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Pure (perfect)
Competition
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Pure Competition
Learning objectives
Students should be able to thoroughly and completely explain:
1. The characteristics of pure competition
2. The 3 questions confronting the producer in pure competition.
3. The Total Revenue Total Cost approach to determining the profit maximizing
output and price for the purely competitive firm.
4. The three features of the MR MC approach to determining the profit
maximizing output and price for the purely competitive firm.
5. The following cases for the purely competitive firm in the short run:
1. Profit maximization
2. Loss minimization
3. Shut down
6. How is the short run supply curve derived
7. The characteristics of long run equilibrium of a purely competitive firm.
8. The implications for productive and allocative efficiency in pure competition
Pure Competition
Issues
1. How do firms make decisions in various market
structures?
2. How do firms determine the profit maximizing level of
output in various market structures?
3. What is the impact of market structure on economic
efficiency?
Four Market Models
Pure (or Perfect) Competition
Market Structure Continuum
Four Market Models
Imperfect Competition
All Markets that are
Not Purely Competitive
Pure
Competition
Market Structure Continuum
Four Market Models
Pure Monopoly
One seller
Pure
Competition
Market Structure Continuum
Four Market Models
Monopolistic Competition
Large # of sellers with differentiated (by brand or quality) products
No perfect substitutes
Such as:
Books, clothing, furniture
Pure
Competition
Pure
Monopoly
Market Structure Continuum
Four Market Models
Oligopoly
A market dominated by a few sellers of
Standardized or differentiated products
Pure
Competition
Monopolistic
Competition
Pure
Monopoly
Market Structure Continuum
Pure Competition characteristics:
1.
2.
3.
4.
Very Large Numbers of buyers and sellers (small
market shares)
Standardized Product – perfect substitutes (all the
same)
“Price Takers” (individual producers and
consumers have no control over price or quantity)
Free Entry and Exit – from the market
Pure
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Market Structure Continuum
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)
Average Revenue = price (AR=P)
Marginal Revenue = price (MR=P)
Pure Competition
$1179
P
$131
131
131
131
131
131
131
131
131
131
131
Firm’s
Revenue
Data
917
QD TR
0
1
2
3
4
5
6
7
8
9
10
TR
1048
$0
131
262
393
524
655
786
917
1048
1179
1310
MR
786
]
]
]
]
]
]
]
]
]
]
$131
131
131
131
131
131
131
131
131
131
Price and Revenue
Firm’s
Demand
Schedule
(Average
Revenue)
655
524
393
262
D = MR = AR
131
2
4
6
Quantity Demanded (Sold)
8
10
12
9-11
Short-Run Profit Maximization
Two Approaches to determine the profit maximizing level of output...
First: Total-Revenue -Total Cost Approach
The Decision Process of the Firm:
3 Questions the firm must answer
1.Should the firm produce?
2.What quantity should be produced?
3.What profit or loss will be realized?
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
Total Revenue Total Cost Approach
What is the profit maximizing level of output?
Price = $131
(1)
Total Product
(Output) (Q)
0
1
2
3
4
5
6
7
8
9
10
(2)
Total Fixed
Cost (TFC)
$100
100
100
100
100
100
100
100
100
100
100
(3)
Total Variable
Cost (TVC)
$0
90
170
240
300
370
450
540
650
780
930
(4)
Total Cost
(TC)
$100
190
270
340
400
470
550
640
750
880
1030
(5)
Total Revenue
(TR)
$0
131
262
393
524
655
786
917
1048
1179
1310
Now Let’s Graph The Results…
(6)
Profit (+)
or Loss (-)
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
Total Economic
Profit
Total Revenue and Total Cost
Total Revenue Total Cost Approach
$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100
Break-Even Point
(Normal Profit)
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)
Short-Run Profit Maximization
Two approaches to determine the profit maximizing level of output
First:
Total-Revenue -Total Cost Approach
Second:
Marginal-Revenue -Marginal Cost Approach
Key Rule: MR = MC
3 Characteristics of MR=MC Rule:
1.The rule applies only if producing is
preferred to shutting down
2.Rule applies to all market structures
3.Rule can be restated P=MC (price=MR)
Marginal Revenue - Marginal Cost Approach
Average Average Average
Price = Total
Total Fixed Variable Total Marginal Marginal Economic
Cost
Cost
Product Cost
Cost Revenue Profit/Loss
0
1
2
3
4
5
6
7
8
9
10
The
$100.00 $90.00 $190.00
same
profit
50.00 85.00
135.00
33.33 80.00 113.33
maximizing
25.00 75.00 100.00
20.00 74.00
94.00
result!
16.67 75.00
91.67
14.29
12.50
11.11
10.00
77.14
81.25
86.67
93.00
91.43
93.75
97.78
103.00
90
80
70
60
70
80
90
110
130
150
$ 131
131
131
131
131
131
131
131
131
131
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 298
+ 299
+ 280
Marginal Revenue Marginal Cost Approach
(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)
$90.00
85.00
80.00
75.00
74.00
75.00
77.14
81.25
86.67
93.00
(4)
Average
Total
Cost
(ATC)
$190.00
135.00
113.33
100.00
94.00
91.67
91.43
93.75
97.78
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
Surprise
- Now
Let’s Graph It…
DoNo
You
See Profit
Maximization
Now?
$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280
Marginal Revenue Marginal Cost Approach
$200
MR = MC
150
MC
Cost and Revenue
P=$131
MR = P
ATC
Economic Profit
100
AVC
A=$97.78
50
0
1
2
3
4
5
6
Output
7
8
9
10
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.
Marginal Revenue - Marginal Cost Approach
Loss Minimization Case - graphically
Cost and Revenue
$200
Economic Loss
MC
150
ATC
AVC
MR
100
$91.67
$81.00
50
0
1 2 3 4 5 6 7 8 9 10
Marginal Revenue - Marginal Cost Approach
Short-Run Shut Down Case
Shut Down means a temporary decision not to produce due to current market conditions
Cost and Revenue
$200
150
The firm would shut down if the
revenue it would earn from producing
is less than its variable costs of
production.
ATC
AVC
100
$71.00
50
0
MC
MR
Minimum AVC
is the Shut-Down
Point
1 2 3 4 5 6 7 8 9 10
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
Observe the impact upon profitability as price
is changed
Price
$151
131
111 P5
91 P3
81 P2
No production 71 P1
No production
61
Quantity
Supplied
Maximum Profit (+)
Or Minimum Loss (-)
10
9
8
7
6
0
0
$+480
+299
+138
-3
-64
-100
-100
Marginal Revenue - Marginal Cost Approach
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
Break-even
(Normal Profit)
Point
MC
MR5
P5
ATC
MR4
P4
AVC
P3
P2
P1
MR3
MR2
MR1
Do not
Produce at price–
Below AVC
Q2 Q3 Q4
Q5
Quantity Supplied
Marginal Revenue - Marginal Cost Approach
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
P5
Yields the
Short-Run
Supply Curve
Supply
MC
MR5
P4
MR4
P3
MR3
MR2
MR1
P2
P1
No Production
if Price is
Below AVC
Q2 Q3 Q4
Q5
Quantity Supplied
Diminishing returns, production costs, and product supply
1. Because of the law of diminishing returns, marginal
costs eventually rise as more units of output are
produced.
2. 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
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
MC2
S2
MC1
S1
AVC2
AVC1
Higher Costs Move the
Supply Curve to the Left
Quantity Supplied
Marginal Revenue - Marginal Cost Approach
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
Lower Costs Move
the Supply Curve
to the Right
MC1
S1
MC2
S2
AVC1
AVC2
Quantity Supplied
Check Your Understanding
1. Explain the TR-TC approach.
2. Explain the MR-MC approach.
Short-run Competitive Equilibrium
The Competitive Firm “Takes” its
Price from the Industry Equilibrium
P
P
S= MCs
Economic
ATC Profit S=MC
start
D
$111
$111
AVC
D
8
Competitive Firm
(price taker)
Q
1000 firms
8000
Industry
Q
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
Profit Maximization in the Long Run
Temporary profits and the reestablishment
of long-run equilibrium
P
S1
P
MC
ATC
$60
50
40
MR
$60
50
40
D1
100
Firm
(1000 firms)
(price taker)
Q
100,000
Industry
Q
Profit Maximization in the Long Run
An increase in demand increases economic profits
P
Economic
Profits
S1
P
MC
ATC
$60
50
40
MR
$60
50
40
D2
D1
100
Firm
(price taker)
Q
100,000
Industry
Q
Profit Maximization in the Long Run
New competitors enter the industry. Supply
increases. Prices fall. Economic profits fall.
P Zero Economic
Profits
S1
P
S2
MC
ATC
$60
50
40
MR
$60
50
40
D2
D1
100
Firm
(1100 firms)
(price taker)
Q
100,000
Q
Industry
110,000
Profit Maximization in the Long Run
Decreases in demand, lead to economic losses,
and the reestablishment of long-run equilibrium
P
S1
P
MC
ATC
$60
50
40
MR $60
50
40
D1
100
Firm
(price taker)
Q
100,000
Industry
Q
Profit Maximization in the Long Run
Demand falls. Equilibrium price falls. Firms suffer losses.
P
Economic
Losses
S1
P
MC
ATC
$60
50
40
MR $60
50
40
D1
D2
100
Firm
(900 firms)
(price taker)
Q
100,000
Industry
Q
Profit Maximization in the Long Run
Competitors with losses leave the industry. Supply falls. Prices
return to zero economic profit levels.
S
Return to Zero
P Economic Profits
3
S1
P
MC
ATC
$60
50
40
MR $60
50
40
D1
D2
100
Firm
(price taker)
100,000
Q
90,000
Industry
Q
Long-Run Supply in a Constant Cost Industry
Constant Cost Industry
• 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...
Long-Run Supply in a Constant Cost Industry
P
P1
P2 =$50
P3
Z3
Z1
Z2
S
D3 D1 D2
Q3
Q1
Q2
90,000 100,000 110,000
Q
Long-Run Supply in a Constant Cost Industry
P
P1
P2 How
=$50
P3
Z3
Z1
Z2
does an increasing
cost industry differ?
S
D3 D1 D2
Q3
Q1
Q2
90,000 100,000 110,000
Q
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.
P
S
P1 $55
P2 50
P3 45
Y1
Y2
Y3
D3
Q3
Q1
Q2
90,000 100,000 110,000
D1
D2
Q
Long-run supply in a decreasing cost industry
• A perfectly competitive industry with a negatively-sloped longrun 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.
LONG-RUN SUPPLY IN AN
INCREASING COST INDUSTRY
P
S
What
is the long$55
50
45
run
competitive
equilibrium?
P1
P2
P3
Y1
Y2
Y3
D3
Q3
Q1
Q2
90,000 100,000 110,000
D1
D2
Q
Long-run equilibrium for a
purely competitive firm
MC
Price
ATC
P
MR
Price = MC = Minimum ATC
(normal profit)
Q
Quantity
Pure Competition and Economic
Efficiency
Pure Competition yields Economic Efficiency
Defined as:
Productive Efficiency and Allocative Efficiency
Price = Minimum ATC
Price = MC
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
1. List and explain the characteristics of pure
competition
2. List and explain the 3 questions confronting the
producer in pure competition?
3. Explain the Total Revenue Total Cost approach to
determining the profit maximizing output and price
for the purely competitive firm.
4. Explain long run equilibrium in pure competition
5. Explain efficiency in pure competition
6. Explain how the short run supply curve is derived
Cost of Production:
1. How is the long run ATC curve derived?
2. How might the presence of economies of scale or
diseconomies of scale impact the shape of the LR ATC
curve?
3. List and explain the Short Run Production Relationships
4. Explain the Law of Diminishing Returns
pure competition
pure monopoly
monopolistic
competition
oligopoly
imperfect competition
price taker
average revenue
total revenue
marginal revenue
break-even point
MR = MC rule
short-run supply curve
long-run supply curve
constant-cost industry
increasing-cost industry
decreasing-cost industry
productive efficiency
allocative efficiency