Pure Competition

1. 21 Pure Competition

2. Chapter Objectives • Names and Main Characteristics of the Four Basic Market Models • Conditions for Perfect Competition • How Do Purely Competitive Firms Maximize Profits or Minimize Losses • Why the Marginal Cost and Supply Curves For Competitive Firms Are Identical • How Industry Entry and Exit Create Economic Efficiency • Differences Between Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries

3. Four Market Models • Pure Competition • Pure Monopoly • Monopolistic Competition • Oligopoly Imperfect Competition Pure Competition Monopolistic Competition Pure Monopoly Oligopoly Market Structure Continuum

4. Pure Competition • Very Large Numbers • Standardized Product • “Price Takers” • Free Entry and Exit • Perfectly Elastic Demand • Average Revenue • Total Revenue • Marginal Revenue Graphically…

5. $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) Pure Competition 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

6. Profit Maximization in the Short Run Total Revenue-Total Cost Approach Consider: • Should Product Be Produced? • If So, In What Amount? • What Economic Profit (Loss) Will Be Realized?

7. Profit Maximization in the Short Run 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…

8. $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 W 21.1 Total Revenue and Total Cost G 21.1 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) Profit Maximization in the Short Run Total Revenue-Total Cost Approach 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. Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule • Important Features: • Firm Will Shut Down Unless MR at Least Meets MC • Profit Maximization in All Market Structures • Can Be Restated P = MC

10. Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule (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?

11. $200 W 21.2 150 Cost and Revenue 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule MR = MC P=$131 MC Economic Profit MR = P ATC AVC A=$97.78

12. $200 150 Cost and Revenue 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule Loss Minimizing Case Lower the Price to $81 and Observe the Results! MC Loss A=$91.67 ATC AVC MR = P P=$81 V = $75

13. $200 150 Cost and Revenue 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Profit Maximization in the Short Run Marginal Revenue-Marginal Cost Approach MR = MC Rule Short-Run Shut Down Case 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

14. Marginal Cost and Short-Run Supply Continuing the Same Numeric 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 and Results

15. Cost and Revenues (Dollars) Quantity Supplied Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use 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

16. Cost and Revenues (Dollars) Quantity Supplied Marginal Cost and Short-Run Supply Generalizing the MR=MC Relationship and its Use 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) This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5 0

17. Changes in Supply • Firm and Industry • Equilibrium Price • Market Price and Profits • Firm Versus Industry Graphically…

18. Single Firm Industry p P W 21.3 0 0 p P Changes in Supply 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

19. Profit Maximization in the Long Run • Assumptions • Entry and Exit Only • Identical Costs • Constant-Cost Industry • Goal of the Analysis • Long-Run Equilibrium • Entry Eliminates Profits • Exit Eliminates Losses

20. Single Firm Industry p P 0 0 p 80,000 90,000 100,000 100 P Supply Readjustment 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

21. Single Firm Industry p P 0 0 p 80,000 90,000 100,000 100 P Supply Readjustment 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

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

23. P 0 Q Long-Run Supply Curve 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?

24. O 21.1 Pure Competition and Efficiency • Productive Efficiency P = Minimum ATC • Allocative Efficiency P = MC • Maximum Consumer and Producer Surplus • Dynamic Adjustments • “Invisible Hand” Revisited

25. Single Firm Market Price Price 0 0 Quantity Quantity Long-Run Equilibrium Competitive Firm and Market 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

26. Efficiency Gains From Entry: Last Word The Case of Generic Drugs • Competitive Model Predicts Lower Price and Greater Output With Increased Efficiency When New Producers Enter Market • Example is Patented Drugs • Patents Enable Greater Profits in Support of R&D and Accelerated Cost Recovery • After Patent Period Generics Enter Market • Profits Decrease and Quantities Increase • Combined Consumer and Producer Surpluses Increase

27. Price Quantity Efficiency Gains From Entry: Last Word The Case of Generic Drugs New Producers Enter Market a S • As Price Decreases to f, • Consumer Surplus abc • Increases to adf • Producer and Consumer • Surplus is Maximized • Together as Shown by • the Gray Triangle Initial Patent Price b c P1 d f P2 D Q1 Q2 Results: Greater Quantity at Lower Prices as Predicted by the Competitive Model

28. pure competition pure monopoly monopolistic competition oligopoly imperfect competition price taker average revenue total revenue marginal revenue break-even point MR=MC 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 Key Terms

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