Lesson 4: Pure competition.

1. Behavior of a firm in a purely competitive market.

Market structures.
Every firm faces two important decisions: choosing how much it should produce and choosing what
price it should set. In general, the firm faces two sorts of constraints on its actions:
– It faces the technological constraint.
– there is also a market constraint. The firm can only sell as much as people are willing to buy.
It depends on the number of firms that produce the same good or similar goods (firm’s
demand curve).
These are the market structures or market environments:
Pure competition Monopoly Oligopoly Monop. compet.
Good homogeneous any type any type differentiated
nº producers many one a few not so many
Barries no yes yes no
nº consumers many many many many
Market structures: Perfect competition.
A market is purely competitive if each firm assumes that the market price is independent of its own
level of output. That is, it can only be sold at one price: the going market price. In a purely
competitive market firms are price-takers. The sort of environment is many firms to produce an
identical product. Many firms to produce the same product requires that there are no barriers to the
entry in the industry. That is, that any entrepreneur that wants to set up a firm and start producing a
good, has the possibility to do so. This means that there are no legal restrictions, patents... An
important implication of freedom to entry is that firms’ long run profits must necessarily be zero.

Profit maximization.
Suppose a firm that produces output x. Its profits are:
Π ( x)= P( x) x − C (x )
It is composed by:
– Revenues: it is the price of the good multiplied by the amount of good that the firm sells:
R( x )=P ( x ) x Tthere are two definitions:
P (x)x
– Average revenue (AR): is the revenue per unit of output. AR( x)= =P ( x)
x
The average revenue always coincides with the price of the good, in any market
structure.
 – Marginal revenue (MR): measures the increase in the revenue when the firm sells one
dR( x) dP (x)
more unit of output. MR( x )= = x+ P (x )
dx dx
When the firm chooses to produce and sell one additional unit, its revenue always increases
in the price at which this last unit is sold. But, for certain market structures, if a firm wants
dP (x)
to sell more output, it has to lower the price. This means x< 0 . In contrast, when
dx
dP (x)
there are many firms in the industry, firms are price-takers, hence x=0 .
dx
It happens because when there is only one firm in the industry, the “firm’s demand curve”
coincides with the “market demand curve”. And remember that for ordinary goods,
dP (x)
< 0 . However, when there are many firms in the industry, the “firm’s demand
dx
curve” does no longer coincide with the “market demand curve”. As usual, the market
demand will have a negative slope, but the firm’s demand will now be horizontal at the level
of the going market price.
– Costs: it refers to the minimum cost function for the short run and the long run. The
expression of costs should include all of the factors of production used by the firm, valued at
their market price. The economic definition of profit requires that we value all inputs and
outputs at their opportunity cost. Note that the economic definition of profits may therefore
differ from the definition of profits used by accountants.
Let us consider a firm that wants to maximize profits, and produces output x. Its problem is:
Max (x): P ( x ) x −C ( x) The conditions for optimality are two. The first order condition (FOC)
tells us when the profit function has a maximum or a minimum. The second order condition (SOC)
allows us to discriminate between the previous solutions and to determine where the maximum is.
dΠ (x ) dR( x ∗) dC (x ∗)
FOC = =0 → − =0 → MR( x ∗)=MC (x ∗)
dx dx dx
d 2Π ( x) dMR( x ∗) dMC ( x ∗) dMR( x ∗) dMC ( x ∗)
SOC = 2
<0 → − <0 → <
dx dx dx dx dx
x ∗ is the optimal choice of output. From the previous two conditions we learn that at x ∗
MR(x ∗)=MC (x ∗) and the slope of the marginal cost is higher than the slope of the marginal
revenue.

In both ponints the FOC is satisfy, but only in the second point is satisfy th SOC, because the
second point is in the increasing part of the MC(x).
Profit maximization of a purely competitive firm.
dP (x)
In a purely competitive market, firms are price-takers. This means x=0 , and thus
dx
MR( x )=P Then, the previous problem simplifies to: Max (x): P · x −C ( x) . Accordingly:
FOC → MR( x ∗)=MC ( x ∗) → P=MC ( x ∗)
dMR( x ∗) dMC ( x ∗) dMR( x ∗)
SOC → < → <0
dx dx dx
– The FOC tells us that at the optimal level of output x ∗ : P=MC ( x ∗) . That is, at the
optimal level of output, x ∗ , the cost of producing this last unit of output is equal to the
revenue associated with its production.
dMR( x ∗)
– The SOC tells us that at the optimal level of output x ∗ : < 0 . That is, the
dx
optimal level of output, x ∗ , must be in the convex part of the cost curve.

To represent the profits of a purely competitive firm, we can rewrite the profits of a purely
competitive firm as: Π ( x)= P · x −C ( x)=(P − AC ( x)) x

There are three situations:

– Π(x) > 0: extraordinary profits.
– Π(x) = 0: zero, null or normal profits.
– Π(x) < 0: losses.
2. Firm and industry supply in the short and the long run.
Let us consider a purely competitive industry, with a going market price of P. Given P, if a firm
finds it profitable to produce at that price, it will produce the level of output that is given by its
marginal cost. For those market prices for which the competitive firm finds it profitable to produce,
its supply curve must lie along the upward-sloping part of the marginal cost curve. When does a
competitive firm find it optimal to produce depends on whether the firm operates in the short or in
the long run.
Firm supply in the short run.
Let us consider a firm with a given level of fixed capital: Π ( x)= P x − FC −V C ( x) . If the firm
produces zero output, it still has to pay its fixed costs: Π ( 0)=0 − FC −V C (0)=− FC . Then,
the firm is better off going on with business when: Π ( x)≥ Π (0) ⇒R(x )− FC − V C ( x )≥ − FC
⇒R( x)≥ VC (x )⇒P x ≥ AVC ( X ) x .That is, P ≥ AVC ( x ) .

We call shut-down price the price for which: Pshut − down=min AVC
We call break-even price in the short run the price for which total revenues are equal to total costs:
Pbreak − even=min AC . So, the supply curve of a competitive firm in the short run is the
upward-slopping part of the marginal cost curve that lies above the average variable cost curve. The
firm will not operate on those points on the marginal cost curve below the average variable cost
curve, since it would have greater profits (less losses) by shutting down.
The entrepreneur is only willing to increase production when the market price increases in
production. It is because the firm maximizes profits in the convex part of the cost curve, which
means that at the point a profit maximizing firm is producing, the marginal cost curve is upward
slopping. Let us now analyze how the profits of the firm change with the market price.
– If P> Pbreak − even ⇒Π (x )> 0 : firm obtains extraordinary/positive (economic) profits.
– If P=Pbreak − even ⇒Π (x )=0 : firm obtains normal/zero (economic) profits.
– If Pbreak − even> P> Pshut − down⇒ Π ( x )< 0 : firm chooses to produce, even if
producing it incurs in losses. The reason is that the looses it incurs in when producing are
smaller that the looses it will have to face should it close. It is because of the fixed costs it
will have to pay anyway.
– If Pshut − down> P ⇒Π ( x)< 0 : firm shuts down. It is because if it produces nothing it
loses its fixed costs, but it would lose even more if it continued to produce.
The expression of costs should include all of the factors of production used by the firm. A firm
making normal or zero profits gets enough money to cover all of its costs. Hence, making zero
profits means that after paying all of the factors of production, there is no money left... but there is
enough money to pay all of these factors.
Firm supply in the long run.
In the long run, the profit to the firm from producing x units of output is: Π ( x)= P x −C ( x) .
If the firm produces zero output, its profit is: Π (0)=0 since, in the long run, C (0)=0 .
Then, the firm finds it profitable to produce when: Π ( x) ≥ Π (0)⇒R(x )− C (x) ≥ 0
⇒R( x)≥ C ( x)⇒P x ≥ AC ( X ) x that is, P ≥ AC ( x)

We call break-even price in the long run the price for which total revenues are equal to total costs:
Pbreak − even=min AC
In the long run Pbreak−even=Pshuts−down because AC ( x)= AVC ( x)
The supply curve of a competitive firm in the long run is the upward-slopping part of the marginal
cost curve that lies above the average cost curve. The firm will not operate on those points on the
marginal cost curve below the average cost curve, since it would have greater profits (zero profits)
by shutting down.
Entry and exit condition.
Let us consider a firm that is contemplating the option of entering a market, the firm must enter
whenever: P ≥ AC ( x) . Now, let us consider a firm that is already producing good x, and is
contemplating the option of shutting down and exiting the market. The firm must leave whenever:
P< AVC ( x) .
Industry supply in the short run.
In the short run the number of firms producing a good in the market is fixed. Then, the industry
supply curve or market supply curve is simply the sum of all the individual supply curves.

Industry supply in the long run.

Purely competitive markets are characterized by free entry/exit to the industry. In the long run, this
characteristic implies that:
– If a firm is making losses, it will exist the industry
– If a firm is making extraordinary profits... we would expect other firms to enter the market.
Indeed, extraordinary profits “attract” other entrepreneurs that will enter the market trying to
take advantage of the profitable situation.
Of course, as more firms enter the industry (or firms that are losing money exit the industry) total
supply will change, and so the market price. This will affect profits and the incentives to entry/exist
the market. Assuming that all the firms that compete in the industry are equal, a purely competitive
market will be in equilibrium in the long run if and only if firms are making zero profits: Π(x) = 0.
Otherwise, the market will experience either firm entry/exist, which implies it is not in equilibrium.
Hence, in equilibrium, P=MC ( x)= AC (x) .

Since there is a unique price that allows the market to be in equilibrium in the long run... the market
supply in the long run is usually represented as an horizontal straight line at the break-even price.
This means that at P=MC ( x)= AC (x) , the firms in the industry are willing to produce any
level output. And at the break-even price firms are making zero profits. Thus, it is the market
demand that determines how much output is produced in the long run equilibrium of a purely
competitive market.

3. Basic Appendix: Producer surplus.

The producer’s surplus measures the welfare of a producer for producing a good. It is derived as:
PS ( x ∗)=Π ( x ∗)− Π (0) . Working on this condition we obtein three alternative ways of
defining the producer surplus:
– PS ( x ∗)=Π (x ∗)− Π (0)=R( x ∗)− FC − V C (x ∗) −(− FC )=R( x ∗)−V C ( x ∗)
PS ( x ∗)=R( x ∗)−V C ( x ∗)

– We have Π ( x ∗)=R( x ∗)− V C (x ∗)−FC and PS ( x ∗)=R( x ∗)−V C ( x ∗) . So,

Π ( x ∗)=PS ( x ∗)−FC and PS ( x ∗)=Π (x ∗)+ FC
– ∫ MC ( x) d x=VC (x )¿=VC (x ∗) Then: PS ( x ∗)=R( x ∗)−∫ MC ( x)d x.