Module 8: Pure Competition in the Short Run
Rule for profit maximization or loss minimization: If price is greater than the minimum average variable cost, the firm will produce the amount where MR = P = MC.
· If price P is greater than minimum average variable cost, the firm will produce the amount of output where MR (= P) = MC in order to either maximize its profit (if price exceeds minimum ATC) or minimize its loss (if price lies between minimum AVC and minimum ATC). 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.
Define and describe the characteristics of the four market modules: Pure competition, Pure monopoly, Monopolistic competition, Oligopoly (page 197) · Pure, or perfect, competition involves a very large number of firms producing a standardized product (for example, a product like cotton, for which each producer's output is virtually identical to every other producer's output.) New firms can enter or exit the industry very easily. Firms must accept the market price. · Pure monopoly is a market structure in which one firm (for example, a local electric utility) is the sole seller of a product or service. Because the entry of additional firms is blocked, one firm constitutes the entire industry. The monopoly firm produces a single unique product and has full control over that product's price. Page 197
· 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 firms try to distinguish their products on attributes like design and workmanship (an approach called product differentiation). Both entry into and exit from monopolistically competitive industries is quite easy. Monopolistically competitive firms possess some, but not much, control over selling prices. · Oligopoly involves only a few sellers of a standardized or differentiated product, so each firm is affected by its rivals' decisions and must take those decisions into account in determining its own price and output. (look at table 10.1)
The short run supply curve is the MC curve that lies above its AVC curve figure 10.6 . Application of the P = MC rule, as modified by the shutdown case, reveals that the (solid) segment of the firm's MC curve that lies above AVC is the firm's short-run supply curve. More specifically, at price P1, P = MC at point a, but the firm will produce no output because P1 is less than minimum AVC
At price P2 the firm will operate at point b, where it produces Q2 units and incurs a loss equal to its total fixed cost. At P3 it operates at point c, where output is Q3 and the loss is less than total fixed cost. With the price of P4, the firm operates at point d; in this case the firm earns a normal profit because at output Q4 price equals ATC. At price P5 the firm operates at point e and maximizes its economic profit by producing Q5 units.
Understand how marginal revenue and average revenue coincide with the firm's demand curve The firm's demand schedule is also its average-revenue schedule. 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. When a firm is pondering a change in its output, it will consider how its total revenue will change. Marginal revenue (MR) 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. In pure competition, marginal revenue and price are equal. The MR curve coincides with the demand curve because the product price (and hence MR) is constant. The AR curve equals price and therefore also coincides with the demand curve.
How does a perfectly competitive firm maximize profits? Marginal Revenue = Marginal Cost (Key Graph) the marginal revenue (MR) and the marginal cost (MC) of each successive unit of output, with the goal of either increasing the size of its profit (if it was already making a profit at the previous level of output) or decreasing the size of its loss (if it was already incurring a loss at the previous level 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 will gain more in revenue from selling that unit than it will add to its costs by producing it. The firm will increase its profit or decrease its loss. 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. Page 202 In the initial stages of production, where output is relatively low, marginal revenue will usually (but not always) exceed marginal cost (MR > MC). So it is profitable to produce through this range of output. At later stages of production, where output is relatively high, rising marginal costs will exceed marginal revenue (MR < MC). Obviously, a profit-maximizing firm will want to avoid output levels in that range. Separating these two production ranges is a unique output level at which marginal revenue exactly equals marginal cost (MR = MC). This output level is the key to the output-determining rule: As long as producing some positive amount of output is preferable to shutting down and producing nothing, the firm will maximize profit or minimize loss in the short run by producing the quantity of output at which marginal revenue equals marginal cost (MR = MC). This profit-maximizing guide is known as the MR = MC rule.
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. · The rule applies only if producing is preferable to shutting down. If marginal revenue does not equal or exceed average variable cost, the firm will shut down rather than produce. · 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 substituteP for MR in the rule: When producing is preferable to shutting down, the competitive firm should produce at the point where price equals marginal cost (P = MC).
Explain how to derive the short run supply curve from the firm's marginal cost curve (Key Graph) In the preceding section we selected three different prices and asked what quantity the profit-seeking competitive firm, faced with certain costs, would choose to offer in the market at each price. This set of product prices and corresponding quantities supplied constitutes part of the supply schedule for the competitive firm. Table 10.2 summarizes the
Table 10.2 summarizes the supply-schedule data for those three prices ($131, $81, and $71) and four others. This table confirms the direct relationship between product price and quantity supplied. Note first that the firm will not produce at price $61 or $71 because both are less than the $74 minimum AVC. Then note that quantity supplied increases as price increases. Observe finally that economic profit is higher at higher prices A competitive firm's short-run supply curve is the portion of its marginal cost (MC) curve that lies above its average variable cost (AVC) curve.
Explain how the Market supply curve is derived We know that the market equilibrium price is the price at which the total quantity supplied of the product equals the total quantity demanded. So to determine the equilibrium price, we first need to obtain a total supply schedule and a total demand schedule. We find the total supply schedule by assuming a particular number of firms in the industry and supposing that each firm has the same individual supply schedule as the firm represented in Figure 10.6.
Then we sum the quantities supplied at each price level to obtain the total (or market) supply schedule. Columns 1 and 3 in Table 10.4 repeat the supply schedule for the individual competitive firm, as derived in Table 10.2. Suppose 1,000 firms compete in this industry, all having the same total and unit costs as the single firm we discussed. We can calculate the market supply schedule (columns 2 and 3) by multiplying the quantity-supplied figures of the single firm (column 1) by 1,000. Market supply in a competitive industry is the horizontal sum of the individual supply curves of all of the firms in the industry. The market equilibrium price is determined where the industry's market supply curve intersects the industry's market demand curve
Explain how output is determined in the short run (Should the firm produce? What quantity should be produced? Will there be an economic profit) MR = MC approach to determining the competitive firm's profit-maximizing output level. (should this firm be produced?, what quantity should this firm produce?, will the production result in economic profit?)
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. Produce where MR (= P) = MC; there, profit is maximized (TR exceeds TC by a maximum amount) or loss is minimized. Yes, if price exceeds average total cost (so that TR exceeds TC). No, if average total cost exceeds price (so that TC exceeds TR).
How is demand seen by a purely competitive seller (perfectly elastic) figure 10.1 The demand schedule faced by the individual firm in a purely competitive industry is perfectly elastic at the market price, as Figure 10.1 shows. According to column 1 of the table in Figure 10.1, the market price is $131. The firm represented cannot obtain a higher price by restricting its output, nor does it need to lower its price to increase its sales volume. Columns 1 and 2 show that the firm can produce and sell as many or as few units as it likes at the market price of $131. We are notsaying that market demand is perfectly elastic in a competitive market. Rather, market demand graphs as a downward sloping curve. An entire industry (all firms producing a particular product) can affect price by changing industry output. For example, all firms, acting
independently but simultaneously, can increase price by reducing output. But the individual competitive firm cannot do that because its output is such a small fraction of its industry's total output. For the individual competitive firm, the market price is therefore a fixed value at which it can sell as many or as few units as it cares to. Graphically, then, the individual competitive firm's demand curve plots as a horizontal line such as D in
Explain the Loss minimization case. The shutdown case Suppose now that the market price is 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). The smallest loss it can incur by producing is greater than the $100 fixed cost it will lose by shutting down (as shown by column 9). The best action is to shut down. You can see this shutdown situation in Figure 10.5. Price comes closest to covering average variable costs at the MR (= P) = MC output of 5 units. But even here, price or revenue per unit would fall short of average variable cost by $3 (= $74 − $71). By producing at the MR (= P) = MC output, the firm would lose its $100 worth of fixed cost plus $15 ($3 of variable cost on each of the 5 units), for a total loss of $115.
This outcome compares unfavorably with the $100 fixed-cost loss the firm would incur by shutting down and producing no output. So it makes sense for the firm to shut down rather than produce at a $71 price—or at any price less than the minimum average variable cost of $74. The shutdown case reminds us of the qualifier to our MR (= P) = MC rule. A competitive firm maximizes profit or minimizes loss in the short run by producing the output at which MR (= P) = MC, provided that market price exceeds minimum average variable cost.
How does a perfectly competitive firm maximize profits? Total Revenue - Total Cost approach Page 200 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 with the total-revenue-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 the particular set of cost data in columns 1 to 4 of the table in Figure 10.2. These data reflect explicit and implicit costs, including a normal profit. Assuming that the market price is $131, we find the total revenue for each output level 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).
