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Chapter 7:
Pure Competition
McGraw-Hill/Irwin
Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved
Four Basic Market Models
 Economists group industries into four market
structures:
 Perfect competition: large number of sellers,
standardized product, easy entry and exit
 Monopolistic competition: large number of sellers,
differentiated product, easy entry and exit
 Oligopoly: small number of sellers, standardized or
differentiated product, limited entry
 Pure monopoly: one seller, unique product, no entry
LO: 7-1
7-2
Characteristics of Pure
Competition
 Very large numbers of independently acting
sellers who offer their products in large markets.
 Standardized product: firms produce a product
that is identical or homogenous.
 Firms are “price takers”: the firm cannot
change the market price but can only accept it
as “given” and adjust to it.
 Free entry and exit: no barriers to entry exist.
LO: 7-2
7-3
Demand as Seen by A
Purely Competitive Firm
 A purely competitive firm sees its demand as
perfectly elastic (horizontal demand curve).
 Thus, average revenue (AR) is equal to price (P).
 Total revenue (TR) is equal to price times quantity sold
(Q).
 Because the price is constant, marginal revenue
(MR) is also equal to price.
TR = P x Q
AR=TR ÷ Q
MR=change in TR ÷ change in Q
Graphically…
LO: 7-3
7-4
$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
12
Quantity Demanded (Sold)
LO: 7-3
7-5
Profit Maximization
in the Short Run
 A purely competitive firm is a price taker, thus it can
maximize its economic profit only by adjusting its
output.
 In the short run, the firm can adjust its variable
resources to achieve the output level that
maximizes profit.
 In deciding how much to produce, the firm will
compare the marginal revenue and marginal cost
of each successive unit of output.
LO: 7-3
7-6
MR=MC Rule
 MR=MC rule is used to determine the total output at which
economic profit is at a maximum (or losses are at a
minimum) - label this output level q*.
 In perfect competition, because P=MR, we can restate this
rule as P=MC.
MR=MC Rule:
•If producing is preferable to shutting down, the firm
should produce any unit of output for which marginal
revenue exceeds its marginal cost.
•If the marginal cost of a unit of output exceeds its
marginal revenue, the firm should not produce that unit.
LO: 7-3
7-7
Profit Maximization and Loss
Minimization in the Short Run
Profit Maximization
If P>ATC at q* (where MR=MC), the firm will realize an
economic profit equal to q*(P – ATC)>0.
Loss Minimization
If P<ATC but exceeds the minimum AVC, q* output level will
minimize losses, equal to q*(P – ATC)<0.
Firm Shutdown
If P falls below the minimum AVC, the competitive firm will
minimize its losses in the short run by shutting down, because
the total revenue that it would get from producing is less than
the variable costs of production.
LO: 7-3
7-8
Applying MR=MC Rule
(1)
Total
Product
(Output)
0
1
2
3
4
5
6
7
8
9
10
LO: 7-3
(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
7-9
Applying MR=MC Rule
Cost and Revenue
$200
150
MR = MC
P=$131
MC
MR = P
ATC
Economic Profit
100
AVC
ATC=$97.78
50
0
LO: 7-3
1
2
3
4
5
6
7
8
9
10
Output
7-10
Supply Schedule of a
Competitive Firm
Continuing the Same Example…
LO: 7-4
Quantity
Maximum Profit (+)
Price
Supplied
or Minimum Loss (-)
$151
10
$+480
131
9
+299
111
8
+138
91
7
-3
81
6
-64
71
0
-100
61
0
-100
The schedule shows the quantity a firm
will produce at a variety of prices
7-11
Short-Run Supply Curve
Cost and Revenues (Dollars)
Firms produce where MR=MC
LO: 7-4
e
P5
P3
P2
P1
MR5
d
P4
MC
ATC
c
AVC
b
a
MR4
MR3
MR2
MR1
This Price is Below AVC
So Firm will not be Producing
0
Q2
Q3
Q4
Quantity Supplied
Q5
7-12
Short-Run Supply Curve
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
P5
P4
P3
P2
P1
0
MC
MR5
d
ATC
c
AVC
b
a
MR4
MR3
MR2
MR1
Shut-Down Point
(If P is Below)
This Price is Below AVC
And Will Not Be Produced
LO: 7-4
e
S
Q2
Q3
Q4
Quantity Supplied
Q5
7-13
Industry Equilibrium
 The individual supply curves of each of the identical
firms in an industry are summed horizontally to get
the total (market) supply curve.
 Industry equilibrium price and quantity are
determined by the intersection of total; market,
supply, and total; or market and demand.
LO: 7-5
7-14
Profit Maximization in the
Long Run
 Assume that in the long run in a competitive
industry
 The only adjustment is the entry or exit of firms
 All firms in the industry have identical cost curves
 The industry is a constant cost industry
 Then, in the long run, product price will be
exactly equal to, and production will occur at,
each firm’s minimum average total cost.
 Firms seek profit and shun losses
 Firms are free to enter and leave the industry
LO: 7-5
7-15
Long-Run Equilibrium
Single Firm
P=MC=Minimum
ATC (Normal Profit)
Market
MC
S
Price
Price
ATC
MR
P
P
D
0
Qf
Quantity
LO: 7-5
0
Qe
Quantity
Productive Efficiency: Price = minimum ATC
Allocative Efficiency: Price = MC
Pure competition has both in its long-run equilibrium.
7-16
Long-Run Supply Curve
 In a constant cost industry, resource prices are not
affected by the number of firms, thus
 Long-run supply curve is horizontal.
 In an increasing-cost industry the entry of new firms
raise the prices for resources and thus increases their
production costs, thus
 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 a decreasing-cost industry, firms experience lower
costs as the industry expands, thus
 Long-run supply curve is downward-sloping.
LO: 7-6
7-17