Pure Competition

1. Chapter 9 Pure Competition

2. Chapter Objectives • The four basic market models • Conditions for pure competition • Profit maximization for competitive firms • The competitive firm supply curve • Industry entry and exit • Industry cost structure • Economic efficiency 9-2

3. Four Market Models • Pure competition • Pure monopoly • Monopolistic competition • Oligopoly Imperfect Competition Pure Competition Monopolistic Competition Pure Monopoly Oligopoly Market Structure Continuum 9-3

4. Pure Competition • Very large numbers • Standardized product • “Price takers” • Free entry and exit • Perfectly elastic demand • Average revenue • Marginal revenue • Price 9-4

5. Pure Competition $1179 Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data 1048 917 786 ] ] ] ] ] ] ] ] ] ] 655 Price and Revenue 524 393 262 131 2 4 6 8 10 12 Quantity Demanded (Sold) TR P QD TR MR $131 131 131 131 131 131 131 131 131 131 131 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 D = MR = AR 9-5

6. Short Run Profit Maximization • Market price is given • Three questions: • Should the product be produced? • If so, in what amount? • What economic profit (loss) will be realized? 9-6

7. Profit Maximization • Two approaches • Total revenue and total cost approach • Produce where TR-TC is greatest • Marginal revenue and marginal cost approach • Produce where MR=MC 9-7

8. Total Revenue Total Cost Approach Price = $131 (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) or Loss (-) $100 100 100 100 100 100 100 100 100 100 100 0 1 2 3 4 5 6 7 8 9 10 $0 90 170 240 300 370 450 540 650 780 930 $100 190 270 340 400 470 550 640 750 880 1030 $0 131 262 393 524 655 786 917 1048 1179 1310 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 Do You See Profit Maximization? Now Let’s Graph The Results… 9-8

9. Total Revenue Total Cost Approach $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 Total Revenue and Total Cost 0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 10 10 11 11 12 12 13 13 14 14 Quantity Demanded (Sold) $500 400 300 200 100 Total Economic Profit Quantity Demanded (Sold) Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum Economic Profit $299 Total Cost, (TC) P=$131 Break-Even Point (Normal Profit) Total Economic Profit $299 9-9

10. Short-Run Supply Curve Cost and Revenues (Dollars) Quantity Supplied Firms produce where MR=MC MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5 0 9-10

11. Marginal Revenue Marginal Cost Approach (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (1) Total Product (Output) (5) Marginal Cost (MC) (6) Marginal Revenue (MR) (7) Profit (+) or Loss (-) $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 0 1 2 3 4 5 6 7 8 9 10 $90.00 85.00 80.00 75.00 74.00 75.00 77.14 81.25 86.67 93.00 $90 80 70 60 70 80 90 110 130 150 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 $131 131 131 131 131 131 131 131 131 131 $-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280 No Surprise - Now Let’s Graph It… Do You See Profit Maximization Now? 9-11

12. Marginal Revenue Marginal Cost Approach $200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 MR = MC MC P=$131 Economic Profit MR = P ATC Cost and Revenue AVC A=$97.78 Output 9-12

13. Short Run Profit Maximization • Produce where MR (=P) = MC • Suffer loss, still produce? • Yes if loss is less than fixed cost • Cover variable cost • Shut down if loss greater than fixed cost • Produce if P > min AVC 9-13

14. Short Run Loss Minimizing Case $200 150 Cost and Revenue 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Lower the Price to $81 and Observe the Results! MC Loss A=$91.67 ATC AVC P=$81 MR = P V = $75 9-14

15. Short Run Shut Down Case $200 150 Cost and Revenue 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Lower the Price Further to $71 and Observe the Results! MC ATC V = $74 AVC MR = P P=$71 Short-Run Shut Down Point P < Minimum AVC $71 < $74 9-15

16. Short-Run Supply Curve Continuing the Same Example… Supply Schedule of a Competitive Firm Quantity Supplied Maximum Profit (+) or Minimum Loss (-) Price $151 131 111 91 81 71 61 10 9 8 7 6 0 0 $+480 +299 +138 -3 -64 -100 -100 The schedule shows the quantity a firm will produce at a variety of prices 9-16

17. Short-Run Supply Curve Cost and Revenues (Dollars) Quantity Supplied Firms produce where MR=MC Examine the MC for the Competitive Firm MC Above AVC Becomes the Short-Run Supply Curve S Break-even (Normal Profit) Point MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 0 9-17

18. Firm and Industry Supply • Changes in firm supply • Shifts in marginal cost • Input price or technology • The industry (total) supply curve • Sum of individual supply • Industry supply and demand • Determine market price 9-18

19. Firm and Industry Supply Single Firm Industry p P 0 0 p P S = ∑ MC’s s = MC Economic Profit ATC d $111 $111 AVC D 8000 8 Competitive firm must take the price that is Established by industry supply and demand 9-19

20. Long Run Profit Maximization • Assumptions • Entry and exit only • Identical costs • Constant-cost industry • Goal of the analysis • In the long run, P = min ATC • Entry eliminates profits • Exit eliminates losses 9-20

21. Entry Eliminates Profits Single Firm Industry p P 0 0 p 80,000 90,000 100,000 100 P S1 MC ATC $60 50 40 $60 50 40 S2 MR D2 D1 An increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium 9-21

22. Exit Eliminates Losses Single Firm Industry p P 0 0 p 80,000 90,000 100,000 100 P S3 MC ATC $60 50 40 $60 50 40 S1 MR D1 D3 A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium 9-22

23. Long Run Supply • Constant cost industry • Entry/exit does not affect LR ATC • Constant resource price • Special case • Increasing cost industry • Most industries • LR ATC increases with expansion • Specialized resources • Decreasing cost industry 9-23

24. Long-Run Supply Curve P P1 P2 P3 0 Q Constant-Cost Industry S $50 Z3 Z1 Z2 D3 D1 D2 Q2 Q1 Q3 90,000 100,000 110,000 9-24

25. Long-Run Supply Curve P 0 Q Increasing-Cost Industry S P2 $55 Y2 P1 $50 Y1 P3 $40 Y3 D2 D1 D3 Q2 Q1 Q3 90,000 100,000 110,000 How would a decreasing-cost industry look? 9-25

26. Pure Competition and Efficiency • Productive efficiency P = minimum ATC • Allocative efficiency P = MC • Maximum consumer and producer surplus • Dynamic adjustments • “Invisible Hand” revisited 9-26

27. Long-Run Equilibrium Single Firm Market Price Price 0 0 Quantity Quantity MC P=MC=Minimum ATC (Normal Profit) S ATC MR P P D Qf Qe Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC Pure competition has both in its long-run equilibrium 9-27

28. The Case of Generic Drugs • Efficiency gains from entry • Lower price and greater output • Purpose of drug patent • Encourage R&D • Cost recovery • Expiration of patent on drugs • Generics enter • Profits decrease, output increase • Combined CS and PS increase 9-28

29. Key Terms • 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 • consumer surplus • producer surplus 9-29

30. Next Chapter Preview… Pure Monopoly 9-30