Lecture Notes Chapter 10: Pure Competition in the Short Run

Instructional Objectives

After completing this chapter, students should be able to:

1. List the four basic market models and characteristics of each.

2. Describe characteristics of a purely competitive firm and industry.

3. Explain how a purely competitive firm views demand for its product and marginal revenue from each additional unit sale.

4. Compute average, total, and marginal revenue when given a demand schedule for a purely competitive firm.

5. Use both total-revenue—total-cost and marginal-revenue—marginal-cost approaches to determine short-run price and output that maximizes profits (Or minimizes losses) for a competitive firm.

6. Find the short-run supply curve when given short-run cost schedules for a competitive firm.

7. Explain how to construct an industry short-run cost schedules for a competitive firm.

8. Explain how to construct an industry short-run supply curve from information on single competitive firms in the industry.

9. Define and identify terms and concepts listed at the end of the chapter.

Lecture Notes

Learning Objectives — After reading this chapter, students should be able to

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

2. List the conditions required for purely competitive markets.

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

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

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

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

Four Market Models

1. Pure competition entails a large number of firms, standardized product, and easy entry (or exit) by new (or existing) firms.

2. At the opposite extreme, pure monopoly has one firm that is the sole seller of a product or service with no close substitutes; entry is blocked for other firms.

3. Monopolistic competition is close to pure competition, except that the product is differentiated among sellers rather than standardized, and there are fewer firms.

4. An oligopoly is an industry in which only a few firms exist, so each is affected by the price‑output decisions of its rivals.

Pure Competition: Characteristics and Occurrence

1. The characteristics of pure competition:

   1. Pure competition is rare in the real world, but the model is important.

      1. The model helps analyze industries with characteristics similar to pure competition.

      2. The model provides a context in which to apply revenue and cost concepts developed in previous chapters.

      3. Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world.

   2. Many sellers mean that there are enough so that a single seller has no impact on price by its decisions alone.

   3. The products in a purely competitive market are homogeneous or standardized; each seller’s product is identical to its competitor’s.

   4. Individual firms must accept the market price; they are price takers and can exert no influence on price.

   5. Freedom of entry and exit means that there are no significant obstacles preventing firms from entering or leaving the industry.

2. There are four major objectives to analyzing pure competition.

   1. To examine demand from the seller’s viewpoint,

   2. To see how a competitive producer responds to market price in the short run,

   3. To explore the nature of long-run adjustments in a competitive industry, and

   4. To evaluate the efficiency of competitive industries.

Demand as seen by a Purely Competitive Seller

1. The individual firm will view its demand as perfectly elastic.

   1. The demand curve is not perfectly elastic for the industry: It only appears that way to the individual firm, since they must take the market price no matter what quantity they produce.

   2. Note that a perfectly elastic demand curve is a horizontal line at the price.

2. Definitions of average, total, and marginal revenue:

   1. Average revenue is the price per unit for each firm in pure competition.

   2. Total revenue is the price multiplied by the quantity sold.

   3. Marginal revenue is the change in total revenue and will also equal the unit price in conditions of pure competition.

Profit Maximization in the Short-Run: Two Approaches

1. In the short run the firm has a fixed plant and maximizes profits or minimizes losses by adjusting output; profits are defined as the difference between total costs and total revenue.

2. Three questions must be answered.

   1. Should the firm produce?

   2. If so, how much?

   3. What will be the profit or loss?

3. An example of the total-revenue—total-cost approach is shown in Table 10.2.

   1. The firm should produce if the difference between total revenue and total cost is profitable, or if the loss is less than the fixed cost.

   2. In the short run, the firm should produce that output at which maximizes its profit or minimizes its loss.

   3. The profit or loss can be established by subtracting total cost from total revenue at each output level.

   4. The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. Then by shutting down, its loss will just equal those fixed costs.

   5. The firm has no control over the market price.

4. Marginal-revenue—marginal-cost approach

   1. MR = MC rule states that the firm will maximize profits or minimize losses by producing at the point at which marginal revenue equals marginal cost in the short run.

   2. Three features of this MR = MC rule are important.

      1. Rule assumes that marginal revenue must be equal to or exceed minimum-average-variable cost or firm will shut down.

      2. Rule works for firms in any type of industry, not just pure competition.

      3. In pure competition, price = marginal revenue, so in purely competitive industries the rule can be restated as the firm should produce that output where P = MC, because P = MR.

   3. Using the rule with the table in Figure 10.3, compare MC and MR at each level of output. At the tenth unit MC exceeds MR. Therefore, the firm should produce only nine (Not the tenth) units to maximize profits.

   4. Profit maximizing case: the level of profit can be found by multiplying ATC by the quantity, 9, to get $880 and subtracting that from total revenue which is $131 × 9, or $1179. Profit will be $299 when the price is $131. Profit per unit could also have been found by subtracting $97.78 from $131 and then multiplying b 9 to get $299.

5. Loss-minimizing case: The loss-minimizing case is illustrated when the price falls to $81. Marginal revenue does exceed average variable cost at some levels, so the firm should not shut down. Comparing P and MC, the rule tells us to select output level of 6. At this level the loss of $64 is the minimum loss this firm could realize, and the MR of $81 just covers the MC of $80, which does not happen at quantity level of 7.

6. Shut-down case: If the price falls to $71, this firm should not produce. MR will not cover AVC at any output level. Therefore, the minimum loss is the fixed cost and production of zero. It can be seen that the $100 fixed cost is the minimum possible loss.

7. Consider This… The “Still There” Motel

   1. Over time a motel might experience a decrease in demand.

   2. Despite the decrease in demand, it’s still profitable to remain open rather than shut down (Price is greater than minimum AVC).

   3. To increase the falling profits, the hotel owner cuts back on maintenance thereby lowering the costs.

8. Marginal cost and the short-run supply curve can be illustrated by hypothetical prices. At price of $151 profit will be $480; at $111 the profit will be $138 ($888-$750); at $91 the loss will be $3; at $61 the loss will be $100 because the latter represents the close-down case.

   1. Since a short-run supply schedule tells how much quantity will be offered at various prices, this identity of marginal revenue with the marginal cost tells us that the marginal cost above AC will be the short-run supply for this firm.

9. Determining equilibrium price for a firm and an industry:

   1. Total-supply and total-demand data must be compared to find the most profitable price and output levels for the industry.

   2. Individual firm supply curves are summed horizontally to get the total-supply curve S. If product price is $111, industry supply will be 8,000 units, since that is the quantity demanded and supplied at $111. This will result in economic profits.

   3. A loss situation could result from weaker demand (Lower price and MR) or higher marginal costs.

10. Firm vs. industry: Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price.

Last Word… Fixed Costs: Digging Yourself Out of a Hole

1. Since a firm faces fixed costs in the short run, those fixed costs can be viewed as a hole the firm hopes to fill each month by generating enough revenue from the units produced and sold.

2. If the financial hole is exactly filled, the firm breaks even; if the hole is more than full, the firm has received economic profit.

3. The hole gets bigger when the firm produces when it should have shut down because the firm is incurring an even greater loss by producing.

4. A decrease in price is often temporary, so shutting down is also often temporary.

   1. Production of oil has different costs at different wells, so as price changes it may be desirable to shut down some of the wells whose variable costs are too high.

   2. Seasonal resorts often shut down in the “off season” because prices at that time are too low.

   3. During the recession of 2007-2009, many industries like electric generating plants, factories making fiber optic cable, auto factories, chemical plants, textile mills, etc. “mothballed” their facilities until the economy improves.

5. Many firms plan to re-open, but economic conditions do not always improve enough for them to do so.