BB107
Pure Competition in the Short Run and Long Run
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Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Outcomes
• List the conditions required for purely competitive markets. • Convey how purely competitive firm maximize profits or minimize losses.
• Explain why the marginal cost curve and supply curve are identical.
• Explain how the long run differs from the short run in pure competition. • Explain the differences between constant-cost, increasing-cost, and decreasing-cost industries. • Show how long run equilibrium in pure competition produces an efficient allocation of resources.
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Four Market Models 1) Pure competition
2) Pure monopoly
3) Monopolistic competition 4) Oligopoly
Pure Monopolistic Competition Competition Oligopoly Pure Monopoly
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Characteristics of the Four Market Models
Characteristic
Number of firms Type of product Control over price
Pure Competition Very large numbers Standardized None
Monopolistic Competition Many Differentiated Some control Few
The Essay on Short-Run Production and Long-Run Production
According to Sloman, (2004), production is the transformation of inputs into outputs by firms in order to earn profit. Production can be divided into two types, that is short-run production and long-run production. Production in the short-run is the production period of time over which at least one factor is fixed as production in the long-run is the production period of time long enough for all ...
Oligopoly
Monopoly One Unique; no close subs. Considerable
Standardized or differentiated Limited by mutual inter-dependence; considerable with collusion Significant obstacles Typically a great deal product differentiation Steel, auto, banking, airlines
Conditions of entry Non-price Competition
No obstacles None
No obstacles Considerable (advertising, brand names, trademarks) Retail trade, dresses, shoes
Blocked Mostly public relation advertising Local utilities
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Examples
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Agriculture
Pure Competition: Characteristics 1. Very large numbers of sellers
2. Standardized product
3. Easy entry and exit 4. Perfect information
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Pure Competition: Characteristics
Because there are many firms, each firm produces a small portion of the market output. Hence, each firm cannot influence the price. Each firm is a price taker. The firm does not make pricing decisions. The firm faces a perfectly elastic demand for its output.
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Pop Quiz A purely competitive seller is:
A. both a price maker and a price taker. B. neither a price maker nor a price taker. C. a price taker. D. a price maker.
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Pop Quiz
Which of the following is not a basic characteristic of pure competition? A. considerable non price competition
B. no barriers to the entry or exit of firms
C. a standardized or homogeneous product D. a large number of buyers and sellers
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Average, Total, and Marginal Revenue
Total Revenue • TR = P X Q Average Revenue or Revenue per unit • AR = TR/Q = P Marginal Revenue • Extra revenue from 1 more unit • MR = ΔTR/ΔQ
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Average, Total, and Marginal Revenue
Firm’s Demand Schedule (Average Revenue) Firm’s Revenue Data
QD
0 1 2 3 4 5 6 7 8 9 10
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P
TR
$0 131 262 393 524 655 786 917 1048 1179 1310
] ] ] ] ] ] ] ] ] ]
MR
AR
$131 131 131 131 131 131 131 131 131 131 131
$131 131 131 131 131 131 131 131 131 131 131
$131 131 131 131 131 131 131 131 131 131
Average, Total, and Marginal Revenue
TR
The Essay on Oligopolists Market Price Firms
Oligopolists There are four market structures in our economy today: Perfect competition, monopolistic competition, oligopolies and monopolies. This essay shall describe the oligopoly market. The definition of an oligopoly states that in an industry, a small number of firms dominate the market. There are a low number of firms in the industry, becase and adding to the barriers to entry. The barriers ...
D = MR = AR = P
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Pop Quiz For a purely competitive seller, price equals: A. Average revenue. B. Marginal revenue. C. Total revenue divided by output. D. All of these.
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Pop Quiz
For a purely competitive firm total revenue: A. is price times quantity sold. B. increases by a constant absolute amount as output expands. C. graphs as a straight up sloping line from the origin. D. has all of these characteristics.
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Profit Maximization
The goal of a competitive firm is to maximize profit. What output to produce in order to maximize profits or minimize losses? Profit maximization can be shown in two ways: (a) Total Approach
(b) Marginal Approach
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Profit Maximization: Total Approach
Assume 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 1 2
$100 100 100
$0 90 170
$100 190 270
$0 131 262
$-100 -59 -8
3
4 5
100
100 100
240
300 370
340
400 470
393
524 655
+53
+124 +185
6
7 8
100
100 100
450
540 650
550
640 750
786
917 1048
+236
+277 +298
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100
100
780
930
880
1030
1179
1310
+299
+280 15
Profit Maximization: Total Approach
Total Revenue and Total Cost
$1800 1700 1600 1500 1400 1300 1200 1100 1000 900 800 700 600 500 400 300 200 100 0 $500 400 300 200 100 0
Break-Even Point (Normal Profit) Total Revenue, (TR) Maximum economic profit $299 Total Cost, (TC)
Break-Even Point (Normal Profit)
1 2 3 4 5 6 7 8 9 10 11 12 13 14
Profit is maximized when the difference between TR and TC is at the largest!
The Essay on Total Cost Goods Firm Sales
A Market Economy is the most efficient way of organizing economic activities. Millions of suppliers (firm) and consumers (buyers) make the markets. The suppliers and consumers sell and purchase goods that satisfy the wants of consumers and suppliers. Suppliers and consumers make rational decisions, respond to incentives and make tradeoffs. Over all trade makes everyone better off. (Mankiw) If one ...
Quantity Demanded (Sold)
Total Economic Profit
Total Economic Profit
1 2 3 4 5 6 7 8
$299
9 10 11 12 13 14
16 Quantity Demanded (Sold)
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Profit Maximization: Marginal Approach
Assume Price = $131
(1) Total Product (Output) 0 (2) Average Fixed Cost (AFC) − (3) Average Variable Costs (AVC) − (4) Average Total Cost (ATC) − (5) Marginal Cost (MC) − (6) Price = Marginal Revenue (MR) − (7) Total Economic Profit (+) or Loss (-) $-100
1
2 3 4 5 6 7 8 9 10
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$100.00
50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00
$90.00
85.00 80.00 75.00 74.00 75.00 77.14 81.25 86.67 93.00
$190
135 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00
$90
80 70 60 70 80 90 110 130 150
$131
131 131 131 131 131 131 131 131 131
-59
-8 +53 +124 +185 +236 +277 +298 +299 +280
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Profit Maximization: Marginal Approach Hence, profit is maximized when
MR = MC
If MR > MC, the firm will increase output. If MR
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Pop Quiz
In the short run, a purely competitive firm that seeks to maximize profit will produce: A. Where the demand and the ATC curves intersect. B. Where total revenue exceeds total cost by the maximum amount.
C. That output where economic profits are zero.
D. At any point where the total revenue and total cost curves intersect.
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Pop Quiz
A competitive firm in the short run can determine the profit-maximizing (or lossminimizing) output by equating:
A. price and average total cost.
B. price and average fixed cost. C. marginal revenue and marginal cost. D. price and marginal revenue.
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Pop Quiz
In a typical graph for a purely competitive firm, the intersection of the total cost and total revenue curves would be:
A. A point of maximum economic profit.
B. A point of minimum economic loss.
C. A point where MR = MC.
D. A break-even point.
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Profit Maximization: Marginal Approach How to read diagrams that use marginal approach: We know: Total Profit = TR – TC
Can be rewritten as:
Profit per unit = [(TR ÷Q) – (TC ÷Q)] x Q
The Term Paper on Cost Centres, Profit Centres, Investment Centres
The increasing complexity of today’s business environment makes it virtually impossible for most firms to be controlled centrally. Decentralisation is a necessary response to this increasing complexity and involves the delegation of decision-making responsibility by senior management to sub-ordinates. The structure is such that decision making is dispersed to various units within the organisation, ...
Profit per unit = [AR – ATC] x Q
Profit per unit = [P – ATC] x Q
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Profit Maximization: Marginal Approach
By comparing AR against ATC, we can tell the type of profit.
Total Approach TR > TC Marginal Approach AR > ATC Profits
Positive Profit
TR = TC
TR
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AR = ATC
AR
Zero Profit
Negative Profit
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Positive Profit (AR>ATC)
$200
MR = MC Cost and Revenue
150
MC
MR = AR = P
Economic Profit
ATC
100
50
0
1
2
3
4
5
6
7
8
9
10 24
Output
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Zero Profit (AR = ATC)
$200
Cost and Revenue
MC
150
ATC
100
MR = AR = P
MR = MC
50
0
1
2
3
4
5
6
7
8
9
10 25
Output
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Negative Profit (ARATC
• Makes positive profit • Continue business
• AR > AVC (Continue business)
AR
• AR = AVC (Neutral) • AR
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Should A Firm Shut Down If It Suffers Losses
If AR is above ATC, the firm makes positive economics profit. The firm will continue operating.
If AR is below ATC, the firm incurs losses. The firm will face a dilemma in the short run: (i) to shut down or
(ii) to continue the business?
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Should A Firm Shut Down If It Suffers Losses A decision to shut down in the short run means that the firm is only temporarily suspending production. If market conditions improve, and prices increase, the firm can resume production. However, a firm cannot continue to incur losses indefinitely. It will have to exit the business. Exit is a long-term decision.
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When AR > AVC
If AR > AVC, the firm should continue producing.
If shut down, the firm will lose all its TFC. If continue producing, the firm can cover part of the TFC and the entire TVC.
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The Essay on Normal Profit Firms Run Price
... run) marginal cost curve. A supply curve relates quantity to marginal cost. Long Run Equilibrium of the Firm In the long run if typical firms are making economic profits, new firms ... average total costs (ATC) includes all the relevant opportunity costs, this equilibrium is the short run break even point where normal profits (zero economic profits are ...
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When AR > AVC
$200
Cost and Revenue
150
MC ATC
100
Loss
AFC
AVC
MR = P MR = MC
50
AVC
0
1
2
3
4
5
6
7
8
9
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Output
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When AR
If AR
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When AR
$200
Cost and Revenue
150
MC ATC
100
Loss
50
AFC
MR = MC
AVC MR = P
AVC
0 1 2 3 4 5 6 7 8 9 10
Output
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When AR = AVC
If AR = AVC, the firm is neutral between continuing and shutting down.
If shut down, the firm will lose all its TFC. If continue producing, the firm will also lose all its TFC.
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When AR = AVC
$200
Cost and Revenue
150
MC
ATC
100
Loss
50
AFC
MR = MC
AVC MR = P
AVC
0 1 2 3 4 5 6 7 8 9 10 37
Output
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Pop Quiz A purely competitive firm should produce in the short run if its total revenue is sufficient to cover its:
A. total variable costs.
B. total costs. C. total fixed costs.
D. marginal costs.
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Pop Quiz In the short run, a purely competitive firm will always make an economic profit if:
A. P = ATC.
B. P > AVC. C. P = MC.
D. P > ATC.
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Marginal Cost and Short-Run Supply
The short-run supply curve is the portion of MC curve that lies above the min AVC (b + c + d + e points) because a firm can produce if the price is above AVC in the short run even though it suffers losses. The long-run supply curve is the portion of MC curve that lies above the min ATC (d + e points) because a firm must cover all costs in the long run.
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Marginal Cost and Short-Run Supply
Cost and Revenues (Dollars)
ATC
Min ATC P5 P4 P3 P2 P1 AVC c b a Min AVC Shut-Down Point
0
S= MC e
d
MR5 MR4
MR3 MR2 MR1
Q2 Q3
Q4
Q5
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Quantity Supplied
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Pop Quiz
The Term Paper on Cost Leader Firm Strategy Market
... and thus, risk the firm losing its cost-leader status in the industry. The learning curve effect also plays a ... industry thus, Ford had to make their own machines and with this, they effectively saved costs in the long ... on the labour force and thus in the long run cut costs that have the potential to be passed ... Henry Ford, "You can have any colour as long as it is black." This very clearly illustrated ...
In the short run, the individual competitive firm’s supply curve is that segment of the: A. Average variable cost curve lying below the marginal cost curve. B. Marginal cost curve lying above the average variable cost curve.
C. Marginal revenue curve lying below the demand curve.
D. Marginal cost curve lying between the average total cost and average variable cost curves.
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Make Sure You Understand!
Question Should this firm produce? Answer Yes, if AR is equal to, or greater than, minimum AVC. 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 = MC; there, profit is maximized or loss is minimized.
Yes, if AR exceeds ATC. No, if ATC exceeds AR.
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Will production result in economic profit?
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The Long Run in Pure Competition
• 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.
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The Long Run in Pure Competition In the long run: • Firms can expand or contract capacity • Firms can enter and exit the industry
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Entry Eliminates Economic Profits
P P
S1
b c a
MC
$60 50
ATC
$60 50
S2 D2
D1
MR
40
40
0
100
q
0
80,000
90,000
100,000
Q
(a) Single Firm
(b) Industry
Entry of new firms eliminates profits More firms Supply increases Price falls
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Exit Eliminates Losses
P P
S2 S1
c a
MC
$60 50 40
ATC MR1
$60
50
40
MR2
D1
b
D2
Q
0
100
q
0
80,000
90,000
100,000
(a) Single Firm
(b) Industry
Exit of existing firms eliminates losses Less firms Supply decreases Price rises
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LR Supply: Constant-Cost Industry
P
Constant cost industry
P1
P2 $50 P3
•
Z1 Z2 Z3
S
Entry does not affect LRATC Constant resource price
•
D3
D1
0
D2 Q2
100,000
Q1
90,000
Q3
110,000
Q
•
Special case
Long-run supply for a constant cost industry will be perfectly elastic; the curve will be horizontal.
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LR Supply: Increasing-Cost Industry
P
Increasing cost industry
S
Y3 Y2 Y1
•
P2 $55 P1 $50 P3 $40
Entry increases LRATC
•
D3
Rising resource price
Most industries exhibit rising cost
0
D1
Q1
90,000
D2 Q2
100,000
•
Q3
110,000
Q
Long-run supply for an increasing cost industry will be upward sloping as industry expands output.
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LR Supply: Decreasing-Cost Industry
P
Decreasing cost industry
X1 X2 X3
P3 $55
•
S
D3 Q3
110,000
P1 $50 P2 $40
Entry decreases LRATC
• •
D1
Decreasing resource price
Software (do not have to reinvent the wheel).
D2
Q2
100,000
0
Q1
90,000
Q
Long-run supply for a decreasing cost industry will be downward sloping as the industry expands output.
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Pop Quiz
If a purely competitive firm is producing at the MR = MC output level and earning an economic profit, then: A. The selling price for this firm is above the market equilibrium price. B. New firms will enter this market.
C. Some existing firms in this market will leave. D. There must be price fixing by the industry’s firms.
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Pop Quiz
In a purely competitive industry:
A. there will be no economic profits in either the short run or the long run. B. economic profits may persist in the long run if consumer demand is strong and stable.
C. there may be economic profits in the short run, but not in the long run. D. there may be economic profits in the long run, but not in the short run.
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Pop Quiz
An increasing-cost industry is associated with: A. a perfectly elastic long-run supply curve. B. an up sloping long-run supply curve. C. a perfectly inelastic long-run supply curve.
D. an up sloping long-run demand curve.
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Pop Quiz
A decreasing-cost industry is one in which: A. contraction of the industry will decrease unit costs.
B. input prices fall or technology improves as the industry expands. C. the long-run supply curve is perfectly elastic. D. the long-run supply curve is upsloping.
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Pure Competition and Efficiency In the long run, two types of efficiency are achieved in pure competition. Productive efficiency • Producing where P = min. ATC Allocative efficiency • Producing where P = MC
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Pure Competition and Efficiency
Single Firm
P=MC=MR = Minimum ATC (Normal Profit)
Market
Consumer Surplus
Price
ATC
P
MR
P
Price
MC
S
Producer Surplus D
0
0
Qf
Quantity
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Qe
Quantity
Pop Quiz
When a purely competitive industry is in long-run equilibrium, which statement is true?
A. Average total cost is less than marginal cost.
B. Price and average total cost are equal. C. Marginal cost is at its maximum level.
D. Marginal revenue is greater than price.
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Pop Quiz
When a purely competitive firm is in long-run equilibrium: A. marginal revenue exceeds marginal cost. B. price equals marginal cost.
C. total revenue exceeds total cost.
D. minimum average total cost is less than the product price.
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Pop Quiz
Productive efficiency refers to:
A. Cost minimization, where P = minimum ATC. B. Production, where P = MC.
C. Maximizing profits by producing where MR = MC. D. Setting TR = TC.
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Dynamic Adjustments
Purely competitive markets, through “Invisible Hands”, will automatically adjust to changes in:
• Consumer tastes • Resource supplies • Technology
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Technological Advance: Competition
Since firms in pure competition is a price taker, the heart of competition is in innovation. But, no matter how the firm manages to increase his profits, usually these are temporary profits. This is because competition and innovation eventually lead to “creative destruction”. It means creation of new products and methods destroys the old products and business methods.
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Efficiency Gains from Entry
Example: Introduction of a new patented prescription drugs can initially earn substantial economic profits for the pharmaceutical company. Generic drugs become available as the patent expires, and the market changes to more closely resemble pure competition.
• Results in a 30-40% reduction price • Greater consumer surplus and efficiency
Efficiency Gains from Entry
a
P1 b
d
S
c
e
f
Patented drugs: CS = abc PS = bcgh TS = agch Generic drugs: CS = adf PS = dfg TS = agf
P2
h g
D Q1 Q2
Generic products resemble pure competition. Invisible hands mechanism result in larger total surplus.
Pop Quiz
In long-run equilibrium, purely competitive markets: A. minimize total cost.
B. maximize the sum of consumer surplus and producer surplus. C. yield economic profits to most sellers.
D. inevitably degenerate into monopoly in increasing cost industries.
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