Chapter 10: Pure Competition in the Short Run

(Pure Competition: Characteristics and Occurrence) Free entry and exit

New firms can freely enter and existing firms can freely leave purely competitive industries. No significant legal, technological, financial, or other obstacles prohibit new firms from selling their output in any competitive market.

Four Market Models

1. Pure Competition 2. Pure Monopoly 3. Monopolistic Competition 4. Oligopoly

(Pure Competition: Characteristics and Occurrence) Very large numbers

A basic feature of a purely competitive market is the presence of a large number of independently acting sellers, often offering their products in large national or international markets. Examples: markets for farm commodities, the stock market, and the foreign exchange market.

LO10.2 List the conditions required for purely competitive markets.

A purely competitive industry consists of a large number of independent firms producing a standardized product. Pure competition assumes that firms and resources are mobile among different industries.

LO10.6 Explain why a competitive firm's marginal cost curve is the same as its supply curve.

Applying the MR (= P) = MC rule at various possible market prices leads to the conclusion that the segment of the firm's short-run marginal-cost curve that lies above the firm's average-variable-cost curve is its short-run supply curve. A competitive firm shuts down production at least temporarily if price is less than minimum average variable cost because, in those situations, producing any amount of output will always result in variable costs exceeding revenues. Shutting down therefore results in a smaller loss because the firm will lose only its fixed cost, whereas, if it operated, it would lose its fixed cost plus whatever money is lost due to variable costs exceeding revenues. Competitive firms choose to operate rather than shut down whenever price is greater than average variable cost but less than average total cost because, in those situations, revenues will always exceed variable costs. The amount by which revenues exceed variable costs can be used to help pay down some of the firm's fixed costs. Thus, the firm loses less money by operating (and paying down some of its fixed costs) than it would if it shut down (in which case it would suffer a loss equal to the full amount of its fixed costs).

Profit Maximization in the Short Run: Total-Revenue-Total-Cost Approach

Because the purely competitive firm is a price taker, it cannot attempt to maximize its profit by raising or lowering the price it charges. With its price set by supply and demand in the overall market, the only variable that the firm can control is its output. As a result, the purely competitive firm attempts to maximize its economic profit (or minimize its economic loss) by adjusting its output. And, in the short run, the firm has a fixed plant. Thus it can adjust its output only through changes in the amount of variable resources (materials, labor) it uses. It adjusts its variable resources to achieve the output level that maximizes its profit or minimizes its loss. There are two ways to determine the level of output at which a competitive firm will realize maximum profit or minimum loss. One method is to compare total revenue and total cost; the other is to compare marginal revenue and marginal cost. Both approaches apply to all firms, whether they are pure competitors, pure monopolists, monopolistic competitors, or oligopolists.1 We begin by examining profit maximization using the totalrevenue-total-cost approach. Confronted with the market price of its product, the competitive producer will ask three questions: (1) Should we produce this product? (2) If so, in what amount? (3) What economic profit (or loss) will we realize? Let's demonstrate how a pure competitor answers these questions, given a particular set of cost data and a specific market price. Our cost data are already familiar because they are the fixed-cost, variable-cost, and total-cost data in Table 9.2, repeated in columns 1 to 4 of the table in Figure 10.2. (Recall that these data reflect explicit and implicit costs, including a normal profit.) Assuming that the market price is $131, the total revenue for each output level is found by multiplying output (total product) by price. Total-revenue data are in column 5. Then in column 6 we find the profit or loss at each output level by subtracting total cost, TC (column 4), from total revenue, TR (column 5). Should the firm produce? Definitely. It can obtain a profit by doing so. How much should it produce? Nine units. Column 6 tells us that this is the output at which total economic profit is at a maximum. What economic profit (or loss) will it realize? A $299 economic profit—the difference between total revenue ($1,179) and total cost ($880). Figure 10.2a compares total revenue and total cost graphically for this profit-maximizing case. Observe again that the total-revenue curve for a purely competitive firm is a straight line (Figure 10.1). Total cost increases with output because more production requires more resources. But the rate of increase in total cost varies with the efficiency of the firm, which in turn varies with the amount of variable inputs that are being combined with the firm's current amount of capital (which is fixed in the short run). Stated slightly differently, the cost data reflect Chapter 9's law of diminishing returns. From zero to four units of output, total cost increases at a decreasing rate as the firm temporarily experiences increasing returns. At higher levels of output, however, efficiency falls as crowding causes diminishing returns to set in. Once that happens, the firm's total cost increases at an increasing rate because each additional unit of input yields less output than the previous unit. Total revenue and total cost are equal where the two curves in Figure 10.2a intersect (at roughly 2 units of output). Total revenue covers all costs (including a normal profit, which is included in the cost curve), but there is no economic profit. For this reason economists call this output a breakeven point: an output at which a firm makes a normal profit but not an economic profit. If we extended the data beyond 10 units of output, another break-even point would occur where total cost catches up with total revenue, somewhere between 13 and 14 units of output in Figure 10.2a. Any output within the two break-even points identified in the figure will yield an economic profit. The firm achieves maximum profit, however, where the vertical distance between the total-revenue and total-cost curves is greatest. For our particular data, this is at 9 units of output, where maximum profit is $299. The profit-maximizing output is easier to see in Figure 10.2b, where total profit is graphed for each level of output. Where the total-revenue and total-cost curves intersect in Figure 10.2a, economic profit is zero, as shown by the totalprofit line in Figure 10.2b. Where the vertical distance between TR and TC is greatest in the upper graph, economic profit is at its peak ($299), as shown in the lower graph. This firm will choose to produce 9 units since that output maximizes its profit.

LO10.1 Give the names and summarize the main characteristics of the four basic market models.

Economists group industries into four models based on their market structures: (a) pure competition, (b) pure monopoly, (c) monopolistic competition, and (d) oligopoly.

LO10.3 Explain how demand is seen by a purely competitive seller.

In a competitive industry, no single firm can influence market price. This means that the firm's demand curve is perfectly elastic and price equals marginal revenue.

(Pure Competition: Characteristics and Occurrence) "Price takers"

In a purely competitive market, individual firms do not exert control over product price. Each firm produces such a small fraction of total output that increasing or decreasing its output will not perceptibly influence total supply or, therefore, product price. In short, the competitive firm is a price taker: It cannot change market price; it can only adjust to it. That means that the individual competitive producer is at the mercy of the market. Asking a price higher than the market price would be futile. Consumers will not buy from firm A at $2.05 when its 9,999 competitors are selling an identical product, and therefore a perfect substitute, at $2 per unit. Conversely, because firm A can sell as much as it chooses at $2 per unit, it has no reason to charge a lower price, say, $1.95. Doing that would shrink its profit.

Profit Maximization in the Short Run: Marginal-Revenue- Marginal-Cost Approach

In the second approach, the firm compares the amounts that each additional unit of output would add to total revenue and to total cost. In other words, the firm compares the marginal revenue (MR) and the marginal cost (MC) of each successive unit of output. Assuming that producing is preferable to shutting down, the firm should produce any unit of output whose marginal revenue exceeds its marginal cost because the firm would gain more in revenue from selling that unit than it would add to its costs by producing it. Conversely, if the marginal cost of a unit of output exceeds its marginal revenue, the firm should not produce that unit. Producing it would add more to costs than to revenue, and profit would decline or loss would increase. In the initial stages of production, where output is relatively low, marginal revenue will usually (but not always) exceed marginal cost. So it is profitable to produce through this range of output. But at later stages of production, where output is relatively high, rising marginal costs will exceed marginal revenue. Obviously, a profit-maximizing firm will want to avoid output levels in that range. Separating these two production ranges is a unique point at which marginal revenue equals marginal cost.

FIGURE 10.6 The P = MC rule and the competitive firm's short-run supply curve.

Let's observe quantity supplied at each of these prices: ∙ Price P1 is below the firm's minimum average variable cost, so at this price the firm won't operate at all. Quantity supplied will be zero, as it will be at all other prices below P2. ∙ Price P2 is just equal to the minimum average variable cost. The firm will supply Q2 units of output (where MR2 = MC) and just cover its total variable cost. Its loss will equal its total fixed cost. (Actually, the firm would be indifferent as to shutting down or supplying Q2 units of output, but we assume it produces.) ∙ At price P3 the firm will supply Q3 units of output to minimize its short-run losses. At any of the other prices between P2 and P4 the firm will also minimize its losses by producing and supplying the quantity at which MR(= P) = MC. ∙ The firm will just break even at price P4. There it will supply Q4 units of output (where MR4 = MC), earning a normal profit but not an economic profit. Total revenue will just cover total cost, including a normal profit, because the revenue per unit (MR4 = P4) and the total cost per unit (ATC) are the same. ∙ At price P5 the firm will realize an economic profit by producing and supplying Q5 units of output. In fact, at any price above P4 the firm will obtain economic profit by producing to the point where MR (= P) = MC. ----------------------------------------------points such as these are on the upsloping supply curve of the competitive firm. Note, too, that quantity supplied would be zero at any price below the minimum average variable cost (AVC).

Economic Profit equation

Profit = (P - A) x Q where A is average total cost (ATC)

LO10.5 Explain how purely competitive firms can use the marginal-revenue-marginal-cost approach to maximize profits or minimize losses in the short run.

Provided price exceeds minimum average variable cost, a competitive firm maximizes profit or minimizes loss in the short run by producing the output at which price or marginal revenue equals marginal cost. If price is less than minimum average variable cost, a competitive firm minimizes its loss by shutting down. If price is greater than average variable cost but is less than average total cost, a competitive firm minimizes its loss by producing the P = MC amount of output. If price also exceeds average total cost, the firm maximizes its economic profit at the P = MC amount of output.

(Pure Competition: Characteristics and Occurrence) Standardized product

Purely competitive firms produce a standardized (identical or homogeneous) product. As long as the price is the same, consumers will be indifferent about which seller to buy the product from. Buyers view the products of firms B, C, D, and E as perfect substitutes for the product of firm A. Because purely competitive firms sell standardized products, they make no attempt to differentiate their products and do not engage in other forms of nonprice competition.

FIGURE 10.4 Short-run loss minimization for a purely competitive firm.

Suppose now that the market yields a price of only $71. Should the firm produce? No, because at every output level the firm's average variable cost is greater than the price (compare columns 3 and 8 of the table in Figure 10.4)

Average, Total, and Marginal Revenue

The firm's demand schedule is also its average-revenue schedule. Price per unit to the purchaser is also revenue per unit, or average revenue, to the seller. To say that all buyers must pay $131 per unit is to say that the revenue per unit, or average revenue received by the seller, is $131. Price and average revenue are the same thing. The total revenue for each sales level is found by multiplying price by the corresponding quantity the firm can sell. (Column 1 multiplied by column 2 in the table in Figure 10.1 yields column 3.) In this case, total revenue increases by a constant amount, $131, for each additional unit of sales. Each unit sold adds exactly its constant price—no more or no less—to total revenue. When a firm is pondering a change in its output, it will consider how its total revenue will change as a result. Marginal revenue is the change in total revenue (or the extra revenue) that results from selling one more unit of output. In column 3 of the table in Figure 10.1, total revenue is zero when zero units are sold. The first unit of output sold increases total revenue from zero to $131, so marginal revenue for that unit is $131. The second unit sold increases total revenue from $131 to $262, and marginal revenue is again $131. Note in column 4 that marginal revenue is a constant $131, as is price. In pure competition, marginal revenue and price are equal. Figure 10.1 shows the purely competitive firm's total-revenue, demand, marginal-revenue, and average-revenue curves. Total revenue (TR) is a straight line that slopes upward to the right. Its slope is constant because each extra unit of sales increases TR by $131. The demand curve (D) is horizontal, indicating perfect price elasticity. The marginal-revenue (MR) curve coincides with the demand curve because the product price (and hence MR) is constant. The average revenue (AR) curve equals price and therefore also coincides with the demand curve.

MR = MC rule

This point is the key to the output-determining rule: In the short run, the firm will maximize profit or minimize loss by producing the output at which marginal revenue equals marginal cost (as long as producing is preferable to shutting down). Keep in mind these features of the MR = MC rule: ∙ For most sets of MR and MC data, MR and MC will be precisely equal at a fractional level of output. In such instances the firm should produce the last complete unit of output for which MR exceeds MC. ∙ As noted, the rule applies only if producing is preferable to shutting down. We will show shortly that if marginal revenue does not equal or exceed average variable cost, the firm will shut down rather than produce the amount of output at which MR = MC. ∙ The rule is an accurate guide to profit maximization for all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic. ∙ The rule can be restated as P = MC when applied to a purely competitive firm. Because the demand schedule faced by a competitive seller is perfectly elastic at the going market price, product price and marginal revenue are equal. So under pure competition (and only under pure competition) we may substitute P for MR in the rule: When producing is preferable to shutting down, the competitive firm that wants to maximize its profit or minimize its loss should produce at that point where price equals marginal cost (P = MC).

LO10.4 Convey how purely competitive firms can use the total-revenue-total-cost approach to maximize profits or minimize losses in the short run.

We can analyze short-run profit maximization by a competitive firm by comparing total revenue and total cost or by applying marginal analysis. A firm maximizes its short-run profit by producing the output at which total revenue exceeds total cost by the greatest amount.

Short Run Supply Curve

We can conclude that the portion of the firm's marginal-cost curve lying above its average-variable-cost curve is its short-run supply curve. In Figure 10.6, the solid segment of the marginal-cost curve MC is this firm's short-run supply curve. It tells us the amount of output the firm will supply at each price in a series of prices.

breakeven point:

an output at which a firm makes a normal profit but not an economic profit.

Pure competition

involves a very large number of firms producing a standardized product (that is, a product like cotton, for which each producer's output is virtually identical to that of every other producer.) New firms can enter or exit the industry very easily.

Oligopoly

involves only a few sellers of a standardized or differentiated product, so each firm is affected by the decisions of its rivals and must take those decisions into account in determining its own price and output.

Pure monopoly

is a market structure in which one firm is the sole seller of a product or service (for example, a local electric utility). Since the entry of additional firms is blocked, one firm constitutes the entire industry. The pure monopolist produces a single unique product, so product differentiation is not an issue.

Monopolistic competition

is characterized by a relatively large number of sellers producing differentiated products (clothing, furniture, books). Present in this model is widespread nonprice competition, a selling strategy in which a firm does not try to distinguish its product on the basis of price but instead on attributes like design and workmanship (an approach called product differentiation). Either entry to or exit from monopolistically competitive industries is quite easy.