be restated as
the firm should produce that output where P = MC,
because P = MR.
21-12
Copyright 2008 The McGraw-Hill Companies
Profit Maximization in the Short Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule
(1)
Total
Product
(Output)
0
1
2
3
4
5
6
7
8
9
10
(2)
Average
Fixed
Cost
(AFC)
$100.00
50.00
33.33
25.00
20.00
16.67
14.29
12.50
11.11
10.00
(3)
Average
Variable
Cost
(AVC)
(4)
Average
Total
Cost
(ATC)
$90.00 $190.00
85.00 135.00
80.00 113.33
75.00 100.00
74.00
94.00
75.00
91.67
77.14
91.43
81.25
93.75
86.67
97.78
93.00 103.00
(5)
Marginal
Cost
(MC)
$90
80
70
60
70
80
90
110
130
150
(6)
Marginal
Revenue
(MR)
(7)
Profit (+)
or Loss (-)
$131
131
131
131
131
131
131
131
131
131
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
Surprise
- Now
Let’s GraphNow?
It…
DoNo
You
See Profit
Maximization
21-13
Copyright 2008 The McGraw-Hill Companies
• Using the rule, compare MC and MR at each level of
output. At the tenth unit MC exceeds MR. Therefore, the
firm should produce only nine (not the tenth) units to
maximize profits.
• Profit maximizing case: The level of profit can be found
by multiplying ATC by the quantity, 9 to get $880 and
subtracting that from total revenue which is $131 x 9 or
$1179. Profit will be $299 when the price is $131. Profit
per unit could also have been found by subtracting $97.78
from $131 and then multiplying by 9 to get $299.
• Loss-minimizing case: The loss-minimizing case is
illustrated when the price falls to $81. Table 21.4 is used
to determine this. Marginal revenue does exceed average
variable cost at some levels, so the firm should not shut
down. Comparing P and MC, the rule tells us to select
output level of 6. At this level the loss of $64 is the
minimum loss this firm could realize, and the MR of $81
just covers the MC of $80, which does not happen at
quantity level of 7.
21-14
Copyright 2008 The McGraw-Hill Companies
Marginal Cost and
Short-Run Supply
Continuing the Same Numeric
Example…
Supply Schedule of a Competitive Firm
Quantity
Maximum Profit (+)
Price
Supplied
or Minimum Loss (-)
$151
10
$+480
Profit max
131
9
+299
111
8
+138
91
7
-3
Loss min
81
6
-64
71
0
-100
Shut down
61
0
-100
The Schedule Shows the Quantity a Firm Will Produce at a
Variety of Prices and Results
21-15
Copyright 2008 The McGraw-Hill Companies
Profit Maximization in the Short Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule
W 21.2
Cost and Revenue
$200
150
MR = MC
P=$131
MC
MR = P
ATC
Economic Profit
100
AVC
A=$97.78
50
0
1
2
3
4
5
6
Output
21-16
Copyright 2008 The McGraw-Hill Companies
7
8
9
10
Profit Maximization in the Short Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule
Loss Minimizing Case
Cost and Revenue
$200
Lower the Price to $81 and
Observe the Results!
150
Loss
A=$91.67
ATC
AVC
100
MR = P
P=$81
50
0
V = $75
1
2
3
4
5
6
Output
21-17
MC
Copyright 2008 The McGraw-Hill Companies
7
8
9
10
• Shut-down case: If the price falls to $71, this firm should
not produce. MR will not cover AVC at any output level.
Therefore, the minimum loss is the fixed cost and
production of zero. Table 21.4 and Figure 21.5 illustrate
this situation, and it can be seen that the $100 fixed cost is
the minimum possible loss.
• Marginal cost and the short-run supply curve can be
illustrated by hypothetical prices such as those in Table 236. At price of $151 profit will be $480; at $111 the profit will
be $138 ($888-$750); at $91 the loss will be $3.01; at $61
the loss will be $100 because the latter represents the
close-down case.
• Note that Table 21.5 gives us the quantities that will be
supplied at several different price levels in the short-run.
• Since a short-run supply schedule tells how much quantity
will be offered at various prices, this identity of marginal
revenue with the marginal cost tells us that the marginal
cost above AVC will be the short-run supply for this firm
(see Figure 21.6).
21-18
Copyright 2008 The McGraw-Hill Companies
Profit Maximization in the Short Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule
Short-Run Shut Down Case
Cost and Revenue
$200
Lower the Price Further to
$71 and Observe the Results!
MC
150
ATC
V = $74
100
AVC
MR = P
50
0
P=$71
1
Short-Run
Shut Down Point
P < Minimum AVC
$71 < $74
2
3
4
5
6
Output
21-19
Copyright 2008 The McGraw-Hill Companies
7
8
9
10
Marginal Cost and Short-Run
Supply
Cost and Revenues (Dollars)
Generalizing the MR=MC
Relationship and its Use
e
P5
MR5
d
P4
ATC
c
P3
P2
P1
AVC
b
a
This Price is Below AVC
And Will Not Be Produced
0
Q2
Q3
Q4
Quantity Supplied
21-20
Copyright 2008 The McGraw-Hill Companies
MC
Q5
MR4
MR3
MR2
MR1
Marginal Cost and Short-Run
Supply
Generalizing the MR=MC
Relationship and its Use
Cost and Revenues (Dollars)
Examine the MC for the Competitive Firm
MC Above AVC Becomes
the Short-Run Supply Curve
Break-even
(Normal Profit) Point
e
P5
AVC
b
a
Shut-Down Point
(If P is Below)
This Price is Below AVC
And Will Not Be Produced
0
Q2
Q3
Q4
Quantity Supplied
21-21
ATC
c
P3
P2
P1
Copyright 2008 The McGraw-Hill Companies
MC
MR5
d
P4
S
Q5
MR4
MR3
MR2
MR1
• Changes in supply
• Changes in prices of variable inputs or in technology will
shift the marginal cost or short-run supply curve. For
example, a wage increase would shift the supply curve
upward.
• Technological progress would shift the marginal cost curve
downward.
• Using this logic, a specific tax would cause a decrease in
the supply curve (upward shift in MC), and a unit subsidy
would cause an increase in the supply curve (downward
shift in MC).
21-22
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Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
21-23
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MC2
S2
MC1
S1
AVC2
AVC1
Higher Costs Move the
Supply Curve to the Left
Quantity Supplied
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
21-24
Lower Costs Move
the Supply Curve
to the Right
Copyright 2008 The McGraw-Hill Companies
MC1
S1
MC2
S2
AVC1
AVC2
Quantity Supplied
Determining equilibrium price for a firm and an industry:
• Total-supply and total-demand data must be compared to
find most profitable price and output levels for the industry.
Figure 21.7a and b shows this analysis graphically;
individual firm supply curves are summed horizontally to
get the total-supply curve S in Figure 21.7b. If product price
is $111, industry supply will be 8000 units, since that is the
quantity demanded and supplied at $111. This will result in
economic profits.
• Loss situation similar to Figure 21.4 could result from
weaker demand (lower price and MR) or higher marginal
costs.
• Firm vs. industry:
• Individual firms must take price as given, but the supply
plans of all competitive producers as a group are a major
determinant of product price.
21-25
Copyright 2008 The McGraw-Hill Companies
Changes in Supply (figure 27)
b
a
Single Firm
Industry
p
W 21.3
P
S = ∑ MC’s
s = MC
Economic
Profit
ATC
d
$111
$111
AVC
D
0
8
p
0
8000
Competitive Firm Must Take the Price that is Established
By Industry Supply and Demand
21-26
Copyright 2008 The McGraw-Hill Companies
P
Profit Maximization in the long run
•
Several assumptions are made.
1. Entry and exit of firms are the only long-run adjustments.
2. Firms in the industry have identical cost curves.
3. The industry is a constant-cost industry, which means that
the entry and exit of firms will not affect resource prices or
location of unit-cost schedules for individual firms.
•
Basic conclusion to be explained is that after long-run
equilibrium is achieved, the product price will be exactly
equal to, and production will occur at, each firm’s point of
minimum average total cost.
Note
1. Firms seek profits and avoid losses.
2. Under competition, firms may enter and leave industries
freely.
3. If short-run losses occur, firms will leave the industry; if
economic profits occur, firms will enter the industry.
21-27
Copyright 2008 The McGraw-Hill Companies
• The model is one of zero economic profits, but note that
this allows for a normal profit to be made by each firm in
the long run.
1. If economic profits are being earned, firms enter the
industry, which increases the market supply, causing the
product price to gravitate downward to the equilibrium price
where zero economic profits are earned (Figure 21.8).
2. If losses are incurred in the short run, firms will leave the
industry; this decreases the market supply, causing the
product price to rise until losses disappear and normal
profits are earned (Figure 21.9).
• Long-run supply will be perfectly elastic; the curve will be
horizontal. In other words, the level of output will not affect
the price in the long run.
21-28
Copyright 2008 The McGraw-Hill Companies
Supply Readjustment
Single Firm
Industry
p
P
S1
MC
ATC
$60
$60
50
50
S2
MR
D2
40
40
D1
0
100
p
0
80,000
90,000
100,000
An Increase in Demand Temporarily Raises Price Higher Prices Draw
in New Competitors Increased Supply Returns Price to Equilibrium
21-29
Copyright 2008 The McGraw-Hill Companies
P
Supply Readjustment
Single Firm
Industry
p
P
S3
MC
ATC
$60
$60
50
50
S1
MR
D1
40
40
D3
0
100
p
0
80,000
90,000
100,000 P
A Decrease in Demand Temporarily Lowers Price Lower Prices Drive
Away Some Competitors Decreased Supply Returns Price to
Equilibrium
21-30
Copyright 2008 The McGraw-Hill Companies
Pure Competition and Efficiency
1. Productive efficiency occurs where P = minimum AC; at
this point firms must use the least-cost technology or
they won’t survive.
2. Allocative efficiency occurs where P = MC, because
price is society’s measure of relative worth of a product at
the margin or its marginal benefit. And the marginal cost of
producing product X measures the relative worth of the
other goods that the resources used in producing an extra
unit of X could otherwise have produced. In short, price
measures the benefit that society gets from additional units
of good X, and the marginal cost of this unit of X measures
the sacrifice or cost to society of other goods given up to
produce more of X.
a. If price > marginal cost, then society values more units of
good X more highly than alternative products the
appropriate resources can otherwise produce. Resources
are underallocated to the production of good X.
21-31
Copyright 2008 The McGraw-Hill Companies
b. If price < marginal cost, then society values the other
goods more highly than good X, and resources are
overallocated to the production of good X.
•
•
•
•
Allocative efficiency implies maximum consumer and
producer surplus.
Combined consumer and producer surplus is maximized at
equilibrium.
Any quantity less than equilibrium would reduce both
consumer and producer surplus.
Any quantity greater than equilibrium would occur with an
efficiency loss that would subtract from combined
consumer and producer surplus.
21-32
Copyright 2008 The McGraw-Hill Companies
Long-Run Equilibrium
Competitive Firm and Market
Single Firm
P=MC=Minimum
ATC (Normal Profit)
Market
MC
S
Price
Price
ATC
MR
P
P
D
0
Qf
Quantity
0
Qe
Quantity
Productive Efficiency: Price = Minimum ATC
Allocative Efficiency: Price = MC
Pure Competition Has Both in
Its Long-Run Equilibrium
21-33
Copyright 2008 The McGraw-Hill Companies
Efficiency Gains From Entry:
The Case of Generic Drugs
• Competitive Model Predicts Lower Price and
Greater Output With Increased Efficiency When
New Producers Enter Market
• Example is Patented Drugs
• Patents Enable Greater Profits in Support of
R&D and Accelerated Cost Recovery
• After Patent Period Generics Enter Market
• Profits Decrease and Quantities Increase
• Combined Consumer and Producer Surpluses
Increase
21-34
Copyright 2008 The McGraw-Hill Companies
Efficiency Gains From Entry:
The Case of Generic Drugs
New Producers Enter Market
a
Price
S
• As Price
Initial Patent Price
Decreases to f,
b
c
P
1
• Consumer
Surplus abc
d
f
P
2
Increases to
adf
• Producer and
Consumer
Surplus is
D
Maximized
Q1
Q2
Together as
Quantity
Shown by
the Gray
Results: Greater Quantity at Lower Prices
Triangle
as Predicted by the Competitive Model
21-35
Copyright 2008 The McGraw-Hill Companies
Key Terms
• pure competition
• pure monopoly
• monopolistic
competition
• oligopoly
• imperfect
competition
• price taker
• average revenue
• total revenue
• marginal revenue
• break-even point
• MR=MC
• short-run supply
curve
21-36
Copyright 2008 The McGraw-Hill Companies
• long-run supply
curve
• constant-cost
industry
• increasing-cost
industry
• decreasing-cost
industry
• productive
efficiency
• allocative
efficiency
• consumer surplus
• producer surplus
Next Chapter Preview…
Pure
Monopoly
21-37
Copyright 2008 The McGraw-Hill Companies
• B. There are four major objectives to
analyzing pure competition.
• 1. To examine demand from the seller’s
viewpoint,
• 2. To see how a competitive producer
responds to market price in the short
run,
• 3. To explore the nature of long-run
adjustments in a competitive industry,
and
• 4. To evaluate the efficiency of
competitive industries.
21-38
Copyright 2008 The McGraw-Hill Companies
21-39
Copyright 2008 The McGraw-Hill Companies