Four Market Models and Pure Competition

Four Market Models

Economists categorize industries into four market structures based on:

• Number of firms

• Product standardization or differentiation

• Ease of entry

• Control over price

The four models are:

• Pure Competition

• Pure Monopoly

• Monopolistic Competition

• Oligopoly

Pure Competition

• Very large number of firms producing a standardized product (e.g., cotton).

• New firms can easily enter or exit.

• Firms are price takers.

Pure Monopoly

• One firm is the sole seller of a product or service (e.g., local electric utility).

• Entry of additional firms is blocked.

• The firm produces a unique product and has full control over its price.

Monopolistic Competition

• Relatively large number of sellers producing differentiated products (e.g., clothing, furniture, books).

• Widespread nonprice competition through product differentiation.

• Easy entry and exit.

• Firms have some, but not much, control over selling prices.

Oligopoly

• Few sellers of standardized or differentiated products.

• Each firm is affected by rivals' decisions and must consider them in determining price and output.

Imperfect competition collectively refers to pure monopoly, monopolistic competition, and oligopoly.

TABLE 10.1 Characteristics of the Four Basic Market Models

Pure Competition: Characteristics and Occurrence

Pure competition is relatively rare, but serves as a benchmark for evaluating real-world efficiency and for understanding agricultural, commodity, and financial markets.

Characteristics:

• Very Large Numbers: Many independent sellers in large markets (e.g., farm commodities, stock market).

• Standardized Product: Firms produce identical products, making consumers indifferent among sellers. Firms do not differentiate or brand their products.

• Price Takers: Individual firms cannot control market price; they can only adjust to it. Charging above market price is futile, and charging below shrinks profit.

• Free Entry and Exit: No significant barriers prevent new firms from entering or existing firms from leaving the market.

Demand as Seen by a Purely Competitive Seller

Competitive firms are price takers and must accept the market price.

Perfectly Elastic Demand

The demand schedule faced by an individual firm is perfectly elastic (horizontal) at the market price. The firm can sell as much or as little as it wants at that price.

• Market demand is downward sloping, as the entire industry can affect price by changing output.

Average, Total, and Marginal Revenue

• Price equals average revenue (AR) for the firm.

• Total revenue (TR) is found by multiplying price by quantity.

• Marginal revenue (MR) is the change in total revenue from selling one more unit of output. In pure competition, marginal revenue equals price.

  For a purely competitive firm:

  $P = AR = MR$

• Total revenue (TR) is a straight line that slopes upward to the right.

• The demand curve (D) is horizontal, indicating perfect price elasticity.

• The MR curve coincides with the demand curve because price is constant.

• The AR curve also coincides with the demand curve because AR equals price.

Profit Maximization in the Short Run

Firms adjust their output to maximize economic profit or minimize economic loss.

Total-Revenue-Total-Cost Approach

Firms ask three questions:

1. Should we produce this product?

2. If so, in what amount?

3. What economic profit (or loss) will we realize?

• Total revenue (TR) is calculated by multiplying output by price.

• Profit or loss is found by subtracting total cost (TC) from total revenue (TR).
  Maximum profit occurs where the difference between total revenue and total cost is greatest.

Marginal-Revenue-Marginal-Cost Approach

Firms compare the marginal revenue (MR) and marginal cost (MC) of each unit of output.

• Produce any unit where MR > MC to increase profit or decrease loss.

• Do not produce any unit where MC > MR.

• Profit is maximized or loss is minimized where MR = MC, provided that producing is preferable to shutting down.

MR = MC Rule:

• Produce the last complete unit of output for which MR exceeds MC.

• Applies only if producing is preferable to shutting down.

• Applies to all firms, regardless of market structure.

P = MC Rule (Pure Competition Only):

Since P=MR, the MR = MC rule simplifies to P = MC for purely competitive firms.

• The competitive firm should produce the quantity of output at which price equals marginal cost (P = MC).

• Profit = (P - A) × Q, where A is average total cost and Q is quantity.

Loss-Minimizing Case

If price is between average variable cost (AVC) and average total cost (ATC), the firm should still produce to minimize losses.

• The firm covers its variable costs and some fixed costs.

Shutdown Case

If price is below average variable cost (AVC), the firm should shut down.

• The firm cannot cover its variable costs.

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.

Marginal Cost and Short-Run Supply

The supply schedule shows the quantity the firm will offer at various prices.

• There is a direct relationship between price and quantity supplied.

Generalized Depiction

The portion of the firm's marginal-cost curve (MC) lying above its average-variable-cost curve (AVC) is its short-run supply curve.

Changes in input prices or technology will shift the MC or short-run supply curve.

Firm and Industry: Equilibrium Price

The market equilibrium price is where total quantity supplied equals total quantity demanded.

Profit Maximization in the Long Run

In the long run, firms can enter or exit the industry.

Assumptions:

• Entry and Exit Only: Long-run adjustments are solely due to entry or exit.

• Identical Costs: All firms have identical cost curves.

• Constant-Cost Industry: Entry and exit do not affect resource prices or ATC curves.

Long-Run Equilibrium

Price will be equal to, and production will occur at, each firm's minimum average total cost.

If market price exceeds minimum average total cost, economic profit attracts new firms, increasing supply and decreasing price.

If price is less than minimum average total cost, losses cause firms to leave, decreasing supply and increasing price.

Long-Run Supply Curves

The crucial factor is the effect of changes in the number of firms on individual firms' costs.

Constant-Cost Industry

Entry and exit do not affect resource prices or production costs. The long-run supply curve is perfectly elastic (horizontal).

Increasing-Cost Industry

Firms' ATC curves shift upward as the industry expands and downward as it contracts.

Entry increases resource prices and ATC, resulting in a higher equilibrium price. The long-run supply curve is upward sloping.

Decreasing-Cost Industry

Firms experience lower costs as their industry expands. Increased production leads to economies of scale for input suppliers, reducing input prices and firms' costs. The long-run supply curve is downward sloping.

Pure Competition and Efficiency

Long-run equilibrium leads to:

$P = MC = \text{minimum } ATC$

This results in:

Productive Efficiency

Goods are produced in the least costly way.

• Firms produce at minimum average total cost.

• Consumers pay the lowest possible price.

Allocative Efficiency

Resources are allocated to produce the goods and services that people most want to consume.

• It is impossible to produce any net gains for society by altering the combination of goods and services.

• Marginal benefit equals marginal cost.

• Combined consumer and producer surplus is maximized.

Dynamic Adjustments

A purely competitive market can restore efficiency when disrupted by changes in the economy.

Technological Advance and Competition

Firms have a strong profit incentive to develop better production methods and new products.

Creative Destruction

The creation of new products and new production methods destroys the market positions of firms committed to existing products and old ways of doing business.