Chapter 9 (M&B)

Chapter 5 (Lipsey)

Perfect (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
Market Structure & Firm Behavior
 Four Market Models
• Pure competition
• Pure monopoly
• Monopolistic competition
• Oligopoly
Imperfect Competition
Pure Monopolistic Pure
Competition Competition Oligopoly Monopoly

Market Structure Continuum

9-4
 Pure Competition
• Very large numbers
• Standardized product
• “Price takers”
• Free entry and exit
• Perfectly elastic demand
– Average revenue
– Marginal revenue
– Price
9-6
Elements of the Theory of Perfect
Competition
Demand & Revenue for a Firm in
Perfect Competition (PC)
Demand & Revenue for a Firm in
Perfect Competition (PC)
 Pure Competition
$1179
Firm’s Firm’s TR
Demand Revenue 1048
Schedule Data
(Average
Revenue) 917
P QD TR MR

Price and Revenue

786
$131 0 $0
] $131 655
131 1 131
] 131
131 2 262
] 131
131 3 393 524
] 131
131 4 524
] 131
131 5 655 393
] 131
131 6 786
] 131 262
131 7 917
] 131 D = MR = AR
131 8 1048
] 131 131
131 9 1179
131 10 1310
] 131
2 4 6 8 10 12
Quantity Demanded (Sold) 9-10
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?

9-11
 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
9-14
Total Revenue Total Cost Approach

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

0 $100 $0 $100 $0 $-100

1 100 90 190 131 -59
2 100 170 270 262 -8
3 100 240 340 393 +53
4 100 300 400 524 +124
5 100 370 470 655 +185
6 100 450 550 786 +236
7 100 540 640 917 +277
8 100 650 750 1048 +298
9 100 780 880 1179 +299
10 100 930 1030 1310 +280
Do You
Now SeeGraph
Let’s Profit The
Maximization?
Results… 9-15
Total Revenue Total Cost Approach
$1800
1700 Break-Even Point
1600 (Normal Profit)

Total Revenue and Total Cost

1500
1400 Total Revenue, (TR)
1300
1200
1100 Maximum
1000 Economic
Total Cost,
900 Profit
800 $299 (TC)
700
600
500 P=$131
400
300 Break-Even Point
200 (Normal Profit)
100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Total Economic

Quantity Demanded (Sold)

$500
400 Total Economic $299
Profit

300 Profit
200
100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold) 9-16
Marginal Revenue Marginal Cost
Approach

(2) (3) (4)

(1) Average Average Average (5) (6)
Total Fixed Variable Total Marginal Marginal (7)
Product Cost Cost Cost Cost Revenue Profit (+)
(Output) (AFC) (AVC) (ATC) (MC) (MR) or Loss (-)

0 $-100
1 $100.00 $90.00 $190.00 $90 $131 -59
2 50.00 85.00 135.00 80 131 -8
3 33.33 80.00 113.33 70 131 +53
4 25.00 75.00 100.00 60 131 +124
5 20.00 74.00 94.00 70 131 +185
6 16.67 75.00 91.67 80 131 +236
7 14.29 77.14 91.43 90 131 +277
8 12.50 81.25 93.75 110 131 +298
9 11.11 86.67 97.78 130 131 +299
10 10.00 93.00 103.00 150 131 +280
NoYou
Do Surprise - Now
See Profit Let’s Graph Now?
Maximization It…
9-17
Marginal Revenue Marginal Cost
Approach

$200

MR = MC MC
Cost and Revenue

150
P=$131
Economic Profit MR = P
ATC
100
AVC
A=$97.78

50

0
1 2 3 4 5 6 7 8 9 10
Output
9-18
 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
9-19
 Short Run Minimizing Losses

Lower the prices to $81 and observe the

results
Marginal Revenue Marginal Cost
Approach

(2) (3) (4)

(1) Average Average Average (5)
Total Fixed Variable Total Marginal
Product Cost Cost Cost Cost
(Output) (AFC) (AVC) (ATC) (MC)

0
1 $100.00 $90.00 $190.00 $90
2 50.00 85.00 135.00 80
3 33.33 80.00 113.33 70
4 25.00 75.00 100.00 60
5 20.00 74.00 94.00 70
6 16.67 75.00 91.67 80
7 14.29 77.14 91.43 90
8 12.50 81.25 93.75 110
9 11.11 86.67 97.78 130
10 10.00 93.00 103.00 150

9-21
Short Run Loss Minimizing Case

$200

Lower the Price to $81 and

Observe the Results! MC
Cost and Revenue

150

Loss
A=$91.67
ATC
100 AVC
P=$81
MR = P

V = $75
50

0
1 2 3 4 5 6 7 8 9 10
Output
9-22
Marginal Revenue Marginal Cost
Approach

(2) (3) (4)

(1) Average Average Average (5)
Total Fixed Variable Total Marginal
Product Cost Cost Cost Cost
(Output) (AFC) (AVC) (ATC) (MC)

0
1 $100.00 $90.00 $190.00 $90
2 50.00 85.00 135.00 80
3 33.33 80.00 113.33 70
4 25.00 75.00 100.00 60
5 20.00 74.00 94.00 70
6 16.67 75.00 91.67 80
7 14.29 77.14 91.43 90
8 12.50 81.25 93.75 110
9 11.11 86.67 97.78 130
10 10.00 93.00 103.00 150

9-23
Short Run Shut Down Case

$200

Lower the Price Further to

$71 and Observe the Results!MC
Cost and Revenue

150

ATC
V = $74
100 AVC

MR = P
P=$71
50 Short-Run
Shut Down Point
P < Minimum AVC
$71 < $74
0
1 2 3 4 5 6 7 8 9 10
Output
9-24
Marginal Revenue Marginal Cost
Approach

(2) (3) (4)

(1) Average Average Average (5)
Total Fixed Variable Total Marginal
Product Cost Cost Cost Cost
(Output) (AFC) (AVC) (ATC) (MC)

0
1 $100.00 $90.00 $190.00 $90
2 50.00 85.00 135.00 80
3 33.33 80.00 113.33 70
4 25.00 75.00 100.00 60
5 20.00 74.00 94.00 70
6 16.67 75.00 91.67 80
7 14.29 77.14 91.43 90
8 12.50 81.25 93.75 110
9 11.11 86.67 97.78 130
10 10.00 93.00 103.00 150

9-25
 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 9-26
 Short-Run Supply Curve
Firms produce where MR=MC
Cost and Revenues (Dollars)

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

0 Q2 Q3 Q4 Q5
Quantity Supplied 9-27
 Short-Run Supply Curve
Firms produce where MR=MC
Examine the MC for the Competitive Firm

MC Above AVC Becomes

Cost and Revenues (Dollars)

the Short-Run Supply Curve S

Break-even MC
(Normal Profit) Point e
P5 MR5
d
ATC
P4 MR4
c AVC
P3 MR3
b
P2 MR2
a
P1 MR1

Shut-Down Point
(If P is Below)

0 Q2 Q3 Q4 Q5
Quantity Supplied 9-28
Short-Run Supply Curve
 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
9-30
Firm and Industry Supply
Single Firm Industry
p P
S = ∑ MC’s

s = MC

Economic
Profit ATC
d $111
$111
AVC

0 8 p 0 8000 P

Competitive firm must take the price that is

Established by industry supply and demand
9-31
Short-Run Supply Curves
SHORT RUN EQUILIBRIUM PRICE &
PROFITABILITY
• The price of a product sold in PC is determined
by the interaction of the industry’s short run
supply curve and the market demand curve. No
one firm can influence the market price
significantly
• At the equilibrium price, each firm is producing
and selling a quantity for which MC = P
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
9-35
Entry Eliminates Profits
Single Firm Industry
p P
S1

MC

ATC S2
$60 $60

50 50
MR
D2
40 40
D1

0 100 p 0 80,000 90,000 100,000 P

An increase in demand temporarily raises price
Higher prices draw in new competitors
Increased supply returns price to equilibrium 9-37
 Exit Eliminates Losses
Single Firm Industry
p P
S3

MC

ATC S1
$60 $60

50 50
MR
D1
40 40
D3

0 100 p 0 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 9-38
 A More Detailed Analysis of the
Long Run
Requirements when the firm & the industry
are both in the long run equilibrium (i.e. no
change a firm can make to increase its
profits)
1.No firm will want to vary the output of its
existing plants
2.Profits earned by existing plants must be
zero
3.No firm can earn profits by building a plant
of a different size.
Short-run & Long run equilibrium of
a firm in perfect competition
A perfectly firm that is not at the minimum point on
its LRAC curve cannot be in long run equilibrium
 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 9-41
 Long-Run Supply Curve
Constant-Cost Industry
P

P1
$50 S
P2 Z3 Z1 Z2

P3

D3 D1 D2

0 Q3 Q1 Q2 Q
90,000 100,000 110,000

9-42
 Long-Run Supply Curve
Increasing-Cost Industry
P

S
P2 $55
Y2
P1 $50
Y1
P3 $40
Y3
D2

D1
D3
0 Q3 Q1 Q2 Q
90,000 100,000 110,000

How would a decreasing-cost industry look?

9-43
 The Long-Run Industry Supply Curve
The long-run industry supply curve may be horizontal, or
positively or negatively sloped:
The long-run supply curve connects positions of long-run
equilibrium after all demand-induced changes have occurred
Pure Competition and Efficiency
• Productive efficiency
P = minimum ATC
• Allocative efficiency
P = MC
• Maximum consumer and
producer surplus
• Dynamic adjustments
• “Invisible Hand” revisited
9-46
 Long-Run Equilibrium
Single Firm Market
P=MC=Minimum MC S
ATC (Normal Profit)
ATC
Price

Price
P MR 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
9-47
 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
9-48
The Case of Generic Drugs
New Producers Enter Market
a
• As price Initial Patent Price
S
decreases to f, b c
• Consumer P1

surplus abc d

Price
increases to adf P2 f

• Producer and
consumer
surplus is
maximized D
as shown by
the gray triangle Q1 Q2
Quantity

Result: Greater Quantity at Lower Prices

as Predicted by the Competitive Model
9-49
 Key Terms
• pure competition • long-run supply
• pure monopoly
curve
• monopolistic
• constant-cost
competition
industry
• oligopoly
• increasing-cost
• imperfect
industry
competition • decreasing-cost
• price taker
industry
• average revenue
• productive
• total revenue
efficiency
• marginal revenue
• allocative efficiency
• break-even point • consumer surplus
• MR=MC rule
• producer surplus
• short-run supply
curve
9-50
Next Chapter Preview…

Pure
Monopoly

9-51