This is a PowerPoint presentation on pure competition.

1. This is a PowerPoint presentation on pure competition. A left mouse click or the enter key will add and element to a slide or move you to the next slide. The back space key will take you back an element or slide. If you wish to exit the presentation, the escape key will do it! R. Larry Reynoldsã 1997

2. Pure Competition • The word “competition” may be used in two ways; • rivalry - {synonym; opposition, antagonism} • structural competition or “pure competition” • large number of sellers and buyers, none of whom can influence the market, • homogeneous or identical products products, • relatively free entry and exit from the market. There are no major Barriers to Entry. • [Perfect competition includes complete infromation] Principles of Microeconomics

3. Price Takers • Because there is a large number of sellers with identical products, no seller can charge a price above the prevailing market price. • There is no reason to sell below the market price. • Result: firms are “price takers,” they have no control over the price at which they sell. They may adjust the method and level of output, not the selling price. • The market sets the price. Sellers and buyers react. Principles of Microeconomics

4. Firm’s Output • The firm’s choice of method and level of output is dependent on costs and revenue associated with each output alternative. • The costs of production are reflected in the supply side of the model. • the revenue of the firm is reflected in the demand functions. Principles of Microeconomics

5. Markets and Firms • The role of a market is to coordinate the activities of all the producers and buyers of a good. • A firm is an organization that controls the operations of the plant(s) or the physical units of production. • For purposes of simplification we will consider a firm that has a single plant and one good that they produce. Principles of Microeconomics

6. $ $ Firm Market S Dmarket QX/ut QX(millions) ut In the market there are a large number of firms that produce and offer for sale a large output. Each firm’s output is small. Dfirm PE PE The demand functionfaced by the firm is perfectly elastic! QME The market demand and supply functions determine theequilibrium price and quantity. A single firm produces a small portion of the market output and must sell at the market price. Principles of Microeconomics

7. $ $ Firm S Dfirm PE PE Dmarket QX/ut QME QX(millions) ut Market Dfirm AR = PE Average revenue As a price taker, the firm cannot raise price above PE. Thereis no reason to sell for less. The firm can sell all it wants andcan produce at PE . Since each unit can be sold at the price [PE ], the Dfirm is also the average revenue [AR]. PE = AR = Demand Principles of Microeconomics

8. Average and Marginal Revenue • Total revenue is Price times Q: TR =PQ • AR is total revenue divided by Q; it is the revenue per unit of output. TR divided by Q is P, so AR = P. AR , price and the demand function are the same thing. • MR is the change in Total revenue associated with a change in quantity sold. Principles of Microeconomics

9. $ 30 PQ TR AR = = Q Q 10 AR Q/ut 2 1 6 AR and TR Revenue Functions: . TR = PQ [cancel Q’s] TR = P AR = P Consider a purely competitive firm thatfaces a P = $5. . . Since it can sell all itwants at $5/unit,AR = 5. D = P= 5 The demand faced by thefirm is P =f(Q), P=5 for any Q. TR is a straight line with a slope equal to price. This istrue only in pure comp. where demand isperfectly elastic. For Q = 1, TR = PQ = 5X1 = 5 For Q = 2, TR = PQ = 5X2 = 10 For Q = 6, TR = PQ = 5X6 = 30 Principles of Microeconomics

10. $ TR 30 DTR DQ 10 D = AR P= 5 Q/ut 2 1 6 DTR DQ MR, AR and TR Revenue Functions: TR = PQ AR = P MR = The slope of TR = MR = P Consider a purely competitive firm thatfaces a P = $5. P = MR = TR is a straight linewith a slope equal toprice* [in this example $5]. [When Demand is perfectly elastic!] MR = , MR is the slope of the TR which is the price. Because it is a purely comp. firm,each additional unit can be sold at thesame price. P = MR. Since {* only in pure comp} Principles of Microeconomics

11. $ $ Firm S PH D*market Dmarket QX/ut QX(millions) ut Pure Competition Market D*firm PH Dfirm PE PE QME Q An increase in the demand in the market causes an increasein both the output and equilibrium price [to PH]. The demand function [or AR, MR] faced by the firm increasesto D*. Principles of Microeconomics

12. S* $ $ Firm S PH Dmarket QX/ut QX(millions) ut Market D*firm PH Dfirm PE PE Q QME A decrease in supply in the market causes a decreasein output and increase in equilibrium price [to PH]. The demand function [or AR] faced by the firm increasesto D*. Principles of Microeconomics

13. $ $ Firm S S* PE Dmarket D* QX/ut QX(millions) ut Pure Competition Market Dfirm PE PL PL PL D*firm D*firm QME An increase in supply lowers the equilibruim price in the marketand the price, AR of the firm. A decrease in demand would have the same result in price. Principles of Microeconomics

14. Short Run Profit Maximization • Profits [p] = TR - TC. [p are often the objective or goal of firm.] • The firm will choose to produce and offer for sale all additional units of output that they can produce for a cost [MC] that is less than the additional revenue [MR] that they collect. • Maximum profits [or minimum loses] for a firm occur when MR = MC. • Ideally, the market will “signal” the costs of sellers and benefits to buyers with the market price; P = MR = MC Principles of Microeconomics

15. $ TC In pure comp, each firm can sell entire output at marketprice. TR is linear with slope = P. TR TR =TC Notice that the slope of TC,[MC] is the same as theslope of TR [MR] at Q*.MC = MR! slope of TC=MC TR = TC at Q1 & Q4. These are the levels of output where thefirm “breaks even.” DTR DTC TR =TC DQ A firm producing at Q1would increase outputto Q* because the TCwould increase by lessthan the TR. Q1 Q* Q4 Q/ut At output Q*, the vertical distance between TR and TC is the greatest. Since TR - TC = p, this is maximum p. Principles of Microeconomics

16. $ TC TR TR =TC slope of TC=MC TR =TC Q1 Q* Q4 Q/ut At output Q*, the vertical distance between TR and TC is the greatest.Since TR - TC = p, this is maximum p. The firm would notincrease productionabove Q* becauseTC will increase by morethan TR. MC > MR DTR DQ DTC Since DTR [MR] isless than DTC [MC],p would fall if outputwere expanded to Q4 . DQ At Q* MR = MC;Maximum p. Principles of Microeconomics

17. Short Run Profit Maximization In the short run the firm is a price taker. Given the price inthe market and the fixed input(s), the firm’s only alternativesare the amount of the variable input and consequently, the output [Q]. At output levels Q1 & Q4, the firm “breaks even.” AR = ATC and TR = TC.*[Includes “normal p.] Firm MC $ ATC [* (AR)Q=TR=TC=(ATC)Q] D = AR = MR PE The MC of producing theoutput between Q3 and Q*is less than the market price[ MR = P]: TR increases “faster” than TC, Maximum profits at Q*! C3 QX/ut Q1 Q3 Q4 Q* The firm’s minimum cost per unit [C3 ] is at Q3. This is the maximum p perunit, not maximum p. Principles of Microeconomics

18. Dp Short Run Profit Maximization pis TR - TC, so (PE -C3)Q3 = p. TR is PE Q3. At Q3 the TC is C3 Q3; By increasing production from Q3 to Q*, the TC will increase; The Dp is the area above MC and below MR. TR increases; Firm MC $ ATC . D = AR = MR PE p MAXIMUM p IS WHEREMC = MR ! C3 DTR DTC TC QX/ut Q1 Q3 Q4 0 Q* [At Q3 the cost per unit [ATC] is a minimum.] Principles of Microeconomics

19. COST Q FC VC TC AVC ATC MC 0 -- $10 $0 $10 -- -- 1 $5 $10 $5 $15 5.00 15. 2 $3 $10 $8 $18 4.00 9.00 3 $ 1 $10 $9 $19 3.00 6.33 $3 4 $10 $12 $22 3.00 5.50 5 $6 $10 $18 $28 3.60 5.60 $9 6 $10 $27 $37 4.50 6.17 $12 7 $10 $39 $49 5.57 7.00 8 $15 $10 $54 $64 6.75 8.00 9 $19 $83 $10 $73 8.11 9.22 DTC MC = 10 $26 DQ 10.90 9.90 $10 $99 $109 At Q = 0, the only cost isFC. FC is a constant and remains unchanged in the short run. Variable Cost [VC] increases as output increases. Total cost [TC] = VC + FC VC/Q = AVC. AVC first decreases, then increases. ATC = TC/Q. ATC decreases, then increases. MC is the change in TC [or VC] that is associated with change in output [Q]. Principles of Microeconomics

20. COST Q FC VC TC AVC ATC MC 0 -- $10 $0 $10 -- -- 1 $5 $10 $5 $15 5.00 15. 2 $3 $10 $8 $18 4.00 9.00 3 $ 1 $10 $9 $19 3.00 6.33 $3 4 $10 $12 $22 3.00 5.50 5 $6 $10 $18 $28 3.60 5.60 $9 6 $10 $27 $37 4.50 6.17 $12 7 $10 $39 $49 5.57 7.00 8 $15 $10 $54 $64 6.75 8.00 9 $19 $83 $10 $73 8.11 9.22 10 $26 10.90 9.90 $10 $99 $109 The most “efficient” use of the variable input is betweenthe 3rd and 4rth units of Q.*[min AVC and max AP are same.] The lowest cost per unit,[min ATC] is between the 4rthand 5th units of output.* If the objective is to MAX p, the firm will produce and offeroutput for sale so long as the additional unit cost [MC] is lessthan the price at which it can besold [MR = P in pure competition]. {*Remember MC = AVC and ATC at their minimums !} Principles of Microeconomics

21. COST p Q FC VC TC AVC ATC MC 0 -- $10 $0 $10 -- -- 1 $5 $10 $5 $15 5.00 15. 2 $3 $10 $8 $18 4.00 9.00 3 $ 1 $10 $9 $19 3.00 6.33 $3 4 $10 $12 $22 3.00 5.50 5 $6 $10 $18 $28 3.60 5.60 $9 6 $10 $27 $37 4.50 6.17 $12 7 $10 $39 $49 5.57 7.00 8 $15 $10 $54 $64 6.75 8.00 9 $19 $83 $10 $73 8.11 9.22 10 $26 10.90 9.90 $10 $99 $109 Given the cost structure of thefirm in our example and a market price of $13; The most “efficient” use of thevariable does not max p. Q = 3; TR = PQ= ($13)3 = $39TC = $19, p = TR-TC = $39-$19 = $20 $20 $30 Q = 4; TR = PQ= ($13)4 = $52TC = $22, p = TR-TC = $52-$22 = $30 $37 $41 At the least cost per unit[min ATC], p= $65-$28=$37 Q = 6; TR = PQ= ($13)6 = $78TC = $37, p = TR-TC = $78-$37 = $41 The 6th unit can be produced for a cost [MC] of $9 and sold for $13, that would add $4 to p . Principles of Microeconomics Should the 7th unit be produced?

22. COST p Q FC VC TC AVC ATC MC 0 -- $10 $0 $10 -- -- 1 $5 $10 $5 $15 5.00 15. 2 $3 $10 $8 $18 4.00 9.00 3 $ 1 $10 $9 $19 3.00 6.33 $3 4 $10 $12 $22 3.00 5.50 5 $6 $10 $18 $28 3.60 5.60 $9 6 $10 $27 $37 4.50 6.17 $12 7 $10 $39 $49 5.57 7.00 8 $15 $10 $54 $64 6.75 8.00 9 $19 $83 $10 $73 8.11 9.22 10 $26 10.90 9.90 $10 $99 $109 Should the 7th unit be produced? The MC of the 7th unit is $12, it can be sold for $13, that would increase p by $1. <-$10> Q = 7; TR = PQ= ($13)7 = $91TC = $49, p = TR-TC = $91-$49 = $42 <-$2> $ 8 As long as MR [P in pure comp]exceeds MC {and AVC},produce & sell if max pis the goal. $20 $30 $37 $41 The 8th unit will increasecosts by $15 [MC=15] andcan be sold for $13. Do youwant to produce it? $42 $40 $34 NO ! $21 Q = 8; TR = PQ= ($13)8 = $104, TC = $64, p = TR-TC = $104-$64 = $40 Principles of Microeconomics

23. COST p Q FC VC TC AVC ATC MC 0 -- $10 $0 $10 -- -- 1 $5 $10 $5 $15 5.00 15. 2 $3 $10 $8 $18 4.00 9.00 3 $ 1 $10 $9 $19 3.00 6.33 $3 4 $10 $12 $22 3.00 5.50 5 $6 $10 $18 $28 3.60 5.60 $9 6 $10 $27 $37 4.50 6.17 $12 7 $10 $39 $49 5.57 7.00 8 $15 $10 $54 $64 6.75 8.00 9 $19 $83 $10 $73 8.11 9.22 10 $26 10.90 9.90 $10 $99 $109 Loss minimization Due to market conditions,the price falls to $5. <-10> <-10> Profits are calculated:p = TR - TC = PQ -TC. <- 8> <- 4> If the firm “shuts down”the loss is $10. <- 2> <- 3> <- 7> If the firm will produces aslong as MR = P > MC and isgreater than AVC, they canreduce their losses. Lossis $2. <-14> <-24> <-38> <-59> Principles of Microeconomics

24. Short Run Loss Minimization When the price is greater than PP , the firm can make aneconomic p . At a price, PP, the firm “breaks even.” Thiscovers a “normal profit,” [ATC > P = MR > AVC ] MC $ ATC Firm AVC If the price falls belowPL , the firm should“shut down” to minimizelosses. [ P = MR < AVC] PP PL QX/ut Q3 0 QL Between a price of PLand PP, the firm will lose money but can minimizelosses by producing where MC = MR between output levels QL & Q3. Principles of Microeconomics

25. LRMC ATC! ATC6 ATC2 ATC5 ATC3 ATC* ATC* LRAC LONG RUN PROFIT MAXIMIZATION [firm in long run] Plant ATC* is the optimal size! $ PP Firms with Plant size ATC*earn economic p, this attractsentry causing the market price fall. Cmin PM= Q* Q When price falls to PM , entry ceases. In the long run, the envelope curve represented LRAC. All costs are variable in the long run. At a price of PP , the firm can make above normal p if they have plant size ATC3 or greater and smaller than ATC6 . Plants ATC!, ATC2 & ATC6 have costs per unit [ATC] that are greater than the price PP. They will not earn normal p. These firms must adjust or close. Principles of Microeconomics

26. LRMC ATC! ATC6 MC* ATC2 ATC5 ATC3 ATC* ATC* LRAC LONG RUN PROFIT MAXIMIZATION Envelope curve: $ . Cmin P= Q* Q So long as P > LRACmin, firms enter [attracted by econ p] driving price down. When P < LRACmin , firms will exit the industry causing an increase in price.. Long run equilibrium [no entry or exit and price is stable] is at a price where it is equal to minimum of the LRAC. Tangent to bottom of LRAC. In long run equilibrium: P = AR = MR = LRAC = LRMC = ATC* = MC* Principles of Microeconomics

27. LONG RUN EQUILIBRIUM: P = AR = MR = LRAC = LRMC = ATC* = MC* 1. AR = ATC* {CONDITION FOR NORMAL p IN THE SHORT RUN.} 2. AR = LRAC {CONDITION FOR NORMAL p IN THE LONG RUN.} 3. LRAC = LRMC {CONDITION THAT INSURES MINIMUM COST PER UNIT AND OPTIMAL SIZE OR SCALE OF PLANT.} 4. ATC* = MC* {CONDITION INSURES THAT THE OPTIMAL SIZE PLANT IS OPERATED AT ITS MOST EFFICIENT LEVEL OF output.} 5. MR = MC* {CONDITION INSURES FIRM IS MAXIMIZING p IN THE SHORT RUN.} 6. P = MR = LRMC {CONDITION INSURES FIRM IS MAXIMIZING p IN THE LONG RUN RUN.} 7.P = MR = MC [both long and short run]INSURES THAT THEFIRMS’ BEHAVIOR IS CONSISTENT WITH MAXIMUM SOCIAL WELFARE ! Principles of Microeconomics