Chapter 7:

Pure Competition
 What is a Pure Competition?
Pure competition is one of four market
structures in which thousands of firms
each produce a tiny fraction of market
supply in their respective industries.
 Examples: farm commodities (wheat,
soybean, strawberries, milo), the stock
market, and the foreign exchange market

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 Four Market Models
Economists group industries into four
distinct market structures based on their
characteristics. The four market models
are:
 Pure competition
 Monopolistic competition
 Oligopoly
 Pure monopoly

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 Four Market Models
 Pure competition involves a very large
number of firms producing a standardized
product and there are no restrictions on
entry.
 Monopolistic competition is characterized
by a relatively large number of firms
producing differentiated products and entry
into and exit from the market are relatively
easy.

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 Four Market Models
 Oligopoly involves only a few large
producers of homogeneous or differentiated
products, so each firm is affected by the
decisions of its rival and must take those
decisions into consideration when setting its
own price and quantity.
 Pure monopoly involves one firm which is
the sole seller of a good or service for which
there are no good substitutes.

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 Characteristics of
Pure Competition
 Very large numbers – a large number of
independently acting sellers who offer their
products in large markets.
 Standardized product – firms produce a
product that is identical or homogenous.
 “Price taker” – the firm cannot change the
market price, but can only accept it as
“given” and adjust to it.
 Free entry and exit – no barriers to entry
exist.
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 Demand as Seen by a
Purely Competitive Seller
 The demand schedule and demand curve
faced by the individual firm in a purely
competitive industry is perfectly elastic at
the market price.
 Recall that the firm is a price taker and cannot
influence the market price.
 However, the industry as a whole, which
determines the market demand curve, can
affect price by changing industry output.

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 Demand as Seen by a
Purely Competitive Seller
INDUSTRY (OR INDIVIDUAL
MARKET) DEMAND
FIRM DEMAND
AND SUPPLY
Price S Price

P D

D
Q Quantity Quantity

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 Demand as Seen by a
Purely Competitive Seller
If market supply increases, the market price falls. Since each firm is
a price taker, it has no choice but to charge the lower price for its product.

MARKET DEMAND AND SUPPLY FIRM DEMAND

Price S1 Price
S2

P1 D1
P2 D2

D
Q1 Q2 Quantity Quantity

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 Average and Total Revenue
 Average revenue (AR) is total revenue
from the sale of a product divided by the
quantity of the product sold.
 AR = TR ÷ Q
 Total revenue (TR) is the total number of
dollars received by a firm from the sale of
a product.
 TR = P x Q

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 Marginal Revenue
 Marginal revenue (MR) is the change in
total revenue that results from selling 1
more unit of output.
 MR = (change in TR) ÷ (change in Q)
 MR is constant at the market determined
price—each additional unit of output produced
adds the same amount to total revenue.

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 Average, Total, and
Marginal Revenue
Example: Suppose the market price, P, is $4.
Average revenue and marginal revenue are equal to
the price.

Output Price TR AR MR
0 $4 $0 Since TR = P x Q
$4 and AR = TR ÷ Q,
1 $4 $4 $4
$4 AR = (P x Q) ÷ Q
2 $4 $8 $4 or
$4
3 $4 $12 $4 AR = P
$4
4 $4 $16 $4

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 Average, Total, and
Marginal Revenue
 Graphically, total revenue is a straight line
that slopes upward to the right.
 The demand, marginal revenue, and
average revenue curves are horizontal at
the market price P. All three curves
coincide.

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 Average, Total, and
Marginal Revenue
Price
$12
TR

$8

$4 D = AR = MR

1 2 3 4 Quantity

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 Profit Maximization
in the Short Run
 Because the purely competitive firm is a
price taker, it can maximize its economic
profit (or minimize its economic loss) only
by adjusting its output.
 In the short run, the firm can adjust its
variable resources (but not its fixed
resources) to achieve the output level that
maximizes profit.

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 Profit Maximization
in the Short Run
 In deciding how much to produce, the firm
will compare the marginal revenue and
marginal cost of each successive unit of
output.

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 Profit Maximization
in the Short Run
 As long as producing is preferable to
shutting down, the firm should produce
any unit of output whose marginal revenue
exceeds its marginal cost.
 If the marginal cost of a unit of output
exceeds its marginal revenue, the firm
should not produce that unit.

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 Profit Maximization
in the Short Run
 A method of determining the total output at
which economic profit is at a maximum (or
losses at a minimum) is known as the
MR = MC rule.
 This rule only applies if producing is preferable
to shutting down.
 In pure competition only, we can restate this
rule as P = MC.
 A firm will adjust output until marginal revenue
is equal to marginal cost.

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 Profit Maximization
in the Short Run
Profit Maximization
If price exceeds ATC at the MR = MC
output (q*), the firm will realize an
economic profit equal to q*(P – ATC).
Loss Minimization
If price exceeds the minimum AVC but is
less than ATC, the MR = MC output will
permit the firm to minimize losses equal to
q*(P – ATC).

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 A Profitable Firm in
Pure Competition
Using the MR = MC rule, output is q*. Since price is greater
than ATC at q*, the firm is earning an economic profit.
P
ECONOMIC MC
PROFIT ATC

AVC
P* MR
ATC

q* Q
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 A Firm in Pure Competition
that Continues to Operate
The price is less than ATC at q* so the firm is making a loss.
Since price is greater than the minimum AVC at q*, the firm
ATC
continues
P LOSS
to operate
MC AVC
at a loss.
ATC

P* MR
AVC

q* Q
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 Profit Maximization
in the Short Run
Shutdown
 If price falls below the minimum AVC, the
competitive firm will minimize its losses in
the short run by shutting down.
 A firm shuts down if the total revenue that it
would get from producing is less than the
variable costs of production.

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 Marginal Cost and
Short-Run Supply
Price MC
Break-even
(normal profit)
point ATC
P5 MR5
AVC
P4 MR4
P3 MR3

P2 MR2
P1 MR1
Shutdown point
(if P is below)

Q2 Q3 Q4 Q5 quantity

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 Marginal Cost and
Short-Run Supply
Generalized Depiction
 Price P1 is below the firm’s minimum AVC; the
firm will not operation and quantity supplied
will be zero.
 Price P2 is just equal to the minimum AVC.
The firm will produce at a loss equal to its
fixed cost.
 Between price P2 and P4, the firm will
minimize its losses by producing and
supplying the MR = MC quantity.

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 Marginal Cost and
Short-Run Supply
Generalized Depiction
 At price P4, the firm will just break even and
earns a normal profit.
 At price P5, the firm will realize an economic
profit by producing to the point where
MR (=P) = MC.

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 Marginal Cost and
Short-Run Supply
 The competitive firm’s short-run supply
curve tells us the amount of output the
firm will supply at each price in a series of
prices.
 It is the portion of the MC curve above the
shutdown point.
 It slopes upward because of the law of
diminishing returns.

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 Firm and Industry:
Equilibrium Price
 Equilibrium price is determined by the
intersection of total, or market, supply and
total demand.
 The individual supply curve of each of the
identical firms in an industry are summed
horizontally to get the total supply curve.
 The market supply together with market
demand will determine the equilibrium price in
a competitive industry.

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 Profit Maximization
in the Long Run
 The long-run assumptions in a competitive
industry are:
 The only adjustment is the entry or exit of
firms.
 All firms in the industry have identical cost
curves.
 The industry is a constant cost industry.

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 Goal of Our Analysis
 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.
 Firms seek profit and shun losses
 Firms are free to enter and leave the industry

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 Long-Run Equilibrium
 In long-run equilibrium, firms earn zero
economic profit. There is no tendency for
firms to enter or leave and the existing
firms earn a normal profit.
 P (=MR) = MC = minimum ATC

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 Long-Run Equilibrium

INDUSTRY SINGLE FIRM

MC
Price S Price
ATC

$50 $50 MR

10,000 Quantity Q1 Quantity

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 Long-Run Equilibrium
 Suppose the market demand for the
product increases. Product price will rise,
each firm’s marginal-revenue curve will
shift upward, price will exceeds ATC at the
MR = MC output, and firms will realize an
economic profit.

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 Long-Run Equilibrium

INDUSTRY SINGLE FIRM

MC
Price S1 Price
ATC

$60 $60 MR2

$50 $50 MR1

D2
D1

10,000 Quantity Q1 Q 2 Quantity

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 Long-Run Equilibrium
 When existing firms are earning economic
profit, new firms are lured into the industry
and will enter, the market supply curve will
shift right, and there will be downward
pressure on equilibrium price. (If firms are
making losses, the opposite will occur.)
 Long-run equilibrium will be restored as price
and minimum ATC equalize once again.

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 Long-Run Equilibrium

INDUSTRY SINGLE FIRM

MC
Price S1 Price
S2 ATC

$60 $60 MR2

$50 $50 MR1

D2
D1

15,000 Quantity Q1 Quantity

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 Long-Run Supply in a
Constant-Cost Industry
 In a constant-cost industry, the long-run
supply curve is horizontal.
 The entry of new firms has no effect on
resource prices and thus no effect on
production costs.

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 Long-Run Supply in a
Increasing-Cost Industry
 An increasing-cost industry is an industry
in which the entry of new firms raise the
prices for resources and thus increases
their production costs.
 As the industry expands (or contracts), it
produces a larger (smaller) output at a higher
(lower) product price. The result is a long-run
supply curve that is upsloping.

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 Long-Run Supply: Constant-Cost
versus Increasing-Cost Industry

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 Long-Run Supply in a
Decreasing-Cost Industry
 In decreasing-cost industries, firms
experience lower costs as the industry
expands.
 Thus, the long-run supply curve of a
decreasing-cost industry is downsloping.

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 Pure Competition
and Efficiency
 In long-run equilibrium, the triple equality
of P = MC = minimum ATC tells us that:
 Firms will only earn a normal profit
 Firms in a competitive industry use the limited
resources in a way to maximize the
satisfaction of consumers
 This leads to allocative and productive
efficiency

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