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A Lecture Presentation
in PowerPoint
to accompany
Essentials of Economics
by Robert L. Sexton
Copyright © 2003 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333
Copyright © 2003 by Thomson Learning, Inc.
Chapter 8
Competition
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

Economists have identified four different
market structures in which firms operate:





perfect competition,
monopoly,
monopolistic competition, and
oligopoly.
Each structure has key characteristics, but it
is sometimes difficult to decide which
structure a given firm or industry most
appropriately fits.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

At one end of the continuum of market
environments is pure monopoly.


There is a single seller.
The seller sets the price that will maximize
its profits.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

Monopolistic competition falls between
perfect competition and monopoly; firms
have elements of both competition and
monopoly power.


Each firm's product is differentiated from
competitors’, so each has some monopoly
power.
However, because there are so many
competitors, it also has an element of
competitive markets.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

Oligopoly also falls between perfect
competition and monopoly, where a few
firms produce similar or identical goods,
as opposed to one firm or many.


Unlike monopoly, oligopoly allows for some
competition between firms.
Unlike competition, individual firms have a
significant share of the total market for the
good being produced.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures


An oligopolist is very conscious of the
actions of competing firms, and its
behavior is closely related to that of its
competitors.
An oligopolist does have some control
over price and thus is a price searcher.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

At the other end of the spectrum,
perfect competition involves



a large number of buyers and sellers,
a homogeneous (standardized) product,
and
easy market entry and exit.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures


In perfect competition, no single firm
produces more than an extremely small
proportion of output, so no firm can
influence the market price or quantity.
Firms are price takers, who must accept
the market price as determined by the
forces of demand and supply.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

In perfectly competitive market,
consumers believe that all firms sell
identical (homogeneous) products, so
the products are perfect substitutes.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures


Product markets characterized by
perfect competition have no significant
barriers to entry or exit.
This means that it is fairly easy for
entrepreneurs to become suppliers of
the product or, if they are already
producers, to stop supplying the
product.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures


Barriers to entry are modest, so large
numbers of firms can enter the business
if they so desire.
Because of easy market entry and exit,
perfectly competitive markets generally
consist of a large number of small
suppliers.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

Highly organized markets for securities
and agricultural commodities are the
best example of a perfectly competitive
market.
Copyright © 2003 by Thomson Learning, Inc.
8.1 The Four Different Market
Structures

While the assumptions for perfect
competition may seem a bit unrealistic,
the model is useful.


Many markets resemble perfect
competition: Firms face very elastic
demand curves and relatively easy entry
and exit.
It gives us a standard of comparison.
Copyright © 2003 by Thomson Learning, Inc.
8.2 The Price Taker’s Demand Curve

Perfectly competitive firms are price
takers, selling at the market-determined
price.


An individual seller cannot sell at any price
higher than the current market price
because buyers could purchase the same
good from someone else at the market
price.
A seller would not charge a lower price
when he could sell all he wants at the
market price.
Copyright © 2003 by Thomson Learning, Inc.
8.2 The Price Taker’s Demand Curve


In a perfectly competitive market, an
individual seller can change his output
and it will not alter the market price.
Each producer provides such a small
fraction of the total supply that a change
in the amount he or she offers does not
have a noticeable effect on market
price.
Copyright © 2003 by Thomson Learning, Inc.
8.2 The Price Taker’s Demand Curve


In a perfectly competitive market, then,
an individual firm can sell as much as it
wishes to place on the market at the
prevailing price.
In other words, the demand, as seen by
the seller, is perfectly elastic at the
market price.
Copyright © 2003 by Thomson Learning, Inc.
8.2 The Price Taker’s Demand Curve

Since a perfectly competitive seller



won't charge more than the market price
because no one will buy at higher prices,
nor charge less because the seller can sell
all she wants at the market price,
the demand curve is horizontal at the
market price over the entire range of
output that she could possibly produce.
Copyright © 2003 by Thomson Learning, Inc.
Market and Individual Demand Curves in
Perfect Competition
Market price
and output
determined
here
Price
Firm's Demand
Curve
d
$5
S
$5
Firm is a price taker—must
take market price
D
0
100
200
Quantity of Wheat
(bushels)
Copyright © 2003 by Thomson Learning, Inc.
0
150
Quantity of Wheat
(millions of bushels)
8.2 The Price Taker’s Demand Curve


The position or height of each firm’s
demand curve varies with every change
in the market price.
Sellers are provided with current
information about market demand and
supply conditions as a result of price
changes.
Copyright © 2003 by Thomson Learning, Inc.
8.2 The Price Taker's Demand Curve

The perfectly competitive model does
not assume any knowledge on the part
of individual buyers and sellers about
market demand and supplythey only
have to know the price of the good they
sell.
Copyright © 2003 by Thomson Learning, Inc.
Market Prices and the Position of a Firm’s
Demand Curve
Price
S
$6
5
d1
d0
$6
5
D0
0
0
Quantity
(firm)
Copyright © 2003 by Thomson Learning, Inc.
Q0 Q1
Quantity
(market)
D1
8.3 Profit Maximization


The firm’s objective is to maximize
profits.
It wants to produce the amount that
maximizes the difference between its
total revenues and total costs.
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization


Total revenue (TR) is the revenue that
the firm receives from the sale of its
products.
Total revenue for a perfectly competitive
firm equals the market price of the good
(P) times the quantity (q) of units sold:
(TR = P x q).
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization

Average revenue (AR) equals total
revenue divided by the number of units
sold of the product (TR/q).
Pq
q
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization


Marginal revenue (MR) is the additional
revenue derived from the sale of one
more unit of the good.
In a perfectly competitive market,


additional units of output can be sold
without reducing the market price,
therefore marginal revenue is constant and
equal to the market price, which is also the
average revenue.
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization


In perfect competition, marginal
revenue, average revenue, and price
are all equal: P = MR = AR.
There are two methods for identifying a
firm's profit maximizing output.


the marginal approach
the total cost-total revenue approach
Copyright © 2003 by Thomson Learning, Inc.
Revenues for a Perfectly Competitive Firm
Quantity
Price
(q)
1
2
3
4
5
(P)
$5
5
5
5
5
Copyright © 2003 by Thomson Learning, Inc.
Total
Average
Revenue
Revenue
(TR = P  q) (AR = TR/q)
$5
$5
10
5
15
5
20
5
25
5
Marginal
Revenue
(MR = TR/q)
$5
5
5
5
8.3 Profit Maximization

In all types of market environments,
firms will maximize profits at that output
where one maximizes the difference
between total revenue and total costs,
which is the same output level where
marginal revenue equals marginal
costs.
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization

The importance of equating marginal
revenue and marginal costs for
maximizing profits is straightforward.
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization


As long as the marginal revenue
derived from expanded output exceeds
the marginal cost of that output, the
expansion of output creates additional
profits.
However, expansion of output when the
marginal cost of production exceeds
marginal revenue will lead to losses on
the additional output, decreasing profits.
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization

The profit-maximizing output rule
says a firm should always produce
where its MR = MC.
Copyright © 2003 by Thomson Learning, Inc.
Finding the Profit Maximizing Level of
Output
MC
Price
Profit increasing
up to q*
$5
MR
MR
MC
0
Profit decreasing
beyond q*
P = MR = AR
MC
A firm maximizes profits
by producing the quantity
where MR = MC, at q*
qTOO LITTLE q* qTOO MUCH
Quantity of Wheat
(bushels per year)
Copyright © 2003 by Thomson Learning, Inc.
8.3 Profit Maximization

Total revenues and total costs and the
profit-maximizing output rule give the
same result.
Copyright © 2003 by Thomson Learning, Inc.
Cost and Revenue Calculations For A
Perfectly Competitive Firm
Quantity
Total
Revenue
Total
Cost
(1)
0
1
2
3
4
5
(2)
$0
5
10
15
20
25
(3)
$2
4
7
11
16
22
Copyright © 2003 by Thomson Learning, Inc.
Profit
(TR – TC)
(4)
$–2
1
3
4
4
3
Marginal
Cost
(TR/q)
(5)
$5
5
5
5
5
Marginal
Cost
(TC/q)
(6)
$2
3
4
5
6
8.4 Short-Run Profits and Losses

Producing at the profit-maximizing
output level does not mean that a firm is
actually generating profits.


It merely means that a firm is maximizing
its profit opportunity at a given price level.
A firm could be
earning profits,
 generating losses, or
 breaking even.

Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses

Three easy steps to determine economic
profits, economic losses, or zero
economic profits:



Where MR equals MC proceed down to
horizontal axis to find q*, the profitmaximizing output level.
At q*, go straight up to demand curve, then
to price axis to find the market price, P*.
Now you can find TR at the profit-maximizing
output level because TR = P x q.
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses



The last step is to find total costs.
Go straight up from q* to the short-run
average total cost (SRATC) curve; this
will give you the average cost per unit.
If we multiply average total costs by the
output level, we can find the total costs
(TC = ATC x q).
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses



If TR > TC at the profit-maximizing
output level, the firm is generating
economic profits.
If TR < TC, the firm is generating
economic losses.
If TR - TC, the firm is earning zero
economic profits,

Covering both implicit and explicit costs,
economists sometimes call zero economic
profit a normal rate of return.
Copyright © 2003 by Thomson Learning, Inc.
Short-Run Profits, Losses and Zero Economic
Profits
P > ATC at q*
Economic Profit
Price
MC
P < ATC at q*
Economic Loss
Price
Price
MC
Total Loss MC
ATC
ATC
P = MR = AR
ATC = $5
P* = $6
ATC = $5
P = ATC at q*
Economic Profit
ATC
$4.90
P = MR = AR
P* = $4
P = MR = AR
Total Profit
0
q* = 120 Quantity
(firm)
(Profit-maximizing quantity)
Copyright © 2003 by Thomson Learning, Inc.
0
q* = 80
Quantity
(firm)
(Loss-minimizing quantity)
0
q* = 100
Quantity
(firm)
(Profit-maximizing quantity)
8.4 Short-Run Profits and Losses

A firm generating an economic loss
faces a tough choice:



Should it continue to produce or
shut-down its operation?
To make this decision, we need to
consider average variable costs.
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses

If a firm cannot generate enough
revenues to cover its variable costs,
then it will have larger losses if it
operates than if it shuts down


(losses in that case = fixed costs).
Thus, a firm will not produce at all unless
the price is greater than its average
variable costs.
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses

At price levels greater than or equal to
average variable costs, a firm may
continue to operate in the short run
even if average total costsvariable
and fixed costsare not completely
covered.

Because fixed costs continue whether the
firm produces or not, it is better to earn
enough to cover a portion of these costs
rather than earn nothing at all.
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses

When price is less than average total
costs but more than average variable
costs, the firm produces in the short run,
but at a loss.

To shut down would make this firm worse
off because it can cover at least some of its
fixed costs with the excess of revenue over
its variable costs.
Copyright © 2003 by Thomson Learning, Inc.
Short-Run Losses
Price
P > AVC
Do not shut down
MC
P
ATC
AVC
P = MR = AR
Shutdown Point
0
Copyright © 2003 by Thomson Learning, Inc.
q
Quantity
(firm)
8.4 Short-Run Profits and Losses

When the price a firm is able to obtain
for its product is below its average
variable costs at all ranges of output, it
is unable to cover even its variable
costs in the short run.

Since it is losing even more than the fixed
costs it would lose if it shut down, it is most
logical for the firm to cease operations.
Copyright © 2003 by Thomson Learning, Inc.
Short-Run Losses: Price Below AVC
Price
P < AVC
Shutdown
MC
P
ATC
AVC
P = MR = AR
Shutdown Point
0
Copyright © 2003 by Thomson Learning, Inc.
q
Quantity
8.4 Short-Run Profits and Losses



At all prices above minimum AVC, the
firm produces in the short run, even if
ATC is not completely covered.
At all prices below the minimum AVC
the firm shuts down.
Therefore the short-run supply curve of
an individual competitive seller is
identical with that portion of the MC
curve that lies above the minimum of
the AVC curve.
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses


As a cost relation, the MC curve above
minimum AVC shows the marginal cost
of producing any given output.
As a supply curve, the MC curve above
minimum AVC shows the equilibrium
output that the firm will supply at various
prices in the short run.
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses

Beyond the point of lowest AVC, the MC
of successively larger outputs are
progressively greater, so the firm will
supply larger amounts only at higher
prices.
Copyright © 2003 by Thomson Learning, Inc.
The Firm’s Short-Run Supply Curve
Short-Run Supply
MC
Price
ATC
AVC
0
Quantity
Copyright © 2003 by Thomson Learning, Inc.
8.4 Short-Run Profits and Losses

The short-run market supply curve



is the horizontal summation of the
individual firms' supply curves,
providing that input prices are not affected
by increased production of existing firms.
Because the short run is too brief for
new firms to enter the market, the
market supply curve is the horizontal
summation of existing firms.
Copyright © 2003 by Thomson Learning, Inc.
Deriving the Short-Run Supply Curve
Price per
Bushel
Individual
Firm
Supply (MC)
P1
P0
P = AVC
0
b
80
Quantity of Wheat
(bushels per day)
Copyright © 2003 by Thomson Learning, Inc.
Market
Supply
P1
P0
P = AVC
a
50
Price per
Bushel
0
B
B
A
A
50
80
Quantity of Wheat
(Thousands of
bushels per day)
The Short-Run Output Decision
MC
ATC
d4, mr4
d3, mr3
AVC
d2, mr2
d1, mr1
P4
P3
P2
P1
Shutdown
point
0
Copyright © 2003 by Thomson Learning, Inc.
q2 q3 q4
8.5 Long-Run Equilibrium

If perfectly competitive producers make
economic profits,



resources devoted to that lucrative
business increase.
More firms enter the industry and existing
firms expand, shifting the market supply
curve to the right over time.
The impact of increasing supply, other
things equal, is to reduce the equilibrium
price.
Copyright © 2003 by Thomson Learning, Inc.
8.5 Long-Run Equilibrium


As entry into the profitable industry
pushes down the market price,
producers will move from making a
profit (P > ATC) to zero economic profits
(P = ATC).
In long-run equilibrium, perfectly
competitive firms make zero economic
profits, earning a normal return on the
use of their capital.
Copyright © 2003 by Thomson Learning, Inc.
8.5 Long-Run Equilibrium

Zero economic profits is an equilibrium
or stable situation because any positive
economic (above-normal) profits signal
resources into the industry, beating
down prices and thus revenues to the
firm.
Copyright © 2003 by Thomson Learning, Inc.
8.5 Long-Run Equilibrium


Economic losses signal resources to
leave the activity, reducing supply which
leads to increased prices and higher
firm revenues to the remaining firms.
Only at zero economic profits is there
no tendency for firms to either enter or
leave the business.
Copyright © 2003 by Thomson Learning, Inc.
Profits Disappear With Entry
Price
Price
S0
MC
S1
P0
ATC
d0, mr0
P0
P1
d1, mr1
P1
D
0
q1
q0
Quantity
Copyright © 2003 by Thomson Learning, Inc.
0
Q0
Q1
Quantity
8.5 Long-Run Equilibrium


The long-run competitive equilibrium for
a perfectly competitive firm can be
graphically illustrated.
Where MC = MR, short-run and longrun average total costs are also equal.

The ATC curves touch the MC and MR
(demand) curves at the equilibrium output
point.
Copyright © 2003 by Thomson Learning, Inc.
8.5 Long-Run Equilibrium

Because the MR curve is also the AR
curve, average revenues and average
total costs are equal at the equilibrium
point.
Copyright © 2003 by Thomson Learning, Inc.
8.5 Long-Run Equilibrium

The long-run equilibrium output in
perfect competition occurs at the lowest
point on the ATC curve, so the
equilibrium condition in the long run in
perfect competition is for firms to
produce at that output that minimizes
per-unit total costs.
Copyright © 2003 by Thomson Learning, Inc.
The Long-Run Competitive
Equilibrium
Price
MC
ATC
P
0
Copyright © 2003 by Thomson Learning, Inc.
P = MR = AR
q*
Quantity of Wheat
(bushels per year)
8.6 Long-Run Supply

When the output of an entire industry
changes, we consider two possible
industry cost conditions.



constant costs
increasing costs
The shape of the long-run supply curve
depends on the extent to which input
costs change when there is entry or exit
of firms in the industry.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply

In a constant-cost industry, the prices of
inputs do not change as output is
expanded. The industry does not use
inputs in sufficient quantities to affect
input prices.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply

Because the industry is one of constant
costs, industry expansion does not alter
firm's cost curves, and the industry
long-run supply curve is horizontal.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply



The short-run higher profits from an
increase in demand attracts entry until
long-run equilibrium is again reached.
The long-run equilibrium price is at the
same level that prevailed before
demand increased.
The only long-run effect of the increase
in demand is an increase in industry
output.
Copyright © 2003 by Thomson Learning, Inc.
Demand Increase in a Constant-Cost
Industry
a. Initial Equilibrium
MC
S
ATC
A
a
P0
P0
D
0
0
q0
Quantity of Blueberries
(firm)
Q0
Quantity of Blueberries
(market)
b. Short-Run Profits
MC
P1
P0
b
Profits
a
ATC
d1, mr1 P1
B
S
A
d0, mr0 P0
D0
0
q0 q1
Quantity of Blueberries
(firm)
Copyright © 2003 by Thomson Learning, Inc.
0
Q0
D1
Q1
Quantity of Blueberries
(market)
Continued . . .
Demand Increase in a Constant-Cost
Industry
c. Long-Run Entry and No Economic Profits
MC
P1
ATC
d1, mr1 P1
P0
d0, mr0 P0
S0
B
A
C
S1
LRS
D1
D0
0
q0
q1
Quantity of Blueberries
(firm)
Copyright © 2003 by Thomson Learning, Inc.
0
Q0 Q1 Q2
Quantity of Blueberries
(market)
8.6 Long-Run Supply

In an increasing-cost industry, the cost
curves of the individual firms rise as the
total output of the industry increases.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply

When an industry utilizes a large portion
of an input,



input prices will rise when the industry uses
more of that input as it expands output,
which will shift firms' cost curves upward.
Examples include “extractive” industries,
which utilize large portions of the total
supply of specialized natural resources
such as land or mineral deposits.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply


The short-run higher profits from an
increase in demand attracts entry until
long-run equilibrium is again reached;
producers' MC and AC curves will be
higher, so that the new long-run
equilibrium is at a higher price.
The long-run industry supply curve in
this case has a positive slope.
Copyright © 2003 by Thomson Learning, Inc.
Increasing-Cost Industry
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply

Even in this case, the long-run supply is
usually more elastic than the short-run
supply because in the long run, firms
can enter and exit the industry.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply


The output that results from equilibrium
conditions of market demand and
supply in perfectly competitive markets
is economically efficient.
Only at this outcome can maximum
output be obtained from our scarce
resources.
Copyright © 2003 by Thomson Learning, Inc.
8.6 Long-Run Supply

Once the competitive equilibrium is
reached,



the buyers' marginal benefit equal the
sellers' marginal cost (both equal to the
price) and
the sum of consumer and producer
surplus is maximized.
If there are no externalities, then total
welfare is maximized and resources are
allocated efficiently.
Copyright © 2003 by Thomson Learning, Inc.
Allocative Efficiency and Perfect Competition
S = MC
S = MC
Q*
Price
Price
MB
A
B
D = MB
MC
MB
Q*
MC
D = MC
0
Q0 Q*
Quantity
Copyright © 2003 by Thomson Learning, Inc.
0
Q* Q0
Quantity