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Pure Competition

21. Pure Competition. 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

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Pure Competition

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  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 • Point of Profit Maximization in All 4 Market Structures • Rule 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

  29. Next Chapter Preview… Pure Monopoly Chapter 22!

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