ecn 2 q
Pure (perfect) Competition Please listen to the audio as you work through the slides.
Creative Commons Attribution 4.0 License, Charles Hackner Houston Community College unless otherwise noted CC BY NC
Learning objectives
Students should be able to thoroughly and completely explain:
The characteristics of pure competition
The 3 questions confronting the producer in pure competition.
The Total Revenue Total Cost approach to determining the profit maximizing output and price for the purely competitive firm.
The three features of the MR MC approach to determining the profit maximizing output and price for the purely competitive firm.
The following cases for the purely competitive firm in the short run:
Profit maximization
Loss minimization
Shut down
How is the short run supply curve derived
The characteristics of long run equilibrium of a purely competitive firm.
The implications for productive and allocative efficiency in pure competition
Pure Competition
Issues
How do firms make decisions in various market structures?
How do firms determine the profit maximizing level of output in various market structures?
What is the impact of market structure on economic efficiency?
Pure Competition
Market Structure Continuum
Four Market Models
Pure (or Perfect) Competition
Market Structure Continuum
Pure
Competition
Four Market Models
Imperfect Competition
All Markets that are
Not Purely Competitive
Market Structure Continuum
Pure
Competition
Four Market Models
Pure Monopoly
One seller
Market Structure Continuum
Pure
Competition
Pure
Monopoly
Four Market Models
Monopolistic Competition
Large # of sellers with differentiated (by brand or quality) products No perfect substitutes
Such as:
Books, clothing, furniture
Market Structure Continuum
Pure
Competition
Pure
Monopoly
Monopolistic
Competition
Four Market Models
Oligopoly
A market dominated by a few sellers of
Standardized or differentiated products
Market Structure Continuum
Pure
Competition
Pure
Monopoly
Monopolistic
Competition
Oligopoly
Pure Competition characteristics:
Very Large Numbers of buyers and sellers (small market shares)
Standardized Product – perfect substitutes (all the same) Examples?
“Price Takers” (individual producers and consumers have no control over price or quantity)
Free Entry and Exit – from the market
Demand as seen by a Purely Competitive Seller
The individual seller faces a perfectly elastic demand curve
Horizontal Demand Curve
A firm cannot obtain a higher price by restricting its output,
nor does it need to lower its price to increase its sales volume.
The firm can sell all it wants at the equilibrium price.
The Price Taker Role of the firm:
3 characteristics to know
Total Revenue = price * quantity (TR=P*Q)
Average Revenue = price (AR=P)
Marginal Revenue = price (MR=P)
Firm’s
Demand
Schedule
(Average
Revenue)
Firm’s
Revenue
Data
Pure Competition
Price and Revenue
2
4
6
8
10
12
131
262
393
524
655
786
917
1048
$1179
Quantity Demanded (Sold)
P = MR = AR
TR
P
QD
TR
MR
$131
131
131
131
131
131
131
131
131
131
131
0
1
2
3
4
5
6
7
8
9
10
$0
131
262
393
524
655
786
917
1048
1179
1310
$131
131
131
131
131
131
131
131
131
131
]
]
]
]
]
]
]
]
]
]
9-11
Short-Run Profit Maximization
Two Approaches to determine the profit maximizing level of output...
First: Total-Revenue -Total Cost Approach
The Decision Rule:
Produce in the short-run if the firm can realize:
1- A profit (or)
2- A loss less than its fixed costs
The Decision Process:
3 Questions
Should the firm produce?
What quantity should be produced?
What profit or loss will be realized?
Total Revenue Total Cost Approach What is the profit maximizing level of output?
(1)
Total Product
(Output) (Q)
(2)
Total Fixed
Cost (TFC)
(3)
Total Variable
Cost (TVC)
(4)
Total Cost
(TC)
(5)
Total Revenue
(TR)
(6)
Profit (+)
or Loss (-)
Price = $131
0
1
2
3
4
5
6
7
8
9
10
$100
100
100
100
100
100
100
100
100
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
Now Let’s Graph The Results…
1
0
2
3
4
5
6
7
8
9
10
11
12
13
14
1
0
2
3
4
5
6
7
8
9
10
11
12
13
14
$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
$500
400
300
200
100
Total Revenue and Total Cost
Total Economic
Profit
Quantity Demanded (Sold)
Quantity Demanded (Sold)
Total Revenue, (TR)
Break-Even Point
(Normal Profit)
Break-Even Point
(Normal Profit)
Maximum
Economic
Profit
$299
Total Economic
Profit
$299
P=$131
Total Cost,
(TC)
Total Revenue Total Cost Approach
Short-Run Profit Maximization
Two approaches to determine the profit maximizing level of output
First:
Total-Revenue -Total Cost Approach
3 Characteristics of MR=MC Rule:
The rule applies only if producing is preferred to shutting down
Rule applies to all market structures
Rule can be restated P=MC (price=MR)
Second:
Marginal-Revenue -Marginal Cost Approach
Key Rule: MR = MC
Marginal Revenue Marginal Cost Approach
(1)
Total
Product
(Output)
(2)
Average
Fixed
Cost
(AFC)
(3)
Average
Variable
Cost
(AVC)
(4)
Average
Total
Cost
(ATC)
(6)
Marginal
Revenue
(MR)
(7)
Profit (+)
or Loss (-)
0
1
2
3
4
5
6
7
8
9
10
$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
75.00
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
$131
131
131
131
131
131
131
131
131
131
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
No Surprise - Now Let’s Graph It…
Do You See Profit Maximization Now?
(5)
Marginal
Cost
(MC)
$90
80
70
60
70
80
90
110
130
150
Cost and Revenue
$200
150
100
50
0
1
2
3
4
5
6
7
8
9
10
Output
Economic Profit
MR = P
MC
MR = MC
AVC
ATC
P=$131
A=$97.78
Marginal Revenue Marginal Cost Approach
Marginal Revenue - Marginal Cost Approach
The Loss Minimization Case
Lower the price from $131 to $81…
The MR=MC rule still applies
But the MR = MC point changes.
Assume the cost structure remains the same.
$200
150
100
50
0
Cost and Revenue
1 2 3 4 5 6 7 8 9 10
MC
MR
AVC
ATC
Economic Loss
$81.00
$91.67
Marginal Revenue - Marginal Cost Approach
Loss Minimization Case - graphically
$200
150
100
50
0
Cost and Revenue
1 2 3 4 5 6 7 8 9 10
MC
MR
AVC
ATC
$71.00
Marginal Revenue - Marginal Cost Approach
Short-Run Shut Down Case
Minimum AVC
is the Shut-Down
Point
Shut Down means a temporary decision not to produce due to current market conditions
The firm would shut down if the revenue it would earn from producing is less than its variable costs of production.
Agenda
Derive the short run supply curve
Short – Run Competitive Equilibrium
Profit Maximization in the long run
Pure competition and Efficiency
Deriving the short-run supply curve for the Perfectly Competitive Firm Using the Marginal Cost Curve
Marginal Revenue - Marginal Cost Approach
Marginal Cost & Short-Run Supply
Price
Quantity
Supplied
Maximum Profit (+)
Or Minimum Loss (-)
Observe the impact upon profitability as price is changed
$151
131
111 P5
91 P3
81 P2
71 P1
61
10
9
8
7
6
0
0
$+480
+299
+138
-3
-64
-100
-100
No production
No production
Cost and Revenue, (dollars)
MC
MR1
AVC
ATC
Marginal Revenue - Marginal Cost Approach
Quantity Supplied
MR2
MR3
MR4
MR5
P1
P2
P3
P4
P5
Q2
Q3
Q4
Q5
Marginal Cost & Short-Run Supply
Do not
Produce at price–
Below AVC
Break-even
(Normal Profit)
Point
Cost and Revenue, (dollars)
MC
MR1
Marginal Revenue - Marginal Cost Approach
Quantity Supplied
MR2
MR3
MR4
MR5
P1
P2
P3
P4
P5
Q2
Q3
Q4
Q5
Marginal Cost & Short-Run Supply
Yields the
Short-Run
Supply Curve
Supply
No Production
if Price is
Below AVC
Diminishing returns, production costs, and product supply
Because of the law of diminishing returns, marginal costs eventually rise as more units of output are produced.
Because marginal costs rise with output, a purely competitive firm must get successively higher prices to motivate it to produce additional units of output
Marginal Revenue - Marginal Cost Approach
Marginal Cost & Short-Run Supply
AVC2
MC2
Higher Costs Move the
Supply Curve to the Left
Cost and Revenue, (dollars)
MC1
AVC1
Quantity Supplied
S1
S2
Marginal Revenue - Marginal Cost Approach
Marginal Cost & Short-Run Supply
AVC2
MC2
Lower Costs Move
the Supply Curve
to the Right
Cost and Revenue, (dollars)
MC1
AVC1
Quantity Supplied
S1
S2
Check Your Understanding
Explain the TR-TC approach.
Explain the MR-MC approach.
P
Q
S=MC
AVC
ATC
8
D
P
Q
8000
D
S= MCs
Industry
Competitive Firm
(price taker)
Economic
Profit
$111
$111
Short-run Competitive Equilibrium
The Competitive Firm “Takes” its
Price from the Industry Equilibrium
1000 firms
start
Output determination in pure competition in the short run
Rules of thumb
Should the firm produce?
Yes, if price is equal to, or greater than, minimum AVC. This means that the firm is profitable or that its losses are less than it’s fixed costs.
What quantity should this firm produce?
Produce where MR (=P) = MC; there, profit is maximized or loss is minimized.
Will production result in economic profit?
Yes, if price exceeds ATC. No, if ATC exceeds price.
Profit Maximization in the Long Run
Assumptions...
Entry and Exit of firms is the only long run adjustment
Identical Costs – all firms in industry face identical cost curves
Constant-Cost Industry – entry and exit does not affect resource prices or the location of ATC curves of individual firms
Goal of the Analysis
Show that Price = Minimum ATC in the long run
Long-Run Equilibrium –
The Zero Economic Profit Model
Temporary profits and the reestablishment
of long-run equilibrium
S1
MC
ATC
P
Q
100
P
Q
100,000
Industry
Firm (1000 firms)
(price taker)
$60
50
40
$60
50
40
Profit Maximization in the Long Run
MR
D1
An increase in demand increases economic profits
MR
D1
MC
ATC
P
Q
100
P
Q
100,000
Industry
Firm
(price taker)
$60
50
40
$60
50
40
Profit Maximization in the Long Run
D2
Economic
Profits
S1
New competitors enter the industry. Supply increases. Prices fall. Economic profits fall.
MR
D1
MC
ATC
P
Q
100
P
Q
100,000
Industry
Firm (1100 firms)
(price taker)
$60
50
40
$60
50
40
Profit Maximization in the Long Run
D2
Zero Economic
Profits
S1
S2
110,000
Decreases in demand, lead to economic losses,
and the reestablishment of long-run equilibrium
S1
MC
ATC
P
Q
100
P
Q
100,000
Industry
Firm
(price taker)
$60
50
40
$60
50
40
Profit Maximization in the Long Run
D1
MR
Demand falls. Equilibrium price falls. Firms suffer losses.
MR
D1
MC
ATC
P
Q
100
P
Q
100,000
Industry
Firm (900 firms)
(price taker)
$60
50
40
$60
50
40
Profit Maximization in the Long Run
D2
Economic
Losses
S1
MR
D1
MC
ATC
P
Q
100
P
Q
100,000
Industry
Firm
(price taker)
$60
50
40
$60
50
40
Profit Maximization in the Long Run
D2
Return to Zero
Economic Profits
S1
S3
Competitors with losses leave the industry. Supply falls. Prices
return to zero economic profit levels.
90,000
Long-Run Supply in a Constant Cost Industry
Constant Cost Industry
Characteristics:
Industry expansion or contraction does not affect resource prices.
Long-run average costs are not changed for the individual firm.
The industry represents only a small fraction of total resource demand.
Result:
Perfectly Elastic Long-Run Supply
Graphically...
P
Q
=$50
S
D1
Z1
Q1
D2
Z2
Q2
Q3
D3
Z3
100,000
110,000
90,000
Long-Run Supply in a Constant Cost Industry
P1
P2
P3
P
Q
=$50
S
D1
Z1
Q1
D2
Z2
Q2
Q3
D3
Z3
100,000
110,000
90,000
Long-Run Supply in a Constant Cost Industry
P1
P2
P3
How does an increasing
cost industry differ?
P
Q
$55
50
45
S
D1
Y1
Q1
D2
Y2
Q2
Q3
D3
Y3
100,000
110,000
90,000
Long-run Supply in an increasing cost industry
A perfectly competitive industry with a positively-sloped long-run industry supply curve that results because expansion of the industry causes higher production cost and resource prices.
An increasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift upward.
P1
P2
P3
Long-run supply in a decreasing cost industry
A perfectly competitive industry with a negatively-sloped long-run industry supply curve that results because expansion of the industry causes lower production cost and resource prices.
A decreasing-cost industry occurs because the entry of new firms, prompted by an increase in demand, causes the long-run average cost curve of each firm to shift downward.
P
Q
$55
50
45
S
D1
Y1
Q1
D2
Y2
Q2
Q3
D3
Y3
100,000
110,000
90,000
P1
P2
P3
What is the long-
run competitive
equilibrium?
LONG-RUN SUPPLY IN AN
INCREASING COST INDUSTRY
P
MR
Q
MC
ATC
Quantity
Price
Price = MC = Minimum ATC
(normal profit)
Long-run equilibrium for a competitive firm
Pure Competition and Economic Efficiency
Pure Competition yields Economic Efficiency
Defined as:
Productive Efficiency and Allocative Efficiency
Price = Minimum ATC Price = MC
Resources are
efficiently allocated
under competition
All Other Market Structures Relative to Economic Efficiency
Under Allocation of Resources:
Price > MC
Or
Over Allocation of Resources:
Price < MC
For the Pure Competition Market Structure
List and explain the characteristics of pure competition
List and explain the 3 questions confronting the producer in pure competition?
Explain the Total Revenue Total Cost approach to determining the profit maximizing output and price for the purely competitive firm.
Explain long run equilibrium in pure competition
Explain efficiency in pure competition
Explain how the short run supply curve is derived
Cost of Production:
How is the long run ATC curve derived?
How might the presence of economies of scale or diseconomies of scale impact the shape of the LR ATC curve?
List and explain the Short Run Production Relationships
Explain the Law of Diminishing Returns
KEY TERMS