HANDOUT_1

Lecture_01. PURE COMPETITION

Firm’s decisions concerning price and production depend greatly on the character of
the industry in which it is operating. There is no “average” or “typical” industry. At one
extreme is a single producer that dominates the market; at the other extreme are industries
in which thousands of firms each produces a tiny fraction of market supply. Between these
extremes are many other industries. We will focus on four basic models of market
structure. Together, these models will help us understand how price and output are
determined in the many product markets in the economy, evaluate the efficiency or
inefficiency of those markets and provide a crucial background for assessing public
policies (such as antitrust policy) relating to certain firms and industries.
1. Four market models (review)
Economists group industries into four distinct market structures: pure competition, pure
monopoly, monopolistic competition, and oligopoly. These market models differ in several
respects: the number of firms in the industry, the type of product, price control, conditions
of entry and presence of nonprice competition. These factors sometimes are referred to as
structural variables. Let’s fill the table.

Characteristics of the Four Basic Market Models

Market Model Pure Comp. Monopol. Comp. Oligopoly
Pure Monopoly

Number of firms

Type of product

Control over price

Conditions of entry

Nonprice
competition

Examples

Pure competition involves a very large number of firms producing a standardized

product (product identical to that of other producers).
Pure monopoly – one firm is the sole seller of a product or service (for example, a
local electric utility). Since the entry of additional firms is blocked, one firm constitutes
the entire industry.
Monopolistic competition – relatively large number of sellers producing differentiated
products (clothing, furniture, books). Widespread nonprice competition, a selling strategy
in which one firm tries to distinguish its product or service from all competing products on
the basis of attributes like design and workmanship (product differentiation).
 HANDOUT_1
Oligopoly involves only a few sellers of a standardized or differentiated product, so
each firm is affected by the decisions of its rivals.
The last three are called imperfect competition.
2. The features of pure competition markets
Key characteristics:
- very large numbers;
- standardized product;
- “price takers”; each firm produces such a small fraction of total output that increasing or
decreasing its output will not influence total supply or, therefore, product price. The
competitive firm is a price taker: it cannot change market price; it can only adjust to it
(clause: until its size is comparable with that of others);
- free entry and exit.
Why study pure competition that is relatively rare in the real world?
1) This market model is highly relevant to several industries (markets for agricultural
goods, fish products, foreign exchange, basic metals, and stock shares);
2) pure competition is a convenient starting point for any discussion of price and output
determination;
3) the operation of a purely competitive economy provides a standard, or norm, for
evaluating the efficiency of the real-world economy.
Demand to a Competitive Seller. We begin by examining demand from a
competitive seller’s viewpoint. This seller might be a wheat farmer, a strawberry grower,
a sheep rancher. Because each purely competitive firm offers only a negligible fraction of
total market supply, it must accept the price determined by the market. As a result the
demand schedule faced by the individual firm in a purely competitive industry is perfectly
elastic at the market price (graph_01). However, market demand graphs as a down sloping
curve.
The firm’s demand schedule is also its average-revenue schedule. Price per unit to
the purchaser is also average revenue to the seller. The total revenue for each sales level is
found by multiplying price by the corresponding quantity the firm can sell. Analogy:
y=kx; graph_02.
Marginal revenue is the change in total revenue (or the extra revenue) that results
from selling one more unit of output. In differential form it’s simply derivative of TR.
Graph_01 shows the purely competitive firm’s total revenue, demand, marginal-
revenue, and average-revenue curves. Total revenue (TR) is a straight line that slopes
upward to the right. Its slope is constant. The demand curve (D) is horizontal, indicating
perfect price elasticity. The marginal-revenue (MR) curve coincides with the demand
curve because the product price (and hence MR) is constant. The average revenue (AR)
curve equals price and therefore also coincides with the demand curve.

Quick Review
• In a purely competitive industry a large number of firms produce a standardized product
and there are no significant barriers to entry.
• The demand seen by a purely competitive firm is perfectly elastic – horizontal on a graph
– at the market price.
 HANDOUT_1
• Marginal revenue and average revenue for a purely competitive firm coincide with the
firm’s demand curve; total revenue rises by the product price for each additional unit sold.

3. Profit Maximization in the Short Run: Total-Revenue–Total-Cost Approach

Because the purely competitive firm is a price taker, it can maximize its economic
profit (or minimize its loss) only by adjusting its output. And, in the short run, the firm has
a fixed plant. It adjusts its variable resources to achieve the output level that maximizes its
profit.
There are two ways to determine the level of output. One method is to compare total
revenue and total cost; the other is to compare marginal revenue and marginal cost.
Recall: Costs in the Short Run.
We begin by examining profit maximization using the total-revenue–total-cost
approach. Confronted with the market price of its product, the competitive producer will
ask three questions: (1) Should we produce this product? (2) If so, in what amount? (3)
What economic profit (or loss) will we realize?
Let’s demonstrate how a pure competitor answers these questions, given certain cost
data and a specific market price. See the graph_04.
Should the firm produce? Definitely. It can obtain a profit by doing so. How much
should it produce? It is the output at which total economic profit is at a maximum. The
graph compares total revenue and total cost for this profit-maximizing case.
Observe again that the total-revenue curve for a purely competitive firm is a straight
line. Total cost increases with output because more production requires more resources.
But the rate of increase in total cost varies with the relative efficiency of the firm. Total
revenue and total cost are equal where the two curves intersect. Total revenue here covers
all costs (including a normal profit, which is included in the cost curve), but there is no
economic profit. So economists call this output a break-even point: an output at which a
firm makes a normal profit but not an economic profit.
Any output within the two break-even points will yield an economic profit. The firm
achieves maximum profit, where the vertical distance between the total-revenue and total-
cost curves is greatest.
Two other possibilities – loss-minimizing case and shutdown case are realized under
less favorable conditions in the industry when price of the product goes down (see
graph_05, graph_06).

4. Profit Maximization in the Short Run: Marginal-Revenue – Marginal-Cost

Approach
In the second approach, the firm compares the amounts that each additional unit of
output would add to total revenue and to total cost. In other words, the firm compares the
marginal revenue (MR) and the marginal cost (MC) of each successive unit of output.
The firm should produce any unit of output whose marginal revenue exceeds its
marginal cost because the firm would gain more in revenue from selling that unit than it
would add to its costs by producing it. Conversely, if the marginal cost of a unit of output
exceeds its marginal revenue, the firm should not produce that unit.
In the initial stages of production, where output is relatively low, marginal revenue will
usually (but not always) exceed marginal cost. So it is profitable to produce through this
 HANDOUT_1
range of output. But at later stages of production, where output is relatively high, rising
marginal costs will exceed marginal revenue. Separating these two production ranges is a
unique point at which marginal revenue equals marginal cost. This point is the key to the
output-determining rule: In the short run, the firm will maximize profit or minimize loss by
producing the output at which marginal revenue equals marginal cost (as long as
producing is preferable to shutting down). This profit-maximizing guide is known as the
MR = MC rule.
The link between TR–TC and MR–MC approaches.
Keep in mind these features of the MR = MC rule:
1) for most sets of MR and MC data, MR and MC will be precisely equal at a fractional
level of output. In such instances the firm should produce the last complete unit of output
for which MR exceeds MC;
2) the rule is an accurate guide to profit maximization for all firms whether they are purely
competitive, monopolistic, monopolistically competitive, or oligopolistic;
3) the rule can be restated as P = MC when applied to a purely competitive firm. Because
the demand schedule faced by a competitive seller is perfectly elastic at the going market
price, product price and marginal revenue are equal.
Now let’s apply the MR = MC rule first analyzing the profit-maximizing case and
then two others.
1) Profit-Maximizing Case (graph_07). 2) Loss-Minimizing Case (graph_08). 3)
Shutdown Case (graph_09).
Modified MR = MC rule: a competitive firm will maximize profit or minimize loss
in the short run by producing that output at which MR (= P) = MC, provided that market
price exceeds minimum average variable cost.
Marginal Cost and Short-Run Supply.
Question: what quantity the profit-seeking competitive firm, faced with certain
costs, would choose to offer in the market at each price. This set of product prices and
corresponding quantities supplied constitutes part of the supply schedule for the
competitive firm (graph_10) .
Firm and Industry: Equilibrium Price. Graph_11, graph_12.
Last figure underscores a point made earlier: Product price is a given fact to the
individual competitive firm, but the supply plans of all competitive producers as a group
are a basic determinant of product price. Although one firm, supplying a negligible
fraction of total supply, cannot affect price, the sum of the supply curves of all the firms in
the industry constitutes the industry supply curve, and that curve does have an important
bearing on price.
Quick Review
• Profit is maximized, or loss minimized, at the output at which marginal revenue (or price
in pure competition) equals marginal cost, provided that price exceeds AVC.
• If the market price is below the minimum average variable cost, the firm will minimize
its losses by shutting down.
• The segment of the firm’s marginal-cost curve that lies above the average-variable-cost
curve is its short-run supply curve.
• Under competition, equilibrium price is a given to the individual firm and simultaneously
is the result of the production (supply) decisions of all firms as a group.
 HANDOUT_1

QUICK REVIEW 9.2PROBL

5. Profit Maximization in the Long Run
In the short run the industry is composed of a specific number of firms, each with a
fixed plant. By contrast, in the long run firms already in an industry have sufficient time
either to expand or to contract their capacities. More important, the number of firms in the
industry may either increase or decrease as new firms enter or existing firms leave.
Assumptions
We make three simplifying assumptions, none of which alters our conclusions:
• Entry and exit only. The only long-run adjustment is the entry or exit of firms.
• Identical costs. All firms in the industry have identical cost curves. This assumption lets
us discuss an “average,” or “representative,” firm.
• Constant-cost industry. The industry is a constant cost industry. This means that the
entry and exit of firms does not affect resource prices or, consequently, the locations of the
average-total-cost curves of individual firms.
The basic conclusion: After all long-run adjustments are completed, product price
will be exactly equal to, and production will occur at, each firm’s minimum average total
cost (graph_13, graph_14).
This conclusion follows from two basic facts: (1) Firms seek profits and evade
losses, and (2) under pure competition, firms are free to enter and leave an industry. If
market price initially exceeds minimum average total costs, the resulting economic profits
will attract new firms to the industry. But this industry expansion will increase supply until
price is brought back down to equality with minimum average total cost. Conversely, if
price is initially less than minimum average total cost, resulting losses will cause firms to
leave the industry. As they leave, total supply will decline, bringing the price back up to
equality with minimum average total cost. So: 1) Entry Eliminates Economic Profits; 2)
Exit Eliminates Losses.
We have sidestepped the question of which firms will leave the industry when losses
occur by assuming that all firms have identical cost curves. In the “real world,” of course,
managerial talents differ. Even if resource prices and technology are the same for all firms,
less skillfully managed firms tend to incur higher costs and therefore are the first to leave
an industry when demand declines. Similarly, firms with less productive labor forces or
higher transportation costs will be higher cost producers and likely candidates to quit an
industry when demand decreases.

6. Pure Competition and Efficiency (review and self-study)

Quick Review
• In the long run, the entry of firms into an industry will compete away any economic
profits, and the exit of firms will eliminate losses, so price and minimum average total cost
are equal.
• In purely competitive markets both productive efficiency (price equals minimum average
total cost) and allocative efficiency (price equals marginal cost) are achieved in the long
run.
• After long-run adjustments, purely competitive markets maximize the combined amounts
of consumer surplus and producer surplus.
 HANDOUT_1

Summary
1. Economists group industries into four models based on their market structures: (a) pure
competition, (b) pure monopoly, (c) monopolistic competition, and (d) oligopoly.
2. A purely competitive industry consists of a large number of independent firms
producing a standardized product. Pure competition assumes that firms and resources are
mobile among different industries.
3. In a competitive industry, no single firm can influence market price. This means that the
firm’s demand curve is perfectly elastic and price equals marginal revenue.
4. We can analyze short-run profit maximization by a competitive firm by comparing total
revenue and total cost or by applying marginal analysis. A firm maximizes its short run
profit by producing the output at which total revenue exceeds total cost by the greatest
amount.
5. Provided price exceeds minimum average variable cost, a competitive firm maximizes
profit or minimizes loss in the short run by producing the output at which price or
marginal revenue equals marginal cost. If price is less than average variable cost, the firm
minimizes its loss by shutting down. If price is greater than average variable cost but is
less than average total cost, the firm minimizes its loss by producing the P = MC output. If
price also exceeds average total cost, the firm maximizes its economic profit at the P =MC
output.
6. Applying the MR (= P) = MC rule at various possible market prices leads to the
conclusion that the segment of the firm’s short-run marginal-cost curve that lies above the
firm’s average-variable-cost curve is its short-run supply curve.
7. In the long run, the market price of a product will equal the minimum average total cost
of production. At a higher price, economic profits would cause firms to enter the industry
until those profits had been competed away. At a lower price, losses would force the exit
of firms from the industry until the product price rose to equal average total cost.
8. The long-run equality of price and minimum average total cost means that competitive
firms will use the most efficient known technology and charge the lowest price consistent
with their production costs. That is, the firms will achieve productive efficiency.
9. The long-run equality of price and marginal cost implies that resources will be allocated
in accordance with consumer tastes. Allocative efficiency will occur. In the market, the
combined amount of consumer surplus and producer surplus will be at a maximum.
10. The competitive price system will reallocate resources in response to a change in
consumer tastes, in technology, or in resource supplies and will thereby maintain allocative
efficiency over time.

Literature
1. C.R.McConnell, S.L.Brue, S.M.Flynn. Economics. Principles, Problems, and
Policies. 18th ed. McGrow-Hill / Irvin, 2009. – P. 176–199.
2. H.Varian. Intermediate Microeconomics. A Modern Approach. 8th ed. W.W.Norton
& Company, 2010. – P. 420–429.
3. E.K.Browning, M.A.Zupan. Microeconomic Theory and Applications. 6th ed.
Addison-Wesley Educational Publishers, 1999. – P.224–234.
 HANDOUT_1
Glossary
Demand – попит
Supply – пропозиція
Demand schedule – шкала попиту
Supply schedule – шкала пропозиції
Quantity demanded – величина попиту
Quantity supplied – величина пропозиції
Price – ціна
Output – обсяг виробництва, випуск
Production – виробництво
Industry – галузь
Producer – виробник
Consumer – споживач
Pure competition – чиста конкуренція
Pure monopoly – чиста монополія
Monopolistic competition – монополістична конкуренція
Oligopoly – олігополія
Imperfect competition – недосконала конкуренція
Product differentiation – диференціація продукту
Collusion – змова
Barriers to entry – бар’єри для входження у галузь
Nonprice competition – нецінова конкуренція
Advertising – реклама
Local utilities – місцеві підприємства комунальних послуг
Perfectly elastic demand – досконало еластичний попит
Inelastic demand – нееластичний попит
Purely competitive firm – чисто конкурентна фірма
Pure competitor – чистий конкурент
Price taker – той, хто приймає ціну
Total revenue – загальний виторг
Marginal revenue – граничний виторг
Average revenue – середній виторг
Total revenue – total cost approach – підхід “загальний виторг – загальні витрати”
Marginal revenue – marginal cost approach – “граничний виторг – граничні витрати”
Costs – витрати
Economic (opportunity) costs – економічні витрати (альтернативна вартість)
Explicit costs – явні витрати
Implicit costs – неявні витрати
Normal profit – нормальний прибуток
Economic profit – економічний прибуток
Fixed costs – постійні витрати
Variable costs – змінні витрати
Total costs – загальні витрати
Average fixed cost – середні постійні витрати
Average variable cost – середні змінні витрати
Average total cost – середні загальні витрати
 HANDOUT_1
Marginal cost – граничні витрати
Economies of scale – позитивний ефект масштабу
Diseconomies of scale – негативний ефект масштабу
Constant returns to scale – постійна віддача масштабу
Minimum efficient scale – мінімальний ефективний розмір підприємства
Short run – короткостроковий період
Long run – довгостроковий період
Profit maximizing case – випадок максимізації прибутку
Break-even point – точка беззбитковості
Loss-minimizing case – випадок мінімізації збитків
Close -down case – випадок закриття (припинення виробництва)
MR(=P)=MC rule – правило MR=MC
Short run supply curve – крива пропозиції у короткостроковому періоді
Long run supply curve – крива пропозиції у довгостроковому періоді
Shutdown point – точка закриття
Law of diminishing returns – закон спадної віддачі
Entry – входження у галузь
Exit – вихід з галузі
Constant cost industry – галузь з постійними витратами
Increasing cost industry – галузь зі зростаючими витратами
Decreasing cost industry – галузь зі спадними витратами
Consumer surplus – надлишок споживача
Producer surplus – надлишок виробника
Productive efficiency – виробнича ефективність
Allocative efficiency – розподільна ефективність
Fixed factor – постійний фактор (виробництва)
Economic rent – економічна рента

7. Long-Run Supply Curves

 HANDOUT_1
Long-Run Supply for a Constant-Cost Industry. What is the character of the long-
run supply curve of a competitive industry? The crucial factor here is the effect, if any, that
changes in the number of firms in the industry will have on costs of the individual firms in
the industry.
In our analysis of long-run competitive equilibrium we assumed that the industry under
discussion was a constant-cost industry. This means that industry expansion or contraction
will not affect resource prices and therefore production costs. Graphically, it means that
the entry or exit of firms does not shift the long-run ATC curves of individual firms. This
is the case when the industry’s demand for resources is small in relation to the total
demand for those resources. Then the industry can expand or contract without significantly
affecting resource prices and costs.
What does the long-run supply curve of a constant-cost industry look like? We saw that
the entry and exit of firms changes industry output but always brings the product price
back to its original level, where it is just equal to the constant minimum ATC. In other
words, the long-run supply curve of a constant-cost industry is perfectly elastic.
Long-Run Supply for an Increasing-Cost Industry. Constant-cost industries are a
special case. Most industries are increasing-cost industries, in which firms’ ATC curves
shift upward as the industry expands and downward as the industry contracts. Usually, the
entry of new firms will increase resource prices, particularly in industries using specialized
resources whose long-run supplies do not readily increase in response to increases in
resource demand. Higher resource prices result in higher long-run average total costs for
all firms in the industry. These higher costs cause upward shifts in each firm’s long-run
ATC curve.
Thus, when an increase in product demand results in economic profits and attracts new
firms to an increasing cost industry, a two-way squeeze works to eliminate those profits.
As before, the entry of new firms increases market supply and lowers the market price.
But now each firm’s entire ATC curve also shifts upward. The overall result is a higher-
than-original equilibrium price. The industry produces a larger output at a higher product
price because the industry expansion has increased resource prices and the minimum
average total cost.
Long-Run Supply for a Decreasing-Cost Industry. In decreasing-cost industries,
firms experience lower costs as their industry expands. The personal computer industry is
an example. As demand for personal computers increased, new manufacturers of
computers entered the industry and greatly increased the resource demand for the
components used to build them (for example, memory chips, hard drives, monitors, and
operating software).
The expanded production of the components enabled the producers of those items to
achieve substantial economies of scale. The decreased production costs of the components
reduced their prices, which greatly lowered the computer manufacturers’ average costs of
production. The supply of personal computers increased by more than demand, and the
price of personal computers declined.

Comments on the Long Run Supply Curve

 HANDOUT_1
1. Assumptions used during our analysis. 1) We assume technology is constant; a change
in technology will cause the entire supply curve to shift. 2) At all points on the long run
supply curve the supply curves of inputs to the industry remain unchanged. When relevant,
other factors like government regulations or the weather must also be assumed constant
along the supply curve.
2. In reality, an industry is not likely to fully attain a position of long run equilibrium. In
real-world industries input supplies, demand, technology and government regulations
frequently changed. A long run adjustment takes time, so an industry will find itself
moving toward a long run equilibrium that is continually shifting. However the tendency
for the industry to move in the indicated direction is what is important, and the outcome is
correctly predicted by the theory.
3. The economic profit is zero along a competitive industry’s long run supply curve. So
who does benefit? Owners of inputs whose price is bid up by the industry-wide expansion.
4. The tendency toward a zero economic profit means that the rate of return on invested
resources will tend to equalize across the industries. If invested resources yield an annual
return of 10% in some industry, economists regard this 10% return as a cost necessary to
attract resources to that industry (a normal profit).

8. Taxation in the Short Run and in the Long Run

Consider an industry that has free entry and exit. Suppose that initially it is a long run
equilibrium. In the short run with a fixed number of firms the supply curve is upward
sloping, while in the long run with variable number of firms the supply curve is flat at
price equals minimum average cost. What happens when we put a tax on industry? Graph.
In the short run the industry supply curve is upsloping so that part of the tax falls on the
consumers and part on the firms. The consumers will face a higher price and producers
receive a lower price. But the producers were just breaking even before the tax was
imposed, thus they must be losing money at any lower price, so some firms will leave the
industry. The supply will be reduced and the price for the consumers will rise further. In
the long run the industry supply curve will be horizontal so all the tax falls on the
consumers.

9. Fixed Factors and Economic Rent

If there is free entry, profits are driven to zero. But not every industry has free entry. In
some industries number of firms is fixed. A common reason for this is that there are some
factors of production that are available in fixed supply; they are fixed for the economy as a
whole in the long run.
The most obvious example of this is in resource-extraction industries (oil, coal, gas,
precious metals). Agriculture gives another example – there is only a certain amount of
land that is suitable for agriculture.
A more subtle example of such a fixed factor is talent (professional athletes, show
business stars). There may be free entry into such fields – but only for those who are good
enough to get in!
There are other cases where the fixed factor is fixed not by nature, but by law. In many
industries it is necessary to have a permit or license, and there number may be fixed by
law (taxicab industry, liquor licenses).
 HANDOUT_1
If there are restrictions on the number of firms in the industry, so that there is no free
entry, it may appear that it is possible to have an industry with positive profits in the long
run.
This appearance is wrong. There are economic forces that pushed profits to zero. If a
firm is operating at a point where its profits appear to be positive in long run, it is probably
because we are not appropriately measuring the market value of factors that prevent the
entry. If it appears that a farmer is making positive profits after we have subtracted his
costs of production, it is probably because we have forgotten to subtract the cost of his
land.
Suppose that we managed to value all of the inputs to farming except for the land cost,
and we end up with π dollars per year for profits. How much would someone pay to rent
that land for a year? The answer is: π dollars per year. So the market value of that land –
its competitive rent – is just π.
Whenever there is some fixed factor that is preventing entry into an industry, there will
be an equilibrium rental rate for that factor. Thus in some sense it is always the possibility
of entry that drives profits to zero. After all there are two ways to enter an industry: you
can form a new firm, or you can buy out an existing firm. If a new firm can buy everything
necessary to produce in industry and still make a profit, it will do so. But if there are some
factors that are in fixed supply, then competition for those factors among potential entrants
will bid the prices of these factors up to the point where the profit disappears.
We just have considered the instances of economic rent. Economic rent is defined as
those payments to a factor of production that are in excess of the minimum payment
necessary to have factor supplied.
Farmland is a good example of economic rent. In the aggregate, the total amount of
land is fixed, so the payments to land constitute economic rent. Graph. On the graph AVC
represents the average cost curve for all factors excluding land costs (we assume the land
to be the only fixed factor). The area of the box represents the economic rent on the land.
Given the definition of rent, it is now easy to see that it is the equilibrium price that
determines rent, not reverse. The firm supplies along its marginal cost curve – which is
independent of the expenditures on the fixed factors. The rent will adjust to drive profits to
zero.

Quick Review
1. In an industry with a free entry a tax will initially raise the price to the consumers by
less than the amount of the tax, but in the long run the tax will induce firms to exit
from the industry thereby reducing supply, so that consumers will end up paying the
entire burden of the tax.
2. If there are forces preventing the entry of firms into a profitable industry, the (fixed)
factors that prevent entry will earn economic rents. The rent earned is determined by
the price of the output of the industry.