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Pure Competition
Four Market Models
Pure Competition:
• Very Large Numbers
• Standardized Product
• “Price Taker”
• Free Entry and Exit
Pure
Competition
Monopolistic
Competition
Oligopoly
Pure
Monopoly
Market Structure Continuum
Market Demand
P
Downward Sloping
Obeys Law of Demand
D
0
Q
Firm's Demand Curve
Firm Price Taking
• Because a firm produces the same
thing as so many other firms, if an
individual firm increases its price, it
will lose ALL of it’s business. So it has
to sell the product at the market
price.
• Note that it can sell as much as it
wants at that price. The firm’s output
does not alter Market Supply.
Supply & Demand Determine Price
P
P
p*
p*
DF = MR
S
D
Firm
Q
Market
Q
Firm’s Demand Curve
$
PM
0
DF = MR
Q
Price
Firm’s Total Revenue Curve
P
TR
1
2
3
4
5
6
7
8
9
10
Quantity (sold)
Marginal Revenue
Marginal Revenue is the increase in revenue
from selling one more unit
If the firm gets price p* for every unit it sells,
then p* is the marginal revenue at all
quantities.
• MR = TR
Q
Horizontal Demand Curve means MR = P
Total-Revenue-Total Cost Approach
Product
Price
$131
131
Quantity
Demanded Total Marginal
Revenue Revenue
(Sold)
0
1
$
0
]
131
$131
MR = TR
= $131
Q
Total-Revenue-Total Cost Approach
Product
Price
$131
131
131
131
131
131
131
131
131
131
131
Quantity
Demanded Total Marginal
Revenue Revenue
(Sold)
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
Perfect Competition
Price, average and marginal revenue,
total revenue (dollars)
Demand, Marginal Revenue, and Total
P
Revenue
1179
TR
1048
917
786
655
524
TR
393
Firm’s Demand
P = MR
Q
262
131
0
1
2
3
4
5
6
7
8
Quantity Demanded (sold)
9
10
Profit Maximization
We assume that the firm is profit maximizing.
Profit = Total Revenue - Total Cost
Total Revenue is P*Q.
We know what the Total Cost curve looks
like, so let’s graph both
Total Revenue and
Total Cost
TC
TR
$
MR = Slope of TR
MC = Slope of TC
Maximum
Profit
Q*
Q
Profit Maximizing
Since the perfectly competitive firm
cannot choose the price, the only choice
left for the firm is to choose how much
to produce.
The firm will choose the quantity
where TR-TC is the largest, in other
words - where the difference between
the TR and TC curves is the biggest
Total-Revenue-Total Cost Approach
Total Total
Total Fixed Variable Total
Product Cost Cost Cost
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
Price: $131
Total
Revenue
$
0
131
262
393
524
655
786
917
1048
1179
1310
Profit
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 298
+ 299
+ 280
Total-Revenue-Total Cost Approach
Total Total
Total Fixed Variable Total
Product Cost Cost Cost
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
Price: $131
Total
Revenue
$
0
131
262
393
524
655
786
917
1048
1179
1310
Profit
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 298
+ 299
+ 280
Total revenue and total costs (dollars)
Total-Revenue-Total Cost Approach
1,700
1,600
1,500
1,400
1,300
1,200
1,100
1,000
900
800
700
600
500
400
300
200
100
0
P
Total
Revenue
Maximum
Economic
Profits
$299
Break-Even Point
(Normal Profit)
{
Total
Cost
Break-Even Point
(Normal Profit)
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Q
Total Revenue and
Total Cost
TC
TR
$
MR = MC
Maximum
Profit
Q*
Q
Marginal-Revenue-Marginal Cost Approach
Average Average Average
Price =
Total
Fixed Variable Total
Total
Marginal Marginal Profit or
Cost
Cost
Product Cost
Cost Revenue 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
]
190.00
]
135.00
]
113.33
]
100.00
]
94.00
]
91.67
]
91.43
]
93.75
]
97.78
]
90.00
85.00
80.00
75.00
74.00
75.00
77.14
81.25
86.67
93.00 103.00
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
How to Find Cost Areas
P
200
MC
150
100
81
TFC
ATC
AVC
50
TVC
0
1 2 3 4 5 6 7 8 9 10
Q
Marginal-Revenue = Marginal Cost
Revenue and Costs (dollars)
P
MC
150
MR
ATC
131
100
94.78
50
0
TR = $1,179
(131 X 9)
1 2 3 4 5 6 7 8 9 10
Q
Marginal-Revenue = Marginal Cost
Revenue and Costs (dollars)
P
150
Economic Profit
MC
MR
ATC
131
100
97.78
50
TC = $880
0
(97.78 X 9)
1 2 3 4 5 6 7 8 9 10
Q
The Profit Maximizing Rule
A profit maximizing firm will always
produce where MC = MR.
In the case of Perfect Competition,
we know MR = P, so we could also
say that a profit maximizing firm
produces where P = MC.
Profit Maximization
MC
MR = MC
MR < MC
p*
MR
MR > MC
Q*
Q
Firm’s Supply Curve
In other words, given a price, the firm
looks to the MC curve and produces
that quantity. This is a supply curve.
The Perfectly Competitive firm’s MC curve
(the upward sloping portion of it, at least)
is its Supply Curve
Profit
We can also determine exactly how much
profit the firm is making.
We know profit = total revenue - total cost
Since ATC=TC/Q, we know
ATC*Q =Total Cost
We also know that total revenue = price*Q
So Profit = (p*Q) - (ATC*Q) = (p- ATC)*Q
graphically...
Profit
p
MC
p*
D
C
ATC
MR
AVC
B
A
O
Q
Q
Profit
p
MC
C
D
Profit
A
ATC
MR
AVC
B
AREA:
TR = OQCD
TC = OQBA
Profit = ABCD
Profit/unit = CB
O
Q
Q
Profit
p
MC
ATC
MR
AVC
p*
atc
Q*
Q
Loss
Note that as long as p>ATC at Q*,
there will be a profit.
But it may be possible that no matter how
much is produced, the firm will still lose
money
In this case the Q* is the quantity where the
firm loses the least amount of money
For example...
Loss
p
MC
ATC
AVC
atc
p*
MR
Q*
Q
Loss
p
MC
ATC
AVC
atc
p*
MR
TC
Q*
Q
Loss
p
MC
ATC
AVC
atc
p*
MR
TR
Q*
Q
Loss
P
MC
ATC
AVC
atc
p*
Loss
MR
Q*
Q
Maximixed Loss
P
MC
ATC
AVC
atc
Loss
MR
P* =AVC
Q*
Q
Normal profit
P
MC
ATC
AVC
MR
P* =ATC
Q*
Q
The decision of whether to
stay open
Just because a firm is losing money in the
short run doesn’t mean it should close its
doors. Often we hear of major firms like
IBM posting a loss, but they stay open
When does a firm shut down?
If P < or = AVC
Short-run loss minimization
If the Market Price is
lowered from:
$131 to $81
Total-Revenue-Total Cost Approach
Total Total
Fixed Variable Total
Total
Product Cost Cost Cost
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
Price: $81
Total
Revenue
$
0
81
162
243
324
405
486
567
648
729
810
Profit
- $100
- 109
- 108
- 97
- 76
- 65
- 64
- 73
- 102
- 151
- 220
Loss Minimization P > AVC
P
200
MC
150
100
Loss
81
ATC
AVC
MR
50
0
1 2 3 4 5 6 7 8 9 10
Q
Loss Minimization P > AVC
P
200
MC
150
100
81
TFC
ATC
AVC
MR
50
0
1 2 3 4 5 6 7 8 9 10
Q
The decision of whether to
stay open
If AVC<P*<ATC, then the firm is losing
money, BUT they are getting enough
revenue to pay all of the variable cost
and some of the fixed cost. If they shut
down, they will have to pay all of the
fixed cost with no revenue. So they are
better off staying open and being able
to pay some of the fixed costs.
Total-Revenue-Total Cost Approach
Total Total
Fixed Variable Total
Total
Product Cost Cost Cost
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
Price: $71
Total
Revenue
$
0
71
142
213
284
355
426
497
568
639
710
Profit
- $100
- 119
- 128
- 127
- 116
- 115
- 124
- 143
- 182
- 241
- 320
Loss Minimization P < AVC
200
MC
150
100
71
50
ATC
AVC
TFC
MR
At no point is P > AVC
Therefore Shut-down!
0
1 2 3 4 5 6 7 8 9 10
Q
Loss Minimization P < AVC
P
200
MC
150
Economic Loss
ATC
AVC
100
71
50
MR
When price is inadequate
to meet minimum AVC,
0the firm should shut down
Q
1 2 3 4 5 6 7 8 9 10
The Shut Down Point
Shut-down Point - P = min AVC
• Firm is indifferent between staying in
business and going out of business.
Firm Supply Curve
• MC curve at or above the Shut-down Point
Firm’s Short-run Supply Line
Costs and revenues (dollars)
P
MC
ATC
AVC
P3
P2
MR3
MR2
This is the lowest
price that any units
will be supplied
Q2 Q3
Q
Firm’s Short-run Supply Line
Costs and revenues (dollars)
P
Break-even
(normal profit)
point
MC
ATC
P4
P3
P2
AVC MR4
MR3
MR2
At a higher price
a greater quantity
will be supplied
Q2 Q3Q4
Q
Firm’s Short-run Supply Line
Costs and revenues (dollars)
P
Making
Economic
Profit
P5
P4
P3
P2
MC
ATC
MR5
AVC MR4
MR3
MR2
Q2 Q3Q4Q5
Q
Firm’s Short-run Supply Line
Costs and revenues (dollars)
P
Short-run
Supply Curve
P5
P4
P3
P2
MC
ATC
MR5
AVC MR4
MR3
MR2
The Marginal
Cost Curve at points above
AVC represent the short-run
supply curve
Q2 Q3Q4Q5
Q
Adding Individual Firm
Supply to From Market Supply
Price per un it
(a)
Firm A
(b) Firm B
SA
(c) Firm C
SB
(d) Market, supply
SA+SB+SC = S
SC
p'
p'
p'
p'
p
p
p
p
0
10 2 0
Quantit y
per pe riod
0
10 2 0
Quantit y
per pe riod
0
10 2 0
Quantit y
per pe riod
0
30
60
Quantit y
per pe riod
6
Per fect Competitio n
Profit Maximizing in the
Short Run
In the short run, the firm takes the
market price, given by the
intersection of the market supply
and demand curves.
The firm then produces where
MC=MR and takes a profit or loss as
long as P>AVC
Profit Maximizing in Short Run
S
P
P
MR
Firm
p*
Q
D
Market
Q
Profit Maximizing in Short Run
MC
P
MR
Firm
S
P
p*
Q
D
Market
Q
Profit Maximizing in Short Run
MC
P
MR
S
P
p*
ATC
Firm
Q
D
Market
Q
Profit Maximizing in Short Run
MC
P
S
P
MR
p*
ATC
AVC
Firm Q*
Q
D
Market
Q
Profit Maximizing in Short Run
MC
P
S
P
MR
p*
ATC
AVC
Firm Q*
Q
D
Market
Q
Profit Maximizing in Short Run
P
S
P
MC
MR
Profit
p*
ATC
AVC
Firm Q*
Q
D
Market
Q
Profit Maximizing in Short Run
It is also possible that the market
price is so low (of the ATC is so
high) that the firm will lose money
Profit Maximizing in Short Run
(Losses - not shut-down)
S
P
MC
P
ATC
Loss
AVC
p*
MR
Firm Q*
Q
D
Market
Q
The Long Run
Recall that the long run is defined
as the time it takes for fixed costs
to change. In other words - all
costs are variable. The ATC curve
equals the AVC curve
Also recall that Perfect
Competition assumes that there is
free entry and exit.
Perfect Comp. in the Long Run
If there are profits being made in an industry,
firms will enter.
If there are losses in an industry, firms will
leave
But what happens to the market when things
like this happen?
Consider the previous example where the
firm was making profits in the short run
Profit Maximizing in Short Run
MC
P
S
P
MR
Profit
p*
ATC
D
Firm Q*
Q
Market
Q
Profit Maximizing in Long Run
Firms see this profit and enter the industry
More firms in an industry means market
supply increases
This drive price down and profits down
Firms continue to enter until the price
is driven down so low that profits are
zero.
Then no more firms want to enter and there
is a long run equilbrium
Profit Maximizing in Long-Run
P
S SS’
P
MC
ATC
MR
p*
MRprice is driven down
Note:
to the bottom of the ATC curve
FirmQ* Q*
Q
D
Market
Q
Losses in the Long Run
But what if there are losses in the long run?
If there are any losses in the long run, firms
will want to leave the industry
When firms leave, market supply decreases
This drives up price and drives down losses
Firms leave as long as there are losses. Once
profits hit zero, firms stop leaving.
Consider the example from earlier...
Losses Long-Run Adjustment
S
P
MC
P
ATC
Loss
p*
MR
D
Firm Q*
Q
Market
Q
Losses in the Long Run
P
S’ S
P
MC
ATC
MR
p*
MR
D
Firm Q*
Q
Market
Q
In the Long Run...
In the Long Run in a perfectly competitive
market...
there are ALWAYS zero profits
P = MC = ATC
The firm produces at the lowest possible
cost at the minimum ATC both in the
Short-run and the Long-run.
Long-Run Equilibrium
MC
ATCSR
LRAC
p*
MR
Q*
Q
Constant Cost Industries
Suppose an increase in demand
expands an industry
This will increase profit in the short-run
As firms enter the market, if costs do
not change.
Then the zero profit price will not
change as quantity supplied in the long
run expands.
In this case the Long Run Supply Curve
is flat
Long-Run Adjustment
to an Increase in Demand
(b) Industry, or Market
(a) Firm
S
S'
p'
d'
ATC
LRAC
Profit
p
d
Price per unit
Dollars per unit
MC
p'
b
a
c
p
S*
D'
D
0
q
q'
Quantity
per period
0
Qa
Qb
Qc
Quantity
per period
Constant Cost Industry
Perfect Competition
9
Long Run Supply
• If there are profits being made, firms enter
and drive profits down.
• But as firms enter the industry, what is
happening to the industry?
• Demand for inputs is rising and the cost
of inputs is rising.
Long Run Supply
• If the input costs are rising, all of the cost
curves in the industry will rise
• Which means the bottom of the ATC curve is
rising
• Which, in turn, means that the zero profit price
has gone up
Increasing Cost Industries
Thus the industry is called an increasing cost
industry, because as more firms enter the
industry and the market quantity rises, the zero
profit price rises
We can draw a Long Run Supply Curve which
demonstrates the relationship between the long
run quantity supplied and the zero profit price
An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
MC'
S
S'
pb
b
ATC'
pc
c
pa
db
ATC
dc
da
a
Price per unit
Dollars per unit
MC
pb
b
S*
pc
c
D'
p
a
a
D
0
q
qb
Quantity
per period
0
Qa
Qb Qc
Quantity
per period
11
Per fect Competitio n
Decreasing Cost Industries
What if more firm enter the industry and that allows
input suppliers to take advantage of economies of
scale and make inputs at lower cost.
Then as the long run quantity supplied increases,
costs for the firms go down and thus the zero profit
price is going down.
This means the long run supply curve will be
downward sloping
A Decreasing-Cost Industry Adjusts to
an Increase in Demand
Dollars pe r unit
S
b
S'
pa
a
c
pc
S*
D'
D
0
Perfect Competition
Qa
Q c Quantity per period
12
The Benefits of Perfect
Competition
Recall in the beginning of the semester
we discussed Productive Efficiency and
Allocative Effeciency.
Productive Effeciency - producing as
much as possible with a given amount
of resources.
In order to do that the firm must
produce at its lowest cost level of
production.
Productive Efficiency
Therefore, a perfectly competitive
market, in the long run, will always be
productively efficient
This is because, in the long run, a
perfectly competitive firm always
produces at the bottom of the ATC
curve
Long Run Equilibrium
for the Firm and the Industry
(a) Firm
(b) Industry, or market
S
ATC
LRAC
p
0
Perfect Comp etition
e
d
q Quantity per period
Price per unit
Dollars per unit
MC
MB = MC
p
D
0
Q
Q*
Quantity per period
8
Allocative Efficiency
In the context of perfect competition, we
are asking if, given the quantity produced
is the amount people are willing to
pay (the demand curve) equal to the
amount people are willing to sell for
(the Supply and the MC curve)?
The answer is yes, so a perfectly
competitive market is allocatively
efficient as well.
Allocative Efficiency
Note that at any quantity less than the
equilibrium Q*, the amount people are
willing to pay is more than the MC.
If the market produces less than Q*, it is
then inefficient.
This is because we could take resources away
from other goods and put them in this market
because MC < MB.
Long Run Equilibrium
for the Firm and the Industry
(a) Firm
(b) Industry, or market
S
ATC
LRAC
p
0
Perfect Comp etition
e
d
q Quantity per period
Price per unit
Dollars per unit
MC
MB = MC
p
D
0
Q
Q*
Quantity per period
8
Allocative Efficiency
Note that at any quantity more than the
equilibrium Q*, the amount people are
willing to pay is less than the MC.
If the market produces more than Q*, it is
then inefficient.
If we would take resources away from other
products, it would not be justified because
the MC > MB.
pure competition
Freedom of Entry
Homogenous products
Price takers
total revenue
marginal revenue
Market Demand
Firm’s Demand Curve
Perfectly Elastic
Shut-down rule
Slope of TR and TC
break-even point
MR = MC rule
short-run supply curve
long-run equilibrium
constant-cost industry
increasing-cost
industry
decreasing-cost
industry
productive efficiency
allocative efficiency