Download Chapter 23: Pure Competition

Chapter 23:
Pure Competition
Copyright McGraw-Hill/Irwin, 2002
FOUR MARKET MODELS
Pure Competition
Very large number of firms, standardized product, new firms
can enter or exit from the industry very easily
Copyright McGraw-Hill/Irwin, 2002
FOUR MARKET MODELS
Pure Monopoly
Pure
Competition
One firm is the sole seller of a product, entry of additional
producers is blocked, produces a unique product, it makes no effort
to differentiate its product.
Copyright McGraw-Hill/Irwin, 2002
FOUR MARKET MODELS
Imperfect Competition
Pure
Competition
Copyright McGraw-Hill/Irwin, 2002
Pure
Monopoly
FOUR MARKET MODELS
Monopolistic Competition
Pure
Competition
Relatively large number of sellers, producing different
products, widespread non-price competition, product
differentiation.
Copyright McGraw-Hill/Irwin, 2002
Pure
Monopoly
FOUR MARKET MODELS
Oligopoly
Pure
Competition
Monopolistic
Competition
Few sellers of an identical product, each is affected by
decisions of others.
Copyright McGraw-Hill/Irwin, 2002
Pure
Monopoly
Perfect Competition
1. Very large numbers
Very large number of independently acting sellers (e.g.
farm products, stock market, foreign exchange market.
2. Standardized product
Identical or homogeneous product. As long as the
price is the same, consumers will be indifferent about
which seller they buy the product from
Copyright McGraw-Hill/Irwin, 2002
3. Price takers
- Individual firms have no significant control over the
market price. Each firm’s quantity is too small to affect
the market supply or price.
- Competitive firms are price takers, they cannot affect
the price, but adjust their own price to it.
- None of the sellers can ask for a higher price because
it will lose all consumers.
- None will sell at a lower price because it will incur a
loss.
Copyright McGraw-Hill/Irwin, 2002
4. Free entry and exit
• New firms can freely enter and existing firms can
freely leave the market.
• No significant legal, technological, financial, or other
obstacles prohibit new firms from selling their output
in the market.
Relevance of pure competition
• Pure competition is rare.
• It is highly relevant, we can learn much about markets
by studying the pure competition model.
• It is meaningful as a starting point for discussing price
and output determination.
• Useful to compare with other markets with regard to
efficiency, price and output.
Copyright McGraw-Hill/Irwin, 2002
Revenue
Total Revenue (TR)
• Equals the price times the quantity (TR=P x Q).
• Total revenue increases by a constant amount for each
unit sold.
Average Revenue (AR)
• Revenue per unit sold (AR = TR/Q).
• The firm’s demand schedule is its revenue schedule.
• Price and average revenue are the same (P=AR).
Marginal Revenue (MR)
• The change in total revenue due to the change in the
quantity sold by one unit (MR = ΔTR/ Δ Q).
• Marginal revenue is constant because price is constant.
• MarginalCopyright
revenue
equals the price.
McGraw-Hill/Irwin, 2002
Note
Only in a competitive market:
Price = Average revenue = Marginal revenue
Copyright McGraw-Hill/Irwin, 2002
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
Copyright McGraw-Hill/Irwin, 2002
0
$
0
Marginal
Revenue (MR)
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
131
Copyright McGraw-Hill/Irwin, 2002
0
1
$
0]
131
Marginal
Revenue (MR)
$131
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
131
131
Copyright McGraw-Hill/Irwin, 2002
0
1
2
$
0]
131 ]
262
Marginal
Revenue (MR)
$131
131
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
131
131
131
Copyright McGraw-Hill/Irwin, 2002
0
1
2
3
$
0]
131 ]
262 ]
393
Marginal
Revenue (MR)
$131
131
131
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
131
131
131
131
Copyright McGraw-Hill/Irwin, 2002
0
1
2
3
4
$
0]
131 ]
262 ]
393 ]
524
Marginal
Revenue (MR)
$131
131
131
131
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
131
131
131
131
131
131
131
131
131
131
Copyright McGraw-Hill/Irwin, 2002
0
1
2
3
4
5
6
7
8
9
10
$
0]
131 ]
262 ]
393 ]
524 ]
655 ]
786 ]
917 ]
1048 ]
1179 ]
1310
Marginal
Revenue (MR)
$131
131
131
131
131
131
131
131
131
131
DEMAND AS SEEN BY A
PURELY COMPETITIVE SELLER
Product Price (P)
Quantity
Total
(Average Revenue) Demanded (Q) Revenue (TR)
$131
131
131
131
131
131
131
131
131
131
131
Copyright McGraw-Hill/Irwin, 2002
0
1
2
3
4
5
6
7
8
9
10
$
0]
131 ]
262 ]
393 ]
524 ]
655 ]
786 ]
917 ]
1048 ]
1179 ]
1310
Marginal
Revenue (MR)
$131
131
131
131
131
131
131
131
131
131
Perfectly elastic demand
• A firm cannot obtain a higher price by restricting its
output, nor does it need to lower its price to increase its
sales volume.
• Demand curve faced by the individual competitive firm
is perfectly elastic at the market price
• Note that competitive market demand curve is a
downward sloping curve.
Copyright McGraw-Hill/Irwin, 2002
DEMAND, MARGINAL REVENUE, AND TOTAL
REVENUE IN PURE COMPETITION
1179
TR
Price and revenue
1048
917
786
655
524
393
262
D = MR
131
0
1
2
3
4
5
6
7
8
Quantity Demanded (sold)
Copyright McGraw-Hill/Irwin, 2002
9
10
SHORT RUN PROFIT MAXIMIZATION
Two Approaches...
First: Total-Revenue -Total Cost Approach:
The Decision Process:
• Should the firm produce? If YES,
• What quantity should be produced? and,
• What profit or loss will be realized?
The Decision Rule:
Produce in the short-run if you can realize:
1- A profit (or)
2- A loss less than the fixed cost
Copyright McGraw-Hill/Irwin, 2002
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 $ 0 $ 100
100
90
190
100
170
270
100
240
340
100
300
400
100
370
470
100
450
550
100
540
640
100
649
749
100
780
880
100
930 1030
Copyright McGraw-Hill/Irwin, 2002
Price: $131
Total
Revenue Profit
$
0
131
262
393
524
655
786
917
1048
1179
1310
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 299
+ 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 $ 0 $ 100
100
90
190
100
170
270
100
240
340
100
300
400
100
370
470
100
450
550
100
540
640
100
649
749
100
780
880
100
930 1030
Copyright McGraw-Hill/Irwin, 2002
Price: $131
Total
Revenue Profit
$
0
131
262
393
524
655
786
917
1048
1179
1310
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 299
+ 299
+ 280
Total revenue and total cost
TOTAL REVENUE-TOTAL COST APPROACH
$1,800
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
Break-Even Point
(Normal Profit)
Total
Revenue
Maximum
Economic
Profits
$299
Total
Cost
Break-Even Point
(Normal Profit)
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Copyright McGraw-Hill/Irwin, 2002
SHORT RUN PROFIT MAXIMIZATION
Two Approaches...
First: Total-Revenue -Total Cost Approach
Second Approach:
Marginal-Revenue Marginal-Cost Approach
MR = MC Rule
Three Characteristics:
• The rule applies only if producing is preferred to
shutting down (otherwise the firm will shut
down)
• Rule applies to all markets
• Rule can be restated as: P=MC
Copyright McGraw-Hill/Irwin, 2002
MR = MC rule
In the short run, the firm will maximize profit or
minimize losses by producing the output at which
marginal revenue equals marginal cost.
Copyright McGraw-Hill/Irwin, 2002
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
Copyright McGraw-Hill/Irwin, 2002
91.43
93.75
97.78
103.00
90
80
70
60
70
80
90
110
131
150
$ 131
131
131
131
131
131
131
131
131
131
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 299
+ 299
+ 280
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
$100.00 $90.00 $190.00 90
50.00 85.00 135.00 80
33.33 80.00 113.33 70
25.00 75.00 100.00 60
20.00 74.00
94.00 70
16.67 75.00
91.67 80
14.29 77.14
91.43 90
12.50 81.25
93.75 110
11.11 86.67
97.78 131
10.00 93.00 103.00 150
Copyright McGraw-Hill/Irwin, 2002
$ 131
131
131
131
131
131
131
131
131
131
- $100
- 59
-8
+ 53
+ 124
+ 185
+ 236
+ 277
+ 299
+ 299
+ 280
Two Ways to Calculate Profit
First: Calculate total profit
TR = P x Q
TC = ATC x Q
Π = TR – TC
Second: calculate profit per unit
Π /Q = TR/Q – TC/Q
Π /Q = P (or AR) – ATC
Π = (Π /Q) x Q
Copyright McGraw-Hill/Irwin, 2002
MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
Cost and Revenue
$200
Economic Profit
MC
150
MR
ATC
AVC
$131.00
100
$97.78
50
0
1 2 3 4 5 6 7 8 9 10
Copyright McGraw-Hill/Irwin, 2002
MARGINAL REVENUE-MARGINAL COST APPROACH
Profit Maximization Position
Cost and Revenue
$200
Economic Profit
MC
150
$131.00
MR = MC
100
$97.78
Optimum
Solution
50
0
1 2 3 4 5 6 7 8 9 10
Copyright McGraw-Hill/Irwin, 2002
MR
ATC
AVC
MARGINAL REVENUE-MARGINAL COST APPROACH
Loss Minimization Position
If the price is lowered from $131 to $81
The MR=MC rule still applies
…But the MR = MC point changes
Note: π = π per unit x Q
Copyright McGraw-Hill/Irwin, 2002
MARGINAL REVENUE-MARGINAL COST APPROACH
Loss Minimization Position
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
Copyright McGraw-Hill/Irwin, 2002
MARGINAL REVENUE-MARGINAL COST APPROACH
Short-Run Shut Down Point
Cost and Revenue
$200
MC
150
ATC
AVC
100
MR
Minimum AVC
is the Shut-Down
Point
$71.00
50
0
1 2 3 4 5 6 7 8 9 10
Copyright McGraw-Hill/Irwin, 2002
MARGINAL REVENUE-MARGINAL COST APPROACH
Marginal Cost & Short-Run Supply
Observe the impact upon profitability as price
is changed
Price
Quantity
Supplied
Maximum Profit (+)
Or Minimum Loss (-)
$151
131
111
91
81
71
61
10
9
8
7
6
0
0
$+480
+299
+138
-3
-64
-100
-100
Copyright McGraw-Hill/Irwin, 2002
MARGINAL REVENUE-MARGINAL COST APPROACH
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
MC
MR5
P5
ATC
MR4
P4
AVC
P3
P2
P1
MR3
MR2
MR1
Do not
Produce –
Below AVC
Q2 Q3 Q4
Copyright McGraw-Hill/Irwin, 2002
Q5
Quantity Supplied
MARGINAL REVENUE-MARGINAL COST APPROACH
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
Yields the
Short-Run
Supply Curve
P5
Supply
MC
MR5
P4
MR4
P3
MR3
MR2
MR1
P2
P1
No
Production
Below AVC
Q2 Q3 Q4
Copyright McGraw-Hill/Irwin, 2002
Q5
Quantity Supplied
MARGINAL REVENUE-MARGINAL COST APPROACH
Cost and Revenue, (dollars)
Marginal Cost & Short-Run Supply
Copyright McGraw-Hill/Irwin, 2002
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
Copyright McGraw-Hill/Irwin, 2002
MC1
S1
MC2
S2
AVC1
AVC2
Quantity Supplied
SHORT RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” its Price from the Industry
Equilibrium
S= MC’s
P
P
Economic
ATC Profit S=MC
D
$111
$111
AVC
D
8
Firm
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
8000
Industry
Q
SHORT RUN COMPETITIVE EQUILIBRIUM
The Competitive Firm “Takes” it’s Price from the Industry
Equilibrium
P
P
S= MC’s
Economic
ATC Profit S=MC
D
$111
$111
AVC
D
8
Firm
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
8000
Industry
Q
PROFIT MAXIMIZATION IN THE LONG-RUN
Assumptions...
• Entry and Exit Only: the only long run adjustment
is the entry and exit of firms.
• Identical Costs: all firms in the industry have
identical cost curves.
• Constant-Cost Industry: entry and exit does not
affect resource prices.
Goal...
Price = Minimum ATC
Zero Economic Profit Model
Copyright McGraw-Hill/Irwin, 2002
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
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
100,000
Industry
Q
PROFIT MAXIMIZATION IN THE LONG-RUN
An increase in demand increases profits…
P
Economic
Profits
S1
P
MC
ATC
$60
50
40
MR
$60
50
40
D2
D1
100
Firm
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
100,000
Industry
Q
PROFIT MAXIMIZATION IN THE LONG-RUN
New Competitors increase supply and lower Prices decrease
economic profits
S1
Zero
Economic
P
P
S2
Profits
MC
ATC
$60
50
40
MR
$60
50
40
D2
D1
100
Firm
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
100,000
Industry
Q
PROFIT MAXIMIZATION IN THE LONG-RUN
Decreases in demand, 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)
Copyright McGraw-Hill/Irwin, 2002
Q
100,000
Industry
Q
PROFIT MAXIMIZATION IN THE LONG-RUN
A decrease in demand creates losses…
P
Economic
Losses
S1
P
MC
ATC
$60
50
40
MR $60
50
40
D1
D2
100
Firm
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
100,000
Industry
Q
PROFIT MAXIMIZATION IN THE LONG-RUN
Competitors with losses decrease supply and prices return
to zero economic profits
S3
Return to Zero
S1
P Economic Profits P
MC
ATC
$60
50
40
MR $60
50
40
D1
D2
100
Firm
(price taker)
Copyright McGraw-Hill/Irwin, 2002
Q
100,000
Industry
Q
LONG-RUN SUPPLY IN A
CONSTANT COST INDUSTRY
Constant Cost Industry
Perfectly Elastic Long-Run Supply: entry and
exit will set the price back to its original level
Graphically...
Copyright McGraw-Hill/Irwin, 2002
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
Copyright McGraw-Hill/Irwin, 2002
Q
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
Copyright McGraw-Hill/Irwin, 2002
Q
LONG-RUN SUPPLY IN AN
INCREASING COST INDUSTRY
P
S
P1 $55
P2 50
P3 45
Y1
Y2
Y3
D3
Q3
Q1
Q2
90,000 100,000 110,000
Copyright McGraw-Hill/Irwin, 2002
D1
D2
Q
LONG-RUN SUPPLY IN AN
INCREASING COST INDUSTRY
P
S
P1 $55
P2 50
P3 45
Y1
Y2
Y3
D3
Q3
Q1
Q2
90,000 100,000 110,000
Copyright McGraw-Hill/Irwin, 2002
D1
D2
Q
LONG-RUN SUPPLY IN AN
INCREASING COST INDUSTRY
P
S
P1 $55
P2 50
P3 45
Y1
Y2
Y3
D3
Q3
Q1
Q2
90,000 100,000 110,000
Copyright McGraw-Hill/Irwin, 2002
D1
D2
Q
LONG-RUN EQUILIBRIUM
FOR A COMPETITIVE FIRM
MC
Price
ATC
P
MR
Price = MC = Minimum ATC
(normal profit)
Q
Quantity
Copyright McGraw-Hill/Irwin, 2002
PURE COMPETITION AND EFFICIENCY
Productive Efficiency: Price = Minimum ATC
Allocative Efficiency:
Price = MC
Underallocation:
Price > MC
Overallocation:
Price < MC
Resources are
efficiently allocated
Under pure
competition
Copyright McGraw-Hill/Irwin, 2002