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Econ789 chapter010
- 1. Chapter 10 Pure Competition in the Short Run Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
- 2. 10-2 Four Market Models • Pure competition (Perfect competition) • Pure monopoly • Monopolistic competition • Oligopoly Pure Competition Monopolistic Competition Oligopoly Pure Monopoly Market Structure Continuum LO1
- 3. 10-3 Four Market Models Characteristics of the Four Basic Market Models Characteristic Pure Competition Monopolistic Competition Oligopoly Monopoly Number of firms A very large number Many Few One Type of product Standardized Differentiated Standardized or differentiated Unique; no close subs. Control over price None Some, but within rather narrow limits Limited by mutual inter-dependence; considerable with collusion Considerable Conditions of entry Very easy, no obstacles Relatively easy Significant obstacles Blocked Nonprice Competition None Considerable emphasis on advertising, brand names, trademarks Typically a great deal, particularly with product differentiation Mostly public relation advertising Examples Agriculture Retail trade, dresses, shoes Steel, auto, farm implements Local utilities
- 4. 10-4 Pure Competition: Characteristics • Four Conditions for Pure Competition • Very large numbers of sellers • Standardized product • Easy entry and exit • Complete information • Price takers: Because many small firms are selling same products and competing in market, no firm has any control of market (price) LO2
- 5. 10-5 Purely Competitive Demand • Competitive firm faces a perfectly elastic demand • Firm’s demand curve is horizontal • Firm produces as much or little as they wish at the market price • Firm’s marginal revenue = Market price LO3
- 6. 10-6 Average, Total, and Marginal Revenue • Total revenue • TR = P X Q • Average revenue: Revenue per unit • AR = TR/Q = P • Marginal revenue: Extra revenue from 1 more unit of product produced and sold • MR = ΔTR/ΔQ LO3
- 7. 10-7 Average, Total, and Marginal Revenue 42 6 8 10 12 $1179 131 262 524 655 786 917 1048 393 TR D = MR = AR Quantity demanded (sold) Priceandrevenue Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data QD P TR MR $131 131 131 131 131 131 131 131 131 131 131 0 1 2 3 4 5 6 7 8 9 10 $0 131 262 393 524 655 786 917 1048 1179 1310 $131 131 131 131 131 131 131 131 131 131 ] ] ] ] ] ] ] ] ] ]
- 8. 10-8 Profit • Total profit • TP = TR – TC • Marginal profit: Extra profit from 1 more unit of product produced and sold • MP = ΔTP/ΔQ = MR – MC LO4
- 9. 10-9 Profit Maximization • We assume that sole objective of firm is to maximize its profit. • The competitive firm will ask three questions • Should the firm produce? • If so, in what amount? • What economic profit (loss) will be realized? LO4
- 10. 10-10 Profit Maximizing Output • A competitive firm should produce a quantity of product where • Its total profit is largest • A difference between TR and TC is largest • MP > 0 or MR = MC • As long as additional unit produced brings an additional profit (MR is greater than MC), it should produce. • If additional unit brings loss (MC > MR), it should not produce.LO4
- 11. 10-11 Profit Maximization: TR-TC Approach LO3 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price = $131) (1) Total Product (Output) (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Costs (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Profit (+) 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
- 12. 10-12 Profit Maximization: TR–TC Approach 10 2 3 4 5 6 7 8 9 10 11 12 13 14 10 2 3 4 5 6 7 8 9 10 11 12 13 14 $1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 $500 400 300 200 100 Totalrevenueandtotalcost Totaleconomic profit Quantity demanded (sold) Quantity demanded (sold) Total revenue, (TR) Break-even point (Normal profit) Break-even point (Normal profit) Maximum economic profit $299 Total economic profit $299 P=$131 Total cost, (TC) LO4
- 13. 10-13 Profit Maximization: MR-MC Approach LO3 The Profit-Maximizing Output for a Purely Competitive Firm: Marginal Revenue – Marginal Cost Approach (Price = $131) (1) Total Product (Output) (2) Average Fixed Cost (AFC) (3) Average Variable Costs (AVC) (4) Average Total Cost (ATC) (5) Marginal Cost (MC) (5) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) 0 $-100 1 $100.00 $90.00 $190 $90 $131 -59 2 50.00 85.00 135 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
- 14. 10-14 Profit Maximization: MR-MC ApproachCostandrevenue $200 150 100 50 0 1 2 3 4 5 6 7 8 9 10 Output Economic profit MR = P MCMR = MC AVC ATC P=$131 A=$97.78 LO5
- 15. 10-15 Temporary Shutdown Decision • If a firm is incurring an economic loss, what should it do? • In short-run, it cannot exit from the market. • If it shuts down, it still has to pay for fixed input and incurs fixed cost as its loss. • If it produces some, it will earn some from production, but pays for variable inputs. LO5
- 16. 10-16 Loss-Minimizing Case • When MR > minimum AVC • Still produce because producing adds more to revenue than to costs • Losses at a minimum where MR = MC LO5
- 17. 10-17 Loss-Minimizing Case Loss MR = P MC AVC ATC P=$81 A=$91.67 V = $75 LO5
- 18. 10-18 Shutdown Case • When MR < minimum AVC • Stop producing because producing brings more loss • Loss is equal to total fixed cost LO5
- 19. 10-19 Shutdown Case MR = P MC AVC ATC P=$71 V = $74 Short-run shut down point P < minimum AVC $71 < $74 LO5
- 20. 10-20 Marginal Cost and Short Run Supply The Supply Schedule of a Competitive Firm Confronted with Cost Data from Table Price Quantity Supplied Maximum Profit (+) Minimum Loss (-) $151 10 $+480 131 9 +299 111 8 +138 91 7 -3 81 6 -64 71 0 -100 61 0 -100 LO6
- 21. 10-21 Marginal Cost and Short-Run Supply P1 0 MR1 P2 MR2 P3 MR3 P4 MR4 P5 MR5 MC AVC ATC Q2 Q3 Q4 Q5 a b c d e LO6
- 22. 10-22 Marginal Cost and Short-Run Supply P1 0 MR1 P2 MR2 P3 MR3 P4 MR4 P5 MR5 MC AVC ATC Q2 Q3 Q4 Q5 a b c d e S Shut-down point (If P is below) LO6
- 23. 10-23 3 Production Questions LO3 Output Determination in Pure Competition in the Short Run Question Answer Should this firm produce? Yes, if price is equal to, or greater than, minimum average variable cost. This means that the firm is profitable or that its losses are less than its fixed cost. What quantity should this firm produce? Produce where MR (=P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Will production result in economic profit? Yes, if price exceeds average total cost (TR will exceed TC). No, if average total cost exceeds price (TC will exceed TR). LO6
- 24. 10-24 Firm’s Short Run Supply Curve • MC curve above minimum AVC is firm’s short- run supply curve • Industry’s short-run supply is sum of individual firm’s short-run supply in market. • The market short-run supply curve is a horizontal sum of individual firm’s short-run supply curves. LO5
- 25. 10-25 Firm and Industry: Equilibrium LO4 Firm and Market Supply and Market Demand (1) Quantity Supplied, Single Firm (2) Total Quantity Supplied, 1000 Firms (3) Product Price (4) Total Quantity Demanded 10 10,000 $151 4000 9 9000 131 6000 8 8000 111 8000 7 7000 91 9000 6 6000 81 11,000 0 0 71 13,000 0 0 61 16,000 LO6
- 26. 10-26 Firm versus Industry: Equilibrium Economic profit d ATC AVC s = MC $111 $111 D S = ∑ MC’s 8 8000 LO6
- 27. 10-27 Fixed Costs: Digging Out of a Hole • Shutting down in the short run does not mean shutting down forever • Low prices can be temporary • Some firms switch production on and off depending on the market price • Examples: oil producers, resorts, and firms that shut down during a recession
Editor's Notes
- Explanations and characteristics of the four models are outlined at the beginning of this chapter, then the characteristics of a purely competitive industry are detailed. There is an introduction to the concept of the perfectly elastic demand curve facing an individual firm in a purely competitive industry. Next, the total, average, and marginal revenue schedules are presented in numeric and graphic form. Using the cost schedules from the previous chapter, the idea of profit maximization is explored. The total revenue and total cost approach is analyzed first because of its simplicity. More space is devoted to explaining the MR = MC rule, and to demonstrating how this rule applies in all market structures, not just in pure competition. Next, the firm’s short‑run supply schedule is shown to be the same as its marginal-cost curve at all points above the average-variable-cost curve. Then the short‑run competitive equilibrium is discussed at the firm and industry levels. Finally, this chapter’s Last Word discusses firms’ decisions to shut down in the short run and the losses incurred due to fixed costs.
- After an overview of all 4 market models, the chapter focuses on pure competition. The other market models are examples of imperfect competition and will be discussed in future chapters.
- Pure competition is rare in the real world, but the model is important. The model helps analyze industries with characteristics similar to pure competition. The model provides a context in which to apply revenue and cost concepts developed in previous chapters. Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world.
- Very large numbers of independent sellers each acting alone cannot influence the market price by increasing or decreasing their output because each has such a miniscule part of the entire market. A standardized product is a product for which all other products in the market are identical and thus are perfect substitutes. The consequence of this is that buyers are indifferent as to whom they buy from. Price takers are sellers that have no pricing power; in other words, they do not have the ability to price their product. Easy entry and exit means that there are no obstacles to entry or to exit the industry.
- Perfectly elastic demand means that firm has no power to influence price so the firm merely chooses to produce a certain level of output at the price that is given. The demand curve is not perfectly elastic for the industry; it only appears that way to the individual firm, since they must take the market price no matter what quantity they produce. The firm faces a perfectly elastic demand because each individual firm makes up such a small part of the total market and the goods are perfect substitutes. Note that this perfectly elastic demand curve is a horizontal line at the price.
- When a firm charges the same price for each unit of output, the average revenue is just the price of the good. Total revenue refers to the total amount of money that the firm collects for the sale of all of the units of their good. Marginal revenue reflects the additional revenue that the firm will receive by producing one more unit of output. When the firm is deciding how much to produce, the firm considers the marginal revenue in their decision.
- This graph shows a purely competitive firm’s demand curve and revenue curve. The demand curve (D) of a purely competitive firm is a horizontal line (perfectly elastic) because the firm can sell as much output as it wants at the market price (here, $131). Because each additional unit sold increases total revenue by the amount of the price, the firm’s total-revenue (TR) curve is a straight upsloping line and its marginal-revenue (MR) curve coincides with the firm’s demand curve. The average-revenue (AR) curve also coincides with the demand curve.
- When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option.
- When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option.
- When looking at profit maximization there are essentially 3 questions that the firm must answer. The first question is whether or not the firm should produce at all in the short run. In the short run, the firm should shut-down under certain circumstances. If it has been determined that the firm should produce in the short run, then the firm must determine how much to produce. Lastly, based on the answers to the first two questions, it is necessary to calculate the profit or loss for the firm. Part of the profit-maximization rule is producing an output that minimizes losses in the short run when that is the best option.
- In this table, total costs are given as well as total revenue. Here we can start identifying where the firm will choose to produce using the total revenue-total cost approach. Based on TR-TC, the firm will produce where the difference between total revenue and total cost is the greatest. Based on this approach, the profit maximizing output is 9 units when the price is $131.
- The firm’s profit is maximized at an output of 9 units where total revenue, TR, exceeds total cost, TC, by the maximum amount. The vertical distance between TR and TC is plotted as a total economic profit curve.
- Compare MC and MR at each level of output. The firm should continue to expand output as long as MR is greater than MC. The firm will maximize profits by producing the last unit of output where MR still exceeds the MC, or where MR=MC. At the tenth unit MC exceeds MR. Therefore, the firm should produce only nine units to maximize profits.
- This graph shows the short-run profit maximization for a purely competitive firm. The MR=MC output enables the purely competitive firm to maximize profits or to minimize losses. In this case, MR (=P in pure competition) and MC are equal at an output, Q, of 9 units. At this output, P equals $131 and exceeds the average total cost, and A = $97.78, so the firm realizes an economic profit of P - A per unit. The total economic profit is represented by the green rectangle and is (Price - ATC) * 9.
- In the short run the firm only has two choices: produce or shut-down. There is not enough time in the short run for the firm to get out of business. Given these options, sometimes the firm will produce, but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down so this is the firm’s best choice.
- In the short run the firm only has two choices: produce or shut-down. There is not enough time in the short run for the firm to get out of business. Given these options, sometimes the firm will produce, but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down so this is the firm’s best choice.
- This graph shows the short-run loss minimization for a purely competitive firm. If price, P, exceeds the minimum AVC (here $74 at Q = 5) but is less than ATC at the MR = MC output (here 6 units) then the firm will earn losses, but it will produce. In this instance the loss is P - A per unit, where A is the average total cost at 6 units of output and price equals $81. The total loss is shown by the red area and is equal to (P–ATC)*6.
- In the short run the firm only has two choices: produce or shut-down. There is not enough time in the short run for the firm to get out of business. Given these options, sometimes the firm will produce, but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down so this is the firm’s best choice.
- Here the short-run shutdown case for a purely competitive firm. If price, P (here equal to $71), falls below the minimum AVC (here $74 at Q = 5), the competitive firm will minimize its losses in the short run by shutting down. There is no level of output at which the firm can produce and incur a loss smaller than its total fixed cost. In other words, the $100 fixed cost is the minimum possible loss.
- There is a relationship between price and quantity supplied. Since P=MR for the competitive firm, the profit maximization rule MR=MC will yield the short run supply curve. The short run supply curve is the part of the MC that lies above the AVC curve. The schedule shows the quantity a firm will produce at a variety of prices
- This graph displays the quantity a firm will produce at a variety of prices. Firms continue to follow the profit-maximizing rule and produce where MR=MC. They will produce as long as the price is greater than the min AVC.
- Here is a generalized depiction of how the marginal cost curve becomes the short run supply curve. Examine the MC for the competitive firm. If price is below AVC, then the firm should shut down and produce 0. If the price is equal to or above AVC, the firm should produce. The MC curve that is above the AVC curve becomes the short run supply curve. The break-even point is point d where the firm earns a normal profit because Price=ATC here.
- We must work through these 3 questions sequentially every time we are confronted with a new market price. This is a table that summarizes the steps that you need to go through to determine profit maximizing output.
- In the short run the firm only has two choices: produce or shut-down. There is not enough time in the short run for the firm to get out of business. Given these options, sometimes the firm will produce, but still make a loss. In these situations, the loss from producing is smaller than the loss if the firm shut-down so this is the firm’s best choice.
- The market equilibrium condition is where quantity demanded equals quantity supplied. This will occur at a price of $111 and this price is the equilibrium, or market clearing price. We can see that the industry demand curve is a typical, downward sloping demand even though, for the firm, the demand curve is perfectly elastic and horizontal.
- Short-run competitive equilibrium for (a) a firm and (b) the industry. The horizontal sum of the 1000 firms’ individual supply curves (s) determines the industry supply curve (S). Given industry demand (D), the short-run equilibrium price and output for the industry are $111 and 8000 units. Taking the equilibrium price as given, the individual firm establishes its profit-maximizing output at 8 units and, in this case, realizes the economic profit represented by the green area. Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price.
- Firms have to determine whether or not producing in the short run will make their losses bigger or smaller. Firms hope that producing will help to reduce their losses, but if they are wrong their losses (their hole) might grow greater. If firms are forced to shut-down, the shut-down might be temporary. The firm may re-open when prices rise and therefore will be large enough for the firm to reap profits.