Chapter 10 - Pure Competition PDF

economics McConnell Brue Flynn Chapter 10 Pure Competition © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. ...

economics McConnell Brue Flynn Chapter 10 Pure Competition © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter Contents Four Market Models Pure Competition: Characteristics and Occurrence Demand as Seen by a Purely Competitive Seller Marginal Cost and Short-Run Supply Profit Maximization in the Long Run Long Run Supply Curves Pure Competition and Efficiency Technological Advance and Competition 10-2 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Four Market Models Market Structure Pure competition / Perfect competition Pure Monopoly Monopolistic competition Imperfect competition Oligopoly Notes: Perfect competition and imperfect competition are two different market structures that describe the level of competition and the behavior of firms within a market (The differences is number of firms, pricing power, product differentiation, entry and exit). 10-3 © McGraw Hill LLC. All. rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Characteristics of the Four Basic Market Models Market Model Characteristic Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or Unique; no close differentiated substitutes Control over price None Some, but within rather Limited by mutual inter- Considerable narrow limits dependence; considerable with collusion Conditions of Very easy, no obstacles Relatively easy Significant obstacles Blocked entry Nonprice None Considerable emphasis on Typically a great deal, Mostly public relations Competition advertising, brand names, particularly with advertising trademarks product differentiation Examples Financial markets, Restaurants, gyms, gas Airlines, automobiles, Local utilities, patented agricultural products, raw stations, retail trade, wireless service pharmaceuticals materials dresses, shoes providers, space travel, waste disposal 10-4 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Pure Competition: Characteristics Very large numbers of sellers Standardized (identical/homogenous) product Price takers (no pricing power) Free entry and exit 10-5 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Purely Competitive Demand Perfectly elastic demand: Firm produces as much or little as they wish at the market price. Demand graphs as horizontal line. 10-6 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Average, Total, and Marginal Revenue Formulas Average revenue: Revenue per unit AR = TR/Q = P (refer the graph in previous slide 6) Total revenue: TR = P × Q Marginal revenue: Additional revenue that the firm will receive by producing one more unit of output. MR = ΔTR/ΔQ 10-7 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Profit Maximization: (1) TR – TC Approach The competitive producer will wish to produce at the output level where total revenue exceeds total cost (TR > TC) by the greatest amount OR produce at break-even point = normal profit (P = ATC). Remark: Firm makes a normal profit, TR = TC / P = ATC) 10-8 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Profit Maximization: TR – TC Table PRICE: $131 (1) (2) (3) (4) (5) (6) Total Product Total Fixed Cost Total Variable Total Cost Total Revenue Profit (+) (Output) (Q) (TFC) Costs (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 1,048 +298 9 100 780 880 1,179 +299 10 100 930 1,030 1310 +280 10-9 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Total-Revenue–Total Cost Approach to Profit Maximization for a Purely Competitive Firm (a) Profit maximizing case (b) Total economic profit $1,800 Break-even point 1,700 (normal profit) 1,600 1,500 Total revenue, TR 1,400 Total revenue and total cost 1,300 $500 Total economic profit 1,200 Maximum economic 400 1,100 $299 profit Total cost, TC Total economic 1,000 $299 300 profit 900 200 800 700 100 P = $131 600 500 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 400 Quantity demanded (sold) 300 200 Break-even point 100 (normal profit) The firm’s profit is maximized at an output of 9 units 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 where total revenue, TR > TC, by the maximum Quantity demanded (sold) amount. The vertical distance between TR and TC is plotted as a total economic profit curve. 10-10 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Profit Maximization: (2) MR = MC Approach Using the MR = MC rule For a price taker, price (P) = marginal revenue (MR) = average revenue (AR) The firm considers three questions: Should the firm produce? If so, what amount? What economic profit (loss) will be realized? 10-11 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Profit Maximization: MR = MC Table Short-run profit maximization for a purely competitive firm: Table (1) (2) (3) (4) (5) (6) (7) Total Product Average Fixed Average Variable Average Total Marginal Cost Price = Marginal Total Economic (Output) Cost (AFC) Costs (AVC) Cost (ATC) (MC) Revenue (MR) Profit (+) 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 10-12 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Short-run Profit Maximization for a Purely Competitive Firm Profit max: MR = MC Economic profit: P > ATC = (P – ATC ) X Q à ($131 - $97.78) X 9 = $299 10-13 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Short-run Loss Minimization for a Purely Competitive Firm Profit max: MR = MC Economic loss : P < ATC = (P – ATC ) X Q à ($81 - $91.67) X 6 = -$64 (Refer Table slide 15) 10-14 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Short-Run Loss Minimization Table Loss-Minimizing Case Shutdown Case (6) (8) (9) $81 Price (7) $71 Price Profit (+) (1) (2) (3) (4) (5) = Profit (+) = or Loss (-), Total Average Average Average Marginal Marginal or Loss Marginal $71 Product Fixed Cost Variable Total Cost Cost Revenue (−), $81 Revenue Price (Output) (AFC) Cost (AVC) (ATC) (MC) (MR) Price (MR) 0 $-100 $-100 1 $100.00 $90.00 $190.00 $ 90 $81 -109 $71 -119 2 50.00 85.00 135.00 80 81 -108 71 -128 3 33.33 80.00 113.33 70 81 -97 71 -127 4 25.00 75.00 100.00 60 81 -76 71 -116 5 20.00 74.00 94.00 70 81 -65 71 -115 6 16.67 75.00 91.67 80 81 -64 71 -124 7 14.29 77.14 91.43 90 81 -73 71 -143 8 12.50 81.25 93.75 110 81 -102 71 -182 9 11.11 86.67 97.78 130 81 -151 71 -241 10 10.00 93.00 103.00 150 81 -220 71 -320 10-15 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Short-run Normal Profit for a Purely Competitive Firm Profit max: MR = MC Break-even point/normal profit: P = ATC 10-16 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Loss Minimizing Case Loss minimization (Economic loss) à Economic loss : P < ATC à Still produce if MR > minimum AVC. 10-17 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Short-run Shutdown Case for a Purely Competitive Firm Short-run: Shut down à If P < AVC à OR A firm shutdown point is where AVC is at its minimum. × It is also the point at which the MC curve crosses the AVC curve. 10-18 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Summary Profit Maximization Economic profit : P > ATC Economic loss : P < ATC Break-even point/Normal profit : P = ATC Shut-down point in short run: P < AVC / AVC at its minimum point / MC curve crosses the AVC curve. 10-19 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Short-Run Supply Short-run supply curve: As long as P exceeds minimum AVC, the firm continues to produce using the rule: MR (= P) = MC 10-20 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Marginal Cost and Short-Run Supply The Supply Schedule of a Competitive Firm Confronted with the Cost Data in the Table There is a relationship between price and quantity supplied. Since P = MR for the competitive firm, the profit maximization rule MR = MC will yield the short run supply curve. The short run supply curve is the part of the MC that lies above the AVC curve (Refer next slide 21). 10-21 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  MC Becomes Short-Run Supply Curve At price P1, P = MC at point A, firm will produce NO output because price < minimum AVC (shut down point produce 0 output). At price P2, P = AVC at point B, firm will operate and produces Q2 units and incurs a loss = to its total fixed cost. At price P3, P > AVC at point C, firm will operate and produce Q3 units. At price P4, P = ATC at point D, firm will operate and produce Q4 units and earns a normal profit. At price P5, P = MC at point E, firm will operate and maximizes its economics profit by producing Q5 units. 10-22 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Output Determination Output Determination in Pure Competition in the Short Run Question Answer Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost. What quantity should this firm produce? Produce where MR (= P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Will production result in economic profit? Yes, if price exceeds average total cost (TR > TC). NO, if average total cost exceeds price (TC > TR). 10-23 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Firm and Industry: Equilibrium Price Firm and Market Supply and Market Demand (1) (2) Quantity Total (4) Supplied, Quantity (3) Total Single Supplied, 1,000 Product Quantity Market equilibrium: Qd = Qs Firm Firms Price Demanded 10 10,000 $151 4,000 Thus, single firm (industry 9 9,000 131 6,000 firms) equilibrium price and output is $111 and 8 units 8 8,000 111 8,000 (8000 units). 7 7,000 91 9,000 6 6,000 81 11,000 0 0 71 13,000 0 0 61 16,000 10-24 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Short-run Competitive Equilibrium 10-25 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Firm versus Industry Fallacy of composition: false idea/view that what is true as a part must also be true for the whole. E.g., if each student in a classroom studies hard, then the entire class will perform well on the exam. Again, this may not hold true as the collective effort of the students does not guarantee success for the entire class. 10-26 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Profit Maximization in the Long Run: Assumptions Assume all firms in the industry have identical costs – identical costs. The goal of the firm is to make profits and avoid losses – easy entry and exit. Assume entry and exit of firms doesn’t affect resource prices used in the industry – constant-cost industry. 11-27 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Long Run in Pure Competition In the long run: Firms can enter or exit the industry à Enter (P > ATC), Exit (P < ATC) Firms can expand or reduce capacity Decisions are based on the incentives of profits or losses. 11-28 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Temporary Profits and the Reestablishment of Long-run Equilibrium An increase in demand from MR to MR1 à raises price from $50 to $60 à P> ATC = firm earns economic profits As the price falls, economic profits diminish and the firm earns a normal profit in which P = minimum ATC. 11-29 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Temporary Profits and the Reestablishment of Long-run Equilibrium Consumer tastes increase product demand from D1 to D2 à firm is gaining economic profits (P > ATC) Profits attract firms for profitable industries: Firms enter Supply increases S1 to S2 Price falls $60 to $50 Restore to normal profits (p = ATC) 11-30 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Temporary Losses and the Reestablishment of Long-run Equilibrium Consumer tastes decrease product demand from D1 to D3 à firm is facing economic losses (P < ATC) Losses cause the firms leave because unprofitable industry: Firms leave Supply decreases S1 to S3 Price rises $40 to $50 Restore to normal profits (P = ATC) 11-31 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Long-Run Supply Curves (1) Constant-cost industry (2) Increasing-cost industry (3) Decreasing-cost industry 11-32 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Long-run Supply Curve for a Constant-cost Industry In a constant-cost industry (LR supply curve is constant), entry and exit of firms does not affect resource prices and therefore does not affect per-unit costs. So an increase in demand raises output but not the product’s price. Similarly, a decrease in demand reduces output but not the product’s price. Therefore, the long-run supply curve is horizontal. Notes: Constant-cost industry àEntry or exit of firms does not effect on the resource prices àNo effect on production costs 11-33 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Long-run Supply Curve for an Increasing-cost Industry In an increasing-cost industry (LR supply curve is upsloping), the entry of new firms in response to an increase in demand (D3 to D1 to D2) will bid up resource prices ($45 to $50 to $55) and thereby increase unit costs. As a result, an increased industry output (Q3 to Q1 to Q2). The long-run industry supply curve (S) therefore slopes upward through points Y3, Y1, and Y2. Notes: Increasing-cost industry àExpansion through entry of new firms raise the resource prices àIncrease production costs 11-34 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Long-run Supply Curve for a Decreasing-cost Industry In a decreasing-cost industry (LR supply curve is decreasing), the entry of new firms in response to an increase in demand (D3 to D1 to D2) will lead to decreased input prices ($55 to $50 to $45) and, consequently, decreased unit costs. As a result, an increase in industry output (Q3 to Q1 to Q2). The long-run industry supply curve (S) therefore slopes downward through points X3, X1, and X2. Notes: Decreasing-cost industry àExpansion through entry of firms lowers the resource prices àDecrease production costs 11-35 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Long-run Equilibrium: A Competitive Firm and Market In pure competition market, allocative When P = MC = minimum ATC at efficiency occurs at the market equilibrium output Qf indicates firm is achieving output Qe. The sum of consumer surplus productive and allocative efficiency. (green area) and producer surplus (blue area) is maximized. 11-36 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Pure Competition and Efficiency In the long run, efficiency is achieved. Productive efficiency: Producing where P = minimum ATC. Allocative efficiency: Producing where P = MC. Triple equality: P = MC = minimum ATC. Consumer surplus and producer surplus are maximized. 11-37 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Dynamic Adjustments Purely competitive markets will automatically adjust to: Changes in consumer tastes Resource supplies Technology “Invisible hand” - unobservable market force that helps the demand and supply of goods in a free market so society get benefits as a whole. In a free market, there are no regulations imposed by the government. If someone charges less than their competitor, the customer will buy from him. More demand from the buyers, it will supply by the market, and everyone will be happy. 11-38 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Technological Advance and Competition Entrepreneurs would like to increase profits beyond just a normal profit: Decrease costs by innovating New product development 11-39 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Creative Destruction Competition and innovation may lead to creative destruction. Creation of new products and methods may destroy the old products. E.g., CD (compact disc) is being replaced with smartphones and their ability to play music 11-40 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Last Word: The Pandemic Pause COVID pandemic led to a massive decline in revenue for many businesses. Restaurants Hotels Rental Cars 11-41 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.