Chapter 19 “Pure Competition”

ECONOMICS: EXPLORE & APPLYby Ayers and Collinge Chapter 19“Pure Competition”

Learning Objectives • Name four market types and describe the characteristics of pure competition. • Illustrate how market demand and supply determine the competitive firm’s demand curve. • Identify the competitive firm’s short-run supply curve. • Describe the long-run equilibrium in pure competition.

Learning Objectives • Explain how efficiency is achieved in a purely competitive market. • Specify the difference between a constant-cost, increasing cost, and decreasing cost industry. • Show how competition can reduce discrimination in society.

19.1TYPES OF MARKETS • There are clearly different types of markets which are commonly called industries. • Markets also differ according to whether the product is homogenous or differentiated. • Homogeneous products are identical no matter which firms produces them, and are often called commodities. • Differentiated products will vary from one producer to the next. • These differences lead to four different market structures, which are models of the way markets work.

Types of Markets • Monopoly: Only one seller of a good with no close substitutes. • Oligopoly: More than one seller, where at least one of the sellers can significantly influence price. • Monopolistic Competition: Numerous firms, each with slight ability to control price. • Pure competition: a market in which there are many buyers and sellers of a homogeneous product.

Types of Markets

The Spectrum of Market Models Less Market Power More Market Power 0 Pure Competition Monopolistic Competition Oligopoly Monopoly The term market power refers to the degree of influence over price by the individual firm.

Characteristics of Pure Competition Numerous buyers and sellers Homogeneous product Firms do not advertise in pure competition Costless entry and exit of all firms. Firms are price takers with a perfectly elastic demand! A price taker always sells at the market price.

Market Supply Firm’s Supply Market Price Firm’s Demand Market Demand Market Quantity Firm’s Output 19.2THE FIRM AND THE MARKET IN PURE COMPETITION Firm Market Dollars Quantity (millions) Quantity (thousands)

Short-Run Supply • At any price above the shutdown price, the profit-maximizing firm equates marginal revenue and marginal cost. • Because the price taking firm’s marginal revenue equals the market price, the firm produces the quantity associated with its marginal cost curve at that price. • The price taking firm’s short-run supply curve is that part of its marginal cost curve that lies above average variable cost.

Marginal Cost Firm’s supply Market supply $250 $160 Shutdown price Average variable cost 6 7 6000 7000 Supply in Pure Competition Market Firm Dollars Quantity Quantity

Marginal Cost Firms supply is its marginal cost curve above its shutdown price. Firm’s supply Market supply $250 $160 Shutdown price Average variable cost For each price, the market supply adds up the Quantities supplied by each firm. 6 7 6000 7000 Supply in Pure Competition Market Firm Dollars Quantity Quantity

19.3THE LONG-RUN - Entry, Exit, and Efficiency • In the short-run, the market price could be sufficiently high that the firm earns profits, or it could be so low that the firm loses money. • Short-run profits attract new firms to enter the market. • Short-run losses cause existing firms to leave the industry. • The long-run equilibrium market price results in the expectation of zero profit for a firm that is considering entry into the industry. • Zero profit means the firm is breaking even, that is, earning a normal profit.

Higher Price after Exit Initial Price Lower Price after Entry Profit Attracts New Entrants Losses Cause Firms to Leave Supply after Exit Initial Supply Dollars Supply after Entry Demand Quantity

Adjusts until price leaves firms with only a normal profit. Market Price Firm’s Demand Market Demand = price = marginal revenue Market Quantity Firm’s Output Long-Run Equilibrium in Pure Competition Firm Market Market Supply Marginal cost Dollars Average cost The long-run equilibrium in pure competition occurs when the last firm to enter the market earns zero profits, as shown by the firm’s average cost curve just tangent to its demand. There would be no reason for a new firm to enter and no reason for an existing firm to exit. Quantity (millions) Quantity (thousands)

The Efficiency of Pure Competition • The competitive market equilibrium produces an allocatively efficient amount of output. • Competition also forces firms to keep cost in check, thus inducing technological efficiency as well. • For these reasons the model of pure competition is often used as the standard of efficiency by which other market structures are judged.

Maximum social surplus Supply Supply Surplus foregone from producing too little Surplus lost from producing too much The Efficiency of Pure Competition Demand Demand Competitive Output Competitive Output Quantity Quantity Too Much Output Too Little Output

19.4LONG RUN SUPPLY • The expansion or contraction of industries over time sometimes affects the cost of production in that industry. • In response to entry, input prices might remain unchanged, rise, or fall, which gives rise to three industry types…. • Constant-cost industry • Increasing-cost industry • Decreasing-cost industry

Long-Run Characteristics of Industries • Constant-cost industry; an increase in the industry’s output does not affect the cost of production. • Increasing-cost industry; an increase in the industry’s output causes input prices to rise. • Decreasing-cost industry; an increase in the industry’s output causes input prices to fall.

Perfect Competition and Long-Run Supply • Perfect competition is a variant of pure competition. • Perfect competition adds to the model of pure competition a further assumption that all firms are identical, with access to resources and technology, with all information fully and freely available. • In a constant-cost industry, the entry of new firms would have no effect on the production cost of other firm’s, and with perfect competition, expansion of the industry would lead to the same equilibrium output price.

Perfect Competition and Long-Run Supply • In an increasing -cost industry, the entry of new firms would not only increase industry output, but would shift up the cost curves of each firm in the industry. • Thus, an expansion of the industry would lead to a higher equilibrium price of the industry’s output. • Conversely, in a decreasing-cost industry, the entry of new firms would lower production cost for all firms and thus lead to a lower equilibrium price of output.

Perfect Competition and Long-Run Supply Constant-cost industry $ Supply Constant average cost curve as industry size grows Average cost • Long-run supply Price Demand Firm’s quantity Industry’s quantity

Perfect Competition and Long-Run Supply Increasing-cost industry $ Supply Higher average cost curve as industry size grows Long-run supply • • • • Average cost Price Demand Firm’s quantity Industry’s quantity

Perfect Competition and Long-Run Supply Decreasing-cost industry $ Supply Lower average cost curve as industry size grows • • Average cost • • Price Long-run supply Demand Firm’s quantity Industry’s quantity

19.5Discrimination – What a Difference Market Structure Makes • Two features of purely competitive firm’s prevents racial discrimination. • One feature is the homogeneous product, which means that the firm has no opportunity to vary the product in discriminatory ways. • Pure competition gives firms a strong profit incentive to avoid discrimination. • In pure competition a firm that inflicts higher input cost on itself can find itself going from profit to loss.

By increasing costs… Discrimination can turn a profit into a loss Discrimination – What a Difference Market Structure Makes Marginal Cost $ Average cost Price Loss • • Profit Firm’s quantity Quantity

homogenous product differentiated product market structure monopoly oligopoly monopolistic competition pure competition market power constant-cost industry increasing-cost industry decreasing-cost industry perfect competition long-run supply Terms Along the Way

Test Yourself • Price takers are found in • pure competition. • monopolistic competition. • oligopoly. • all of the above.

Test Yourself 2. In pure competition the firm’s demand curve will be • upward sloping. • downward sloping. • hump shaped. • horizontal.

Test Yourself 3. For a price taking firm, demand is • equal to price. • less than price. • greater than price. • unrelated to price.

Test Yourself 4. A price taking firm’s short-run supply curve is associated with its • total revenue curve. • average cost curve. • marginal revenue curve. • marginal cost curve.

Test Yourself 5. Profit maximization calls for the purely competitive firm to produce at the point where its demand curve intersects its • total revenue curve. • average cost curve. • marginal revenue curve. • marginal cost curve.

Test Yourself 6. Which statement best describes the long run in a purely competitive market? • The firm’s demand curve is downward sloping. • The market will shrink as firms exit. • The number of firms will be stable because there no incentive for entry or exit. • In the long run, the market will slowly become a monopoly.

The End! Next Chapter 20 “Monopoly and Antitrust"

Chapter 19 “Pure Competition”