Chapter 9

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
 Four Market Models
• Pure competition
• Pure monopoly
• Monopolistic competition
• Oligopoly
Imperfect Competition
Pure Monopolistic Pure
Competition Competition Oligopoly Monopoly

Market Structure Continuum

9-3
 Pure Competition
• Very large numbers
• Standardized product
• “Price takers”
• Free entry and exit
• Perfectly elastic demand
– Average revenue
– Marginal revenue
– Price
9-4
 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) 9-5
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?

9-6
 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

9-7
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…
9-8
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
Total Economic $299
Profit

400
300 Profit
200
100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)
9-9
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…
9-10
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
9-11
 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
9-12
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
9-13
Short Run Shut Down Case

$200

Lower the Price Further to

$71 and Observe the Results!
Cost and Revenue

150 MC

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
9-14
 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 9-15
 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
9-16
 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
9-17
 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
9-18
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
9-19
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
9-20
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
9-21
 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
9-22
 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 9-23
 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

9-24
 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?

9-25
Pure Competition and Efficiency
• Productive efficiency
P = minimum ATC
• Allocative efficiency
P = MC
• Maximum consumer and
producer surplus
• Dynamic adjustments
• “Invisible Hand” revisited
9-26
 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
9-27
 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
9-28
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
9-29
 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
9-30
Next Chapter Preview…

Pure
Monopoly

9-31