Pure Competition

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Pure Competition

  1. 1. Market structure – identifies how a market is made up in terms of:  The number of firms in the industry  The nature of the product produced  The degree of monopoly power each firm has  The degree to which the firm can influence price  Profit levels  Firms’ behaviour – pricing strategies, non-price competition, output levels  The extent of barriers to entry  The impact on efficiency McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  2. 2. Economists group industries into four distinct market structures based on their characteristics. The four market models are:     Pure competition Monopolistic competition Oligopoly Pure monopoly McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  3. 3. 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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  4. 4.     Ver y 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 entr y and exit – no barriers to entry exist. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  5. 5. Advantages:  optimal allocation of resources  competition encourages efficiency  consumers charged a lower price  responsive to consumer wishes: Change in demand, leads extra supply  Disadvantages:  insufficient profits for investment  lack of product variety  lack of competition over product design and specification  unequal distribution of goods & income  externalities e.g. Pollution McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  6. 6. 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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  7. 7. INDUSTRY (OR MARKET) DEMAND AND SUPPLY Price S INDIVIDUAL FIRM DEMAND Price D P D Q McGraw-Hill/Irwin Quantity Quantity Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  8. 8. 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 Price S1 Price FIRM DEMAND S2 P1 P2 D1 D2 D Q1 Q 2 McGraw-Hill/Irwin Quantity Quantity Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  9. 9.  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 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  10. 10.  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.  McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  11. 11.   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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  12. 12. Price $12 TR $8 D = AR = MR $4 1 McGraw-Hill/Irwin 2 3 4 Quantity Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  13. 13.   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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  14. 14.  In deciding how much to produce, the firm will compare the marginal revenue and marginal cost of each successive unit of output. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  15. 15.   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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  16. 16.  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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  17. 17. 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). McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  18. 18. Using the MR = MC rule, output is q*. Since price is greater than ATC at q*, the firm is earning an economic profit. P MC ECONOMIC PROFIT ATC AVC MR P* ATC q* McGraw-Hill/Irwin Q Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  19. 19. 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 continues LOSS P to operate MC at a loss. ATC AVC ATC P* AVC MR q* McGraw-Hill/Irwin Q Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  20. 20. 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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  21. 21. Price Break-even (normal profit) point MC ATC P5 MR5 AVC P4 P3 MR4 MR3 P2 MR2 P1 MR1 Shutdown point (if P is below) Q2 Q3Q4 Q5 McGraw-Hill/Irwin quantity Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  22. 22. Generalized Depiction Price P1 is below the firm’s minimum AVC; the firm will not operation and quantity supplied will be zero.  Price P is just equal to the minimum AVC. The firm 2 will produce at a loss equal to its fixed cost.  Between price P and P , the firm will minimize its 2 4 losses by producing and supplying the MR = MC quantity.  McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  23. 23. 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.  McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  24. 24.  The competitive firm’s shor t-run supply cur ve 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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  25. 25.  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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
  26. 26.  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. McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

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