McGraw-Hill/Irwin

Chapter 9
Pure
Competition

Copyright 2009 by The McGraw-Hill Companies, Inc. All

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
Competition

Monopolistic
Competition

Oligopoly

Pure
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

Firms
Revenue
Data

917

QD TR

$131 0
131 1
131 2
131 3
131 4
131 5
131 6
131 7
131 8
131 9
131 10

TR

1048

$0
131
262
393
524
655
786
917
1048
1179
1310

MR
] $131
] 131
] 131
] 131
] 131
] 131
] 131
] 131
] 131
] 131

Price and Revenue

Firms
Demand
Schedule
(Average
Revenue)

786
655
524
393
262

D = MR = AR
131
2

10

Quantity Demanded (Sold)

12
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)
Total Product
(Output) (Q)

(2)
Total Fixed
Cost (TFC)

(3)
Total Variable
Cost (TVC)

0
1
2
3
4
5
6
7
8
9
10

$100
100
100
100
100
100
100
100
100
100
100

$0
90
170
240
300
370
450
540
650
780
930

(4)
(5)
(6)
Total Cost Total Revenue Profit (+)
(TC)
(TR)
or Loss (-)

$100
190
270
340
400
470
550
640
750
880
1030

$0
131
262
393
524
655
786
917
1048
1179
1310

$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280

Do
You
SeeGraph
Profit Maximization?
Now
Lets
The Results

9-8

Total Revenue Total Cost Approach

Total Economic
Profit

Total Revenue and Total Cost

$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100

$500
400
300
200
100

Break-Even Point
(Normal Profit)
Total Revenue, (TR)
Maximum
Economic
Profit
$299

Total Cost,
(TC)

P=$131
Break-Even Point
(Normal Profit)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)

Total Economic
Profit

$299

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
(1)
Total
Product
(Output)

0
1
2
3
4
5
6
7
8
9
10

(2)
Average
Fixed
Cost
(AFC)

$100.00
50.00
33.33
25.00
20.00
16.67
14.29
12.50
11.11
10.00

(3)
Average
Variable
Cost
(AVC)

(4)
Average
Total
Cost
(ATC)

$90.00 $190.00
85.00 135.00
80.00 113.33
75.00 100.00
74.00
94.00
75.00
91.67
77.14
91.43
81.25
93.75
86.67
97.78
93.00 103.00

(5)
Marginal
Cost
(MC)

$90
80
70
60
70
80
90
110
130
150

(6)
Marginal
Revenue
(MR)

(7)
Profit (+)
or Loss (-)

$131
131
131
131
131
131
131
131
131
131

$-100
-59
-8
+53
+124
+185
+236
+277
+298
+299
+280

Surprise
- Now
Lets GraphNow?
It
DoNo
You
See Profit
Maximization
9-10

Marginal Revenue Marginal Cost

Approach

Cost and Revenue

$200

MR = MC

150
P=$131

MC
MR = P
ATC

Economic Profit

100

AVC
A=$97.78

50

Output

10
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

Cost and Revenue

$200

Lower the Price to $81 and

Observe the Results!

150

Loss

A=$91.67

ATC
AVC

100
P=$81

50

MC

MR = P
V = $75

Output

10
9-13

Short Run Shut Down Case

Cost and Revenue

$200

Lower the Price Further to

$71 and Observe the Results!
MC

150

100

ATC

V = $74

AVC
MR = P

P=$71
50

Short-Run
Shut Down Point
P < Minimum AVC
$71 < $74
1

Output

10
9-14

Short-Run Supply Curve

Continuing the Same Example
Supply Schedule of a Competitive Firm
Price
$151
131
111
91
81
71
61

Quantity
Supplied
10
9
8
7
6
0
0

Maximum Profit (+)

or Minimum Loss (-)
$+480
+299
+138
-3
-64
-100
-100

The schedule shows the quantity a firm

will produce at a variety of prices

9-15

Short-Run Supply Curve

Cost and Revenues (Dollars)

Firms produce where MR=MC

P5

P4
P3
P2
P1

MC
MR5
ATC

AVC

b
a

MR4
MR3
MR2
MR1

This Price is Below AVC

And Will Not Be Produced
0

Q2

Q3

Q4

Quantity Supplied

Q5
9-16

Short-Run Supply Curve

Cost and Revenues (Dollars)

Firms produce
where
MR=MC
Examine the MC for the Competitive Firm
MC Above AVC Becomes
the Short-Run Supply Curve
P5

Break-even
(Normal Profit) Point
d

P4
P3
P2
P1

S
MC
MR5
ATC

AVC

b
a

MR4
MR3
MR2
MR1

Shut-Down Point
(If P is Below)
0

Q2

Q3

Q4

Quantity Supplied

Q5
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
S = MCs
s = MC

Economic
Profit

ATC
d

$111

$111

AVC
D

8000

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
S1
MC
ATC

$60

$60

50

50

MR

40

S2

D2

40

D1

100

80,000

90,000

100,000

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
S3
MC
ATC

$60

$60

50

50

MR

40

S1

D1

40

D3

100

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
P2

$50

Z3

Z1

Z2

P3
D3

Q3
90,000

D1
Q1
100,000

D2
Q2
110,000

9-24

Long-Run Supply Curve

Increasing-Cost Industry
P

P2

$55

P1

$50

P3

$40

S
Y2
Y1
Y3
D2
D1

D3

Q3
90,000

Q1
100,000

Q2
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
P=MC=Minimum
ATC (Normal Profit)

Market

MC

Price

Price

ATC

MR

P
D

Qf

Quantity

Qe

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
Initial Patent Price
P1
Price

As price
decreases to f,
Consumer
surplus abc
increases to adf
Producer and
consumer
surplus is
maximized
as shown by
the gray triangle

P2

D
Q1

Q2
Quantity

Result: Greater Quantity at Lower Prices

as Predicted by the Competitive Model
9-29

Key Terms
pure competition
pure monopoly
monopolistic
competition
oligopoly
imperfect
competition
price taker
average revenue
total revenue
marginal revenue
break-even point
MR=MC rule
short-run supply
curve

long-run supply
curve
constant-cost
industry
increasing-cost
industry
decreasing-cost
industry
productive
efficiency
allocative efficiency
consumer surplus
producer surplus
9-30

Next Chapter Preview

Pure
Monopoly

9-31