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Page 1 of 13 ECON 1023 SPRING 2012 Instructor: Gibson Nene LECTURE NOTES: CHAPTER 7: Pure Competition Source: Microeconomics Brief Edition, First Edition by McConnell, Brue and Flynn. I. Chapter Learning Objectives In this chapter, you 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 firms 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. F. The differences between constant-cost, increasing-cost, and decreasing-cost industries. II. The four market models. A continuum of four distinct market structures Pure competition Monopolistic competition Pure monopoly Oligopoly Page 2 of 13 A. Pure ____________ entails a large number of firms, standardized product, and easy entry (or exit) by new (or existing) firms. E.g. corn production B. A pure ___________ has one firm that is the sole seller of a product or service with no close substitutes; entry is blocked for other firms. E.g. local electric utility-Minnesota Power C. M___________ competition is close to pure competition, except that the product is differentiated among sellers rather than standardized, and there are fewer firms. E.g. clothing industry D. An ________ is an industry in which only a few firms exist, so each is affected by the price-output decisions of its rivals. Each firm takes into account the actions of its rivals in its own price and output determination. Example: Passenger plane manufacturing industry, Airbus and Boeing III. Pure Competition: Characteristics and Occurrence A. The characteristics of pure competition: 1. Many ______ means that there are enough so that a single seller has no impact on price by its decisions alone. 2. The products in a purely competitive market are homogeneous or standardized; each seller’s product is identical to its competitors’. 3. Individual firms must accept the market price; they are price ________ and can exert no influence on price. 4. Freedom of entry and ______ means that there are no significant obstacles preventing firms from entering or leaving the industry. Page 3 of 13 5. Pure competition is rare in the real world, but the model is important. a. The model helps analyze industries with characteristics similar to pure competition. b. The model provides a context in which to apply revenue and cost concepts developed in previous chapters. c. Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world. 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. IV. Demand as Seen by a Purely Competitive Seller A. 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. Page 4 of 13 B. Definitions of average, total, and marginal revenue: 1. Average revenue is the price per unit for each firm in pure competition or total revenue divided by the quantity of the products sold. 2. Total revenue is the price multiplied by the quantity sold. 3. Marginal revenue is the change in total revenue that results from selling ______ more unit of a firm’s product 4. Marginal revenue equals the unit price in conditions of pure competition. Figure 7.1 Table and graph V. Profit Maximization in the Short-Run A. In the short run the firm has a fixed plant and maximizes profits or minimizes losses by adjusting output only through changes in inputs e.g. labor, materials. Profits are defined as the difference between total costs and total revenue. B. Three questions must be answered. 1. Should the firm produce? 2. If so, how much? Page 5 of 13 3. What will be the profit or loss? C. Marginal-revenue(MR)—marginal-cost(MC) approach 1. 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, Or produce the last complete unit of output for which MR>MC. MR__>___MC The firm should produce any unit of output in this range. Why? Every additional unit of output brings a revenue gain to the firm. MC___>___MR The firm should not produce. Why? Production brings more costs than revenue gains hence lower profits and greater losses. 2. Three features of this MR = MC rule are important. a. Rule assumes that marginal revenue must be equal to or exceed the minimum of average variable cost, or the 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 ________, because P = _______. 3. Using the rule on Figure 7.2, 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. 4. Profit maximizing case: Using Figure 7.2 in your textbook. Page 6 of 13 Economic profit is given by the area of the shaded rectangle. Total Cost(TC) = Output *Average Total Cost = Total revenue(TR) = Price x Output(Q)= ______________. Profit = TR-TC_____________________________ = $1,179 - $880 = $299 Profit per unit could also have been found by subtracting $97.78 from $131 and then multiplying by 9 to get $299. 5. Loss-minimizing case: The loss-minimizing case is illustrated when the price falls to $81 (Figure 7.3 in your text book). 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. Total loss of producing 6 units= TR-TC =-$64 Total Revenue=Price*Output=$81*6=$486, Total Cost =Average Total Cost *Output =$91.67*6 =$550 Total loss = ___486-550_____________=-$64 Page 7 of 13 Why produce when the firm is making a loss? If the firm stops producing it will lose $100 in fixed cost, a loss of $64 is better off than a loss of $100. The firm is covering its variable fixed costs i.e. Price>AVC, firm makes $36 to pay part of its fixed costs. 6. The shut-down case: If the smallest loss the firm can incur is more than $100 fixed cost. Best action-shut down. Figure 7.4 in your textbook P<min AVC – shut down P>min AVC – keep producing If the price falls to $71, this firm should _____ produce. MR will not cover AVC at any output level. Therefore, the minimum loss is the fixed cost and production of zero. The $100 fixed cost is the minimum possible loss. If the firm produces, its loss will be greater than its fixed cost. If MR(P)=MC & P(MR) < minAVC – shut down MR > MC & P < minAVC – shut down MR = MC & P > minAVC – keep producing MR > MC & P > minAVC – increase production MC > MR & P > minAVC – decrease production Page 8 of 13 VI. Marginal Cost and Short-Run Supply Table 7.1 in your textbook. Price ($) Quantity Supplied Maximum Profit(+) or Minimum loss ($) 151 10 +480 131 9 +299 111 8 +138 91 7 -3 81 6 -64 71 0 -100-fixed cost 61 0 -100-fixed cost At $61 and $71 the loss will be $100 because these prices are below the Average Variable Cost which represents the shutdown case. The Table above gives us the quantities that will be supplied at several different price levels in the short-run. Since a short-run supply schedule tells how much quantity will be offered at various prices, this identity of marginal revenue with the marginal cost tells us that the marginal cost above Average Variable Cost will be the short-run supply for this firm. Page 9 of 13 The Competitive firm’s short-run supply curve and the P=MC rule (Figure 7.5 in your textbook) Changes in prices of variable inputs or in technology will shift the marginal cost or short-run supply curve. Examples: 1. A _______ increase would shift the supply curve upward (decrease in supply). 2. _____________ progress would shift the marginal cost curve downward. 3. A _______ tax would cause a decrease in the supply curve (upward shift in MC), 4. A unit _________ would cause an increase in the supply curve (downward shift in MC). Determining equilibrium price for a firm and an industry: 1. Total-supply and total-demand data must be compared to find most profitable price and output levels for the industry. Intentionally left blank Page 10 of 13 Suppose we have 1000 identical firms. The firms produce exactly the same amount of output. Table 7.2 in your textbook Quantity Supplied, single firm Total quantity Price supplied, 1000 ($) firms Total quantity demanded 10 10,000 151 4,000 9 9,000 131 6,000 8 8,000 111 8,000 7 7,000 91 9,000 6 6,000 81 11,000 0 0 71 13,000 0 0 61 16,000 By comparing the total quantity supplied and the total quantity demanded, the equilibrium price = ______ and the equilibrium quantity = __________ units. Graphically, Page 11 of 13 2. Individual firm supply curves are summed __________ to get the total-supply curve S. If product price is $111, industry supply will be 8000 units, since that is the quantity demanded and supplied at $111. D. Firm versus 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. VII. Profit Maximization in the Long Run A. Several assumptions are made. 1. Entry and exit of firms are the only long-run adjustments. 2. Firms in the industry have identical _________ curves. 3. The industry is a _____________ industry, which means that the entry and exit of firms will not affect resource prices or location of unit-cost schedules for individual firms. B. 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. 1. Firms seek _______ and shun ______. 2. Under competition, firms may enter and leave industries ________. 3. If short-run ______ occur, firms will leave the industry; if economic ________ occur, firms will enter the industry. Page 12 of 13 C. The model is one of ________ 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. 2. If losses are incurred in the short run, firms will ______ the industry; this decreases the market supply, causing the product price to rise until losses disappear and normal profits are earned. Long-run supply curves • In a constant cost industry, resource prices are not affected by the number of firms, thus • The long-run supply curve is ______________. • In an increasing-cost industry the entry of new firms raises the prices for resources and thus increases their production costs; therefore, • As the industry expands, it produces a larger output at a higher product price. The result is a long-run supply curve that is upward-sloping. • In decreasing-cost industries, firms experience lower costs as the industry expands, thus • The long-run supply curve is downward-sloping. VIII. Pure Competition and Efficiency A. Whether the industry is one of constant, increasing, or decreasing costs, the final long-run equilibrium will have the same basic characteristics (Figure 7.10). Page 13 of 13 1. ____________ efficiency occurs where P = minimum AC; at this point firms must use the least-cost technology or they won’t survive. 2. _____________ efficiency occurs where P = MC, because 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. 3. If price exceeds marginal cost, then society values more units of good X more highly than alternative products the appropriate resources can otherwise produce. Resources are ____________________ to the production of good X. 4. If price is less than marginal cost, then society values the other goods more highly than good X, and resources are ________________ to the production of good X. 5. ______________ allocation occurs when price and marginal cost are equal. Under pure competition this outcome will be achieved in both the short and long run. END OF NOTES