Chapter 9 Outline: This chapter demands a lot of attention to detail. I will suggest you to go over it slowly, trying to do the exercises that are at the end of the chapter every time that you finish reading a section. Bring this outline to class.

Pure Competition

Introduction

In this chapter

§     We bring together the firm’s demand for its product and the production costs to analyze how a firm decides

•  What price to charge

•  How much output to produce

•  Whether to enter or exit an industry

§      These decisions depend on the characteristics of the market in which the firm is operating

Market Structure

§     Market structure refers to the characteristics of the industry

§     Economists distinguish among four basic types of market structure, according to:

§      Number of firms in the industry

§      Kind of product produced

•  Homogeneous or standardized products, also called commodities

•  Differentiated products

§      Ease of entry into and exit from the industry

§     These characteristics define the way each individual firm sees the demand for its product

The Four Market Types are:

According to their degree of market power (influence over the price)

§     Pure Competition

§     Monopolistic Competition

§     Oligopoly

§     Monopoly

 

 

 

 

 

 

 

 

 

Summary: Market Structure Characteristics

Pure Competition

Characteristics:

§     A very large number of small independent firms in the industry

§      Each seller is very small in relation to the market

§      It will remain small because of the absence of economies of scale

§     Homogeneous product

§      A standardized product that has many perfect substitutes

§      Firms do no advertise in pure competition

 

Characteristics Pure Competition (cont.)

§     “Price takers”

§      Firms do not exert any influence over the price of its product. They take as given the market price. No market power.

§     Free entry and exit

§      There are no significant obstacles that impede new firms to enter or existing firms to exit the industry

Examples of Pure Competition:

•  Most agricultural markets

•  Foreign Exchange market

•  Shares of Common Stock Market

Crucial Characteristic: “Price Taker”

Pure competitive firms are “price takers”

§     They have no control over the price at which they sell.

§     The market demand and supply sets the price. Sellers and buyers react.

§     Each firm must decide how much to produce based upon the market price

Demand Facing a Competitive Firm

§     The demand facing a competitive firm is perfectly elastic (a horizontal line) at the market prevailing price because the firm is a “price taker”

§      The firm can sell any amount at the market determined price

The Demand Curve for a Competitive Firm

Revenue Concepts for a Competitive Firm

We define three terms:

§     Total Revenue (TR) - is the total amount that a firm takes in from the sale of its output

 

 

§     Total revenue is proportional to the amount of output.

§    Graphically: it increases at a constant rate, as each unit sells for a constant price

 

Revenue Concepts for a Competitive Firm

§     Average Revenue (AR) – is the revenue per unit of output

 

 

 

§     Average revenue is always equal to price; the demand curve is the average revenue curve

 

 

Revenue Concepts for a Competitive Firm

§     Marginal Revenue (MR) – is the additional revenue that a firm takes in when it increases output by one additional unit.

 

 

 

§     In pure competition,

§      Only for a competitive firm,

 

 

 

 

 

 

 

Solved Problem

§     When a purely competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue?

 

Profit Maximization in the Short Run

§      Maximization of profits is the goal of any firm

Two Methods to Find the Optimal Output

§      Total Revenue-Total Cost Approach

§       Find the output that realizes the largest amount of profits

§       Compare total revenue to total cost at each level of output

 

§      Marginal Revenue-Marginal Cost Approach

§       Compare marginal revenue to marginal cost at each level of output

§       Profits are maximized at the output level at which, MR = MC

Total Revenue-Total Cost Approach

§     It is one way to find the profit-maximizing output using the total revenue and total costs schedules or curves

§     Profit is maximized at the output level at which total revenue exceeds total cost by the largest amount

 

 

 

Marginal Revenue-Marginal Cost Approach

§      It is another way to find the profit-maximizing output (optimal) using the marginal revenue and marginal cost schedules and curves

§      Profit is maximized at the output level at which marginal revenue is equal to marginal cost

General Rule for Profit Maximization in the Short Run

§     The rule for profit maximization states:

 

“Never produce a unit of output that costs more than it brings in.”

 

§     The rule applies to all market structures

MR compare to MC

Three possible outcomes:

§     MR > MC ŕ The production of an additional unit of output adds more to revenue than to costs

 
It is profitable to increase output

MR compare to MC

§     MR < MC ŕ The production of an additional unit of output costs more than the additional revenue generated by the sale of this unit

 
  Firms can increase their profits by producing less.

MR compare to MC

§     MR = MC ŕ The production of an additional unit of output costs the same amount that generates as additional revenue

 

  Firms have no incentive to produce either less or more output
  Firm’s profits are maximized at the level of output at which
 

Rule of Profit Maximization for a Price Taker

§     For a purely competitive firm only:  MR = P

 

 

  The rule of profit-maximization can be restated as:

 

Profits or Losses at the Profit-Maximizing Output

§     Once the profit-maximizing output is determined using the

MR (=P) = MC  Rule

§     We need to determine whether the firm is making a profit or a loss

§      We compare the P to the ATC at the profit-maximizing output

 

 

 

Profit per Unit of Output

§     Profit per unit of output is the average profit

 

Short-Run Production Decisions

§      P > ATC ŕ The firm is making a profit, the firm will produce the profit-maximizing output

 

§      P < ATC ŕ The firm is making a loss, It has two options:

§       If the loss exceeds the amount of FC ŕ The firm should shutdown

§       If the loss is less than FC ŕ The firm should produce and minimize losses

 

§      P = ATC ŕ The firm is breaking even

§       it should produce the profit-maximizing output because it is making the normal profit

 

 

Short-Run Shutdown Decisions

§      If P < ATC, but TR > VC ŕ P > AVC

§       Producing the profit-maximizing rate of output minimizes losses, the loss is less than FC

§       If the firm shuts down, the loss is equal to FC

 

§      If P< ATC, but TR < VC ŕ P < AVC

§       The loss of producing the profit-maximizing output exceeds FC

§       The firm minimizes losses if it shuts down

The Shutdown Point

§     The shutdown point is the output and price at which the firm’s total revenue just covers its total variable cost

TR = TVC

                           P = Minimum AVC

§     It is the lowest price at which the firm will produce because either way the loss is equal to the amount of fixed costs

§      A profit maximizing firm will never lose more than the amount of its total fixed cost

Loss-Minimizing Output and Shut-Down Decision

 

The Shutdown Point

Solved Problem

§     Mugs-R-Us produce mugs. It can sell their mugs at $2.50 per mug (the market prevailing price). The marginal cost for the first, second, third, fourth, fifth, and sixth mug is respectively $0.50, $1,00,$1.50, $2,00, $2,50, and $3.00 per mug.

§     Using the MR=MC maximizing profit rule, Mugs-R-Us should produce ______ mugs.

§     If the market price of mugs drops to $2.00, what should Mugs-R-Us do?

Short-Run Supply Curve of an Individual Competitive Firm

§      The short-run supply curve of an individual firm shows the amounts of output supplied by the firm at alternative market prices

§      The competitive firm will produce the profit-maximizing output when MR (= P) = MC, as long as the P is above the minimum AVC (shutdown point)

  The short-run supply curve of an individual firm is the portion of the firm’s marginal cost curve that lies above the minimum average variable cost (shutdown point)

Firm’s Short-run Supply Curve

§     A supply curve shows the optimal quantity produced by the firm at each alternative price.

§     For each price, there is an optimal quantity supplied

§      The firm produces the quantity of output at which the firm’s demand (MR = AR) curve intersects its short-run supply (MC) curve.

 

 

 

 

 

 

Marginal Costs and Short-run Supply

§     MC curve is U-shaped because of diminishing marginal returns

§      Marginal costs rise as more units are produced

§      A competitive firm must get higher prices to expand production

§     Anything that will alter MC (variable input prices or technology) will shift the short-run supply curve to a new location

Short-run Equilibrium of the Firm

§     In the short run, the market price could be sufficiently high ŕ firm earns economic profits, in excess of normal profits (P > ATC)

§     Or, it could be so low ŕ firm makes an economic loss (P < ATC), but the loss is less than fixed costs (P > AVC)

Profit Maximization Position Revisited

Loss Minimization Position Revisited

Solved Problem

 

Short-Run Market Supply

§      In the short run, the number of firms in the industry is fixed (no entry, no exit)

§      To derive the short-run supply curve of the industry from those of the individual firms

§       At any given market price, add up the quantity supplied by each firm in the industry

•  Sum the individual short-run supply curves horizontally

Deriving the Competitive Market Supply Curve

Short Run Market Equilibrium

§     To find the market equilibrium

§      Short-run market supply is compared to the market demand

•  Market demand is always downward sloping          

§      The market price is determined by the intersection of the market supply and market demand curves

•  Each competitive firm in the market takes this price as given and produces the profit-maximizing output

 

 

 

Short-run Competitive Equilibrium

§     At the market equilibrium price ($111), each existing firm in the market is making an economic profit ($138)

§      Economic profit = Profit per Unit x Optimal Output = $17.25 x 8 = $ 138

§     The industry profit is:

§      Profit per Firm x Number of Firms in the Market = $138 x 1,000 = $138,000

Important Results in the Short-Run Competitive Equilibrium

§     In the short-run equilibrium, the competitive firm can make

§      Profits, if market price > ATC

§      Losses, if market price < ATC and the price is above the minimum average variable cost

§      A loss equal to fixed costs if the firm shuts down

 

Long Run Profit Maximization

Recall:

§     In the long run, existing firms in the industry have enough time to expand or contract their plant capacities

§     The number of the firms in the industry can change as new firms enter, or existing firms leave the market

Long Run Adjustments

Entry and Exit

§     In the long run, firms respond to economic profit and economic loss by either entering or exiting a market

§      New firms enter a market in which existing firms are making economic profits

§      Existing firms exit a market if they are making economic losses

§     Entry and exit influence price, the quantity produced, and economic profit

 

Entry of New Firms into the Industry

§     If existing firms in the industry are making economic profits ŕ new firms will find attractive to enter the market

§     Expansion of the industry will shift the market supply outwards and price will fall

§     As price falls, existing firms will reduce production and economic profits will decrease

§     Entry will continue until economic profits are eliminated; P = min ATC

 

Exit of Old Firms From the Industry

§     If firms in the industry are incurring an economic loss ŕ some firms will exit the industry

§     Contraction of the industry will shift the market supply inwards and price will rise

§     As price rises, firms will increase production and the economic loss of each remaining firm is reduced

§     Exit will continue as long as firms incur in losses; It stops when P = min ATC

 

Long-Run Equilibrium

§     In the long run equilibrium, economic profits or losses are eliminated and firms are making only normal profits

 

§     P (=MR) = MC = Minimum ATC

 

§     Existing firms in the industry have no incentive to leave, or new firms to enter the market

 

 

Factors that Change Long-Run Equilibrium

§     Many factors can change the long run equilibrium

§      Changes in demand – Shift the demand curve

§      Changes in technology – shift MC and ATC curves downward

 

 

 

A Permanent Change in Demand

§      The market starts in long-run equilibrium where P = min ATC

§      A permanent increase in demand:

§       Initially will raise the price, making firms earn economic profits

§       Economic profits will lure new firms into the industry

§       As the market supply increases, price falls and economic profits decrease

§       Entry ceases when economic profits are zero at the new long-run equilibrium at which P = min ATC

§       At the new long-run equilibrium, the industry has more firms operating in the market

Long-Run Market Supply

§     The long-run market supply shows the relationship between the price and total quantity supplied in the market when the number of firms in the industry changes

§     The shape of the market supply will depend on the effect that changes in the number of firms have on costs of the individual firms in the industry

Long-Run Market Supply

§     Under a constant-cost industry the long-run market supply curve is perfectly elastic (a horizontal line)

§      At the same price, market output increases because there are no external economies or diseconomies

Long-Run Supply for an Increasing-Cost Industry

§     Under an increasing-cost industry the long run market supply is upward sloping

§     There are external diseconomies usually due to specialized resources used in production

§     As the market output increases, the price rises because costs of production increase for the whole industry

Long-Run Supply for a Decreasing-Cost Industry

§     Under a decreasing-costs industry the long-run market supply is downward sloping

§     There are external economies that lower production costs as total output increases

§     The price fall as market output increases

 

Long-Run Market Supplies

Efficiency Under Pure Competition

§      The long-run equilibrium has two desirable efficiency properties:

vP = Min ATC

vP = MC

§      Economic efficiency is achieved under pure competition

Productive Efficiency
P = Minimum ATC

§     In the long run, unless firms use the least-cost production method, they will not survive

§     Under pure competition, the minimum amount of resources will be used to produce any particular output

Allocative Efficiency
P = MC

§     In the long run, under pure competition resources are allocated to the production of the goods that maximizes the satisfaction of consumers

§      The goods that consumers want most

§     When P > MC ŕ under allocation of resources ŕ underproduction

§     When P < MC ŕ over allocation of resources ŕ overproduction

Solved Problem (Key Question No. 4)

§     Assume the following cost data are for a purely competitive firm

 

Solved Problem (cont.)

§           At P = $56, Will this firm produce in the short run? Why or why not?

§           If it produces, what would be the profit-maximizing output?

§           If it produces, what economic profit or loss per unit will the firm realize?

§           What is the lowest price at which the firm will produce?

§           What would be the price at the long-run equilibrium of the firm?

 

 

Solved Problem (cont.)

§          In the table below, complete the short-run supply schedule for the firm

Solved Problem (cont.)

§          Assume 1,500 identical firms, complete the short-run market supply schedule

 

Solved Problem (cont.)

§          Assume the market demand schedule for this product is as follows. What is the market equilibrium price? What will be the equilibrium output for the industry?

 

Solved Problem (cont.)

§          What will be the equilibrium output for the firm? Is the typical firm making profits or losses?

§           What will happen in the long run?

§           What will be the equilibrium price in the long run? 

 

Solved Problem (cont.)

§            Assume Demand increases due to an increase in income.

 

 

 

 

 

§           What will be the equilibrium output for the firm? Is the typical firm making profits or losses?

§           What will happen in the long run? What will be the equilibrium price in the long run if the industry is a constant-cost industry?

§           What happens with the number of firms in the industry when demand for the product increases?

 

 

The End