Characteristics of Pure Competition

  • Very large numbers of independent sellers

  • Standardized product - competition based solely on differences in quality, advertising, or sales promotion

  • Firms are "price takers" and have no significant control over product price

  • Free entry and exit

  • Free flow of information

 

The Demand Curve for a Competitive Seller

  • Perfectly Elastic Demand

    • firms cannot get a change in price by changing output

The demand curve is horizontal

Average, Total, and Marginal Revenue

  • average revenue is the price per unit

  • total revenue = average revenue   x   quantity sold

  • marginal revenue - change in total revenue from selling 1 addition unit

    • in purely competitive conditions, product price is constant (individuals cannot change prices because they are price takers)

    • marginal revenue is constant because additional units are sold at a constant price

Graphical portrayal

  • demand curve is perfectly elastic
  • demand coincides with marginal revenue curve
  • total revenue graph is a straight line
  • firms are price takers and they do not have to decrease price to increase quantity sold

  

Profit Maximization in the Short Run

A firm should produce in the short run if it can realize either

  • a profit

  • a loss less than its fixed costs

 

 Total-Revenue-Total-Cost Approach

Profit Maximizing Case

  • two break even points - only normal profit is earned at these points

  • total revenue is a straight line

  • total cost changes according to law of diminishing returns

  • everything inside two break even points is profitable

  • the most profitable output is at the point where the difference between total revenue and total cost is greatest

Total-Revenue Total-Cost Approach (Profit Maximization)

Loss-Minimizing Case

  • if the total cost curve is higher than total revenue curve, losses are incurred
  • the firm will produce if the smallest loss is less than the fixed costs.
If the smallest loss is greater than fixed costs, the firm will shut down without producing anything

Close-Down Case

  • If the smallest loss is greater than fixed costs, the firm will minimize losses by halting production and shutting down.

 

Marginal-Revenue-Marginal-Cost Approach

MR = MC Rule

  • the firm will maximize profits or minimize losses by producing at that point where MR = MC

  • in pure competition, MR = D = price.  Therefore, the purely competitive firm will produce where price = MC.

 

Graphical Portrayal

To calculate economic profit, go from the point where P = MR = MC and drop down vertically until you reach the ATC curve.  Then draw a rectangle to the y axis.  The area of this rectangle is economic profit.

Calculating Economic Profit

Close-Down Case

If the smallest loss is greater than fixed costs, the firm will minimize losses by halting production and shutting down.

Marginal Cost and the Short-Run Supply Curve

  • proportion of the firm's marginal cost curve lying above its average-variable cost curve is the short run supply curve (see bold portion below)

            Summary graph:

 

Finding Economic Profit

Method 1: Tabular

  • collect total supply and total demand data

  • find where quantity supplied = quantity demanded

  • use product price at that point to find total revenue

  • subtract total cost from total revenue

Method 2: Graphical

  • subtract average total cost from price of product

  • multiply by equilibrium level of output

   

Zero Economic Profit Model

Assumptions

  1. Entry and Exodus - this is only long run adjustment made

  2. Identical Costs - all have identical cost curves

  3. Constant-Cost Industry

  4. Markets will go back to the equilibrium point (price = MR = MC = ATC).  At this point, there is no economic profit, only normal profit.

 

If there is an increase in demand…

  1. Price will rise

  2. Firms will realize economic profit in the short run

  3. Other firms will be attracted by profits and enter the market

  4. Supply rises

  5. Price will fall back to point where MC = ATC

 

If there is a decrease in demand…

  1. Prices will fall

  2. Firms will realize losses in short run

  3. Firms will leave the market

  4. Supply falls

  5. Price increases back to point where MC = ATC

 

Efficiency

Productive Efficiency

  • Productive efficiency is obtained when P = min ATC

 

Allocative Efficiency

  • Allocative Efficiency is obtained when P = MC

  • Both productive and allocative efficiency are obtained at equilibrium position in a purely competitive market.

 

If price > MC  

  • Society values more units of good X thus, there is underallocation of resources to X

If price < MC

  • society values other goods more highly than X thus, there is overallocation of resources to X  


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