Chapter 9

Pure Competition

McGraw-Hill/Irwin

Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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

Four Market Models

Pure competition Pure monopoly Monopolistic competition Oligopoly
Imperfect Competition
Pure Competition Monopolistic Competition Oligopoly Pure Monopoly

Market Structure Continuum

9-3

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

Pure Competition
$1179 Firms Demand Schedule (Average Revenue) Firms Revenue Data 1048 917

TR

Price and Revenue

QD TR
$0 131 262 393 524 655 786 917 1048 1179 1310

MR
] $131 ] 131 ] 131 ] 131 ] 131 ] 131 ] 131 ] 131 ] 131 ] 131

786 655 524

$131 0 131 1 131 2 131 3 131 4 131 5 131 6 131 7 131 8 131 9 131 10

393
262

D = MR = AR
131 2 4 6 8 10 12
9-5

Quantity Demanded (Sold)

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

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

Total Revenue Total Cost Approach

Price = $131
(1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) (5) (6) Total Cost Total Revenue Profit (+) (TC) (TR) or Loss (-)

0 1 2 3 4 5 6 7 8 9 10

$100 100 100 100 100 100 100 100 100 100 100

$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
9-8

Do You SeeGraph Maximization? Now Lets Profit The Results

Total Revenue Total Cost Approach

$1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100

Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum Economic Profit $299

Total Revenue and Total Cost

Total Cost, (TC)

P=$131
Break-Even Point (Normal Profit)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity Demanded (Sold)

Total Economic Profit

$500 400 300 200 100

Total Economic Profit

$299

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity Demanded (Sold)

9-9

Marginal Revenue Marginal Cost Approach

(1) Total Product (Output) (2) Average Fixed Cost (AFC) (3) Average Variable Cost (AVC) (4) Average Total Cost (ATC) (5) Marginal Cost (MC) (6) Marginal Revenue (MR)

(7) Profit (+) or Loss (-)

0 1 2 3 4 5 6 7 8 9 10

$100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00

$90.00 $190.00 85.00 135.00 80.00 113.33 75.00 100.00 74.00 94.00 75.00 91.67 77.14 91.43 81.25 93.75 86.67 97.78 93.00 103.00

$90 80 70 60 70 80 90 110 130 150

$131 131 131 131 131 131 131 131 131 131

$-100 -59 -8 +53 +124 +185 +236 +277 +298 +299 +280
9-10

No Surprise - Now Lets Graph It Do You See Profit Maximization Now?

Marginal Revenue Marginal Cost Approach

$200

Cost and Revenue

150 P=$131

MR = MC

MC MR = P ATC AVC

Economic Profit
100 A=$97.78 50

10
9-11

Output

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
9-12

Short Run Loss Minimizing Case

$200

Cost and Revenue

150

Lower the Price to $81 and Observe the Results!

Loss
A=$91.67

MC

100 P=$81

ATC AVC MR = P

50

V = $75

10
9-13

Output

Short Run Shut Down Case

$200

Cost and Revenue

150

Lower the Price Further to $71 and Observe the Results! MC

ATC
V = $74

100

AVC MR = P
Short-Run Shut Down Point P < Minimum AVC $71 < $74
1 2 3 4 5 6 7 8 9 10
9-14

P=$71
50

Output

Short-Run Supply Curve

Continuing the Same Example
Supply Schedule of a Competitive Firm
Quantity Maximum Profit (+) Price Supplied or Minimum Loss (-) $151 10 $+480 131 9 +299 111 8 +138 91 7 -3 81 6 -64 71 0 -100 61 0 -100 The schedule shows the quantity a firm will produce at a variety of prices 9-15

Short-Run Supply Curve

Firms produce where MR=MC
Cost and Revenues (Dollars)

e P5 P4 P3 P2 P1 b a c d

MC MR5 ATC AVC MR4 MR3 MR2 MR1

This Price is Below AVC And Will Not Be Produced

0 Q2 Q3 Q4 Q5
9-16

Quantity Supplied

Short-Run Supply Curve

Firms produce where MR=MC
Examine the MC for the Competitive Firm
Cost and Revenues (Dollars)

MC Above AVC Becomes the Short-Run Supply Curve

Break-even (Normal Profit) Point P5 P4 P3 P2 P1 b a Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 c d e

S
MC MR5 ATC AVC MR4 MR3 MR2 MR1

Quantity Supplied

9-17

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

Firm and Industry Supply

Single Firm
p P S = MCs s = MC

Industry

Economic Profit
$111

ATC d AVC D
$111

8000

Competitive firm must take the price that is Established by industry supply and demand
9-19

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

Entry Eliminates Profits

Single Firm
p P S1 MC ATC
$60 50 $60 50

Industry

S2

MR
40 40

D2 D1

100

80,000

90,000

100,000

An increase in demand temporarily raises price Higher prices draw in new competitors Increased supply returns price to equilibrium

9-21

Exit Eliminates Losses

Single Firm
p P S3 MC ATC
$60 50 $60 50

Industry

S1

MR
40 40

D1 D3

100

80,000

90,000

100,000 P

A decrease in demand temporarily lowers price Lower prices drive away some competitors Decreased supply returns price to equilibrium

9-22

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

Long-Run Supply Curve

Constant-Cost Industry
P

P1 P2 P3
$50 Z3 Z1 Z2

D3

D1 Q1 100,000 Q2 110,000

D2

Q3 90,000

9-24

Long-Run Supply Curve

Increasing-Cost Industry
P

S
P2 P1 P3
$55
$50 Y1 $40 Y2

Y3
D2 D3 D1 Q1 100,000 Q2 110,000

Q3 90,000

How would a decreasing-cost industry look?

9-25

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

Long-Run Equilibrium
Single Firm
P=MC=Minimum ATC (Normal Profit)

Market
S

MC ATC

Price

MR

Price
P D 0 Qf 0 Qe

Quantity

Quantity

Productive Efficiency: Price = minimum ATC Allocative Efficiency: Price = MC

Pure competition has both in its long-run equilibrium

9-27

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

The Case of Generic Drugs

New Producers Enter Market
As price decreases to f, Consumer surplus abc increases to adf Producer and consumer surplus is maximized as shown by the gray triangle
a
Initial Patent Price P1 Price P2 b d c S

D Q1 Q2 Quantity

Result: Greater Quantity at Lower Prices

as Predicted by the Competitive Model
9-29

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
9-30

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Pure Monopoly

9-31