Four Market Models and Pure Competition

Four Market Models

Economists categorize industries into four market structures based on:

  • Number of firms

  • Product type (standardized or differentiated)

  • Ease of entry

  • Control over price

The four market models are:

  • Pure Competition

  • Pure Monopoly

  • Monopolistic Competition

  • Oligopoly

Pure Competition

  • Very large number of firms

  • Standardized product (e.g., cotton)

  • Easy entry and exit

  • Firms are price takers

Pure Monopoly

  • One firm (sole seller)

  • Entry blocked

  • Unique product

  • Full control over price

Monopolistic Competition

  • Relatively large number of sellers

  • Differentiated products (clothing, furniture, books)

  • Nonprice competition (product differentiation)

  • Easy entry and exit

  • Some control over price

Oligopoly

  • Few sellers

  • Standardized or differentiated products

  • Firms affected by rivals' decisions

Imperfect Competition

  • A collective term for market structures other than pure competition (Monopoly, Monopolistic Competition, and Oligopoly).

Characteristics of Pure Competition

Pure competition is rare but relevant for understanding:

  • Agricultural markets

  • Oil and natural gas markets

  • Basic metal markets

  • Stock and bond markets

  • It serves as a starting point for price and output determination.

  • Provides a standard for evaluating economic efficiency.

Conditions for Pure Competition

  • Very Large Numbers: Many independent sellers in large markets.

  • Standardized Product: Identical or homogeneous products. Consumers are indifferent among sellers.

  • "Price Takers": Firms cannot control product price; they adjust to it. Charging above market price is futile, and lowering price is unnecessary.

  • Free Entry and Exit: No significant barriers to entry or exit.

Demand as Seen by a Purely Competitive Seller

Individual 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.

A firm can sell as much or as little as it wants at the market price.

Market demand is downward sloping, but individual firms are too small to affect price.

Average, Total, and Marginal Revenue

  • The firm's demand schedule is also its average-revenue schedule.

  • Price and average revenue are the same for a purely competitive 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.

  • In pure competition, marginal revenue and price are equal.

Equations

  • TR = P \times Q

  • MR = \frac{\Delta TR}{\Delta Q}

Profit Maximization in the Short Run

Firms maximize economic profit or minimize economic loss by adjusting output.

Total-Revenue-Total-Cost Approach

Firms ask three questions:

  1. Should we produce?

  2. If so, in what amount?

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

Find the output level where total revenue (TR) exceeds total cost (TC) by the maximum amount.

Break-Even Point

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

Marginal-Revenue-Marginal-Cost Approach

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

  • Produce any unit where MR > MC

  • Do not produce any unit where MR < MC

The firm maximizes profit or minimizes loss by producing where MR = MC

MR = MC Rule

  • Applies if producing is preferable to shutting down.

  • Accurate for all firms, regardless of market structure.

Under pure competition, the rule can be restated as P = MC

Profit-Maximizing Case

Produce where P = MC

Use the equation: Profit = (P - A) \times Q where A is the average total cost.

Loss-Minimizing Case

Produce where MR = MC (or P=MC) as long as P > AVC

Shutdown Case

If at every output level AVC > P, the firm should shut down.

Marginal Cost and Short-Run Supply

The firm's supply schedule is determined by its marginal cost curve.

Supply Schedule

Shows the direct relationship between price and quantity supplied.

The P = MC Rule and the Short-Run Supply Curve

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

The MR = MC approach determines the competitive firm's profit-maximizing output level.

Changes in Supply

Changes in input prices or technology shift the MC curve and supply curve.

  • Wage increase: Supply decreases (shifts upward/leftward).

  • Technological progress: Supply increases (shifts downward/rightward).

Firm and Industry: Equilibrium Price

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

The total supply schedule is found by summing individual firms' supply schedules.

Market conditions determine if the industry is profitable or unprofitable.

Firm versus Industry

Product price is a given fact to the individual firm, but the supply plans of all firms determine the price.

Fallacy of Composition

What is true for an individual is not necessarily true for a group.

  • Atoms are not alive, but groups of atoms (e.g. people) are alive.

  • Standing at a game, if everyone stands, no one has a better view. What is true for the individual spectator is not true for the audience as a whole.

  • Selling shares of Google stock, one person cannot affect the price, but if every Google shareholder decides to sell their shares on the same day, the market will be flooded with shares and the share price will fall precipitously.

Individual firms are price takers; their collective supply is a price maker.

Profit Maximization in the Long Run

Entry and exit of firms occur in the long run.

In the short run, the number of firms and plant size are fixed.

In the long run, firms can adjust capacities, and new firms can enter or existing firms can leave.

Assumptions

Entry and exit are the only long-run adjustments.

All firms have identical costs.

The industry is a constant-cost industry.

Long-Run Equilibrium

Product price equals each firm's minimum average total cost.

Firms seek profits and shun losses.

Firms are free to enter and leave the industry.

Entry Eliminates Economic Profits

Economic profits attract new firms, increasing supply and decreasing price until economic profits are zero.

Exit Eliminates Losses

Economic losses cause firms to leave, decreasing supply and increasing price until losses are eliminated.

Long-Run Supply Curves

Effect of changes in the number of firms on individual firms' costs.

Constant-Cost Industry

Expansion or contraction does not affect resource prices or production costs (ATC curves).

Long-run supply curve is perfectly elastic (horizontal).

Increasing-Cost Industry

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

Entry of new firms increases resource prices.

Long-run supply curve is upward sloping.

Decreasing-Cost Industry

Firms experience lower costs as the industry expands.

Long-run supply curve is downward sloping.

Pure Competition and Efficiency

Pure competition leads to the most efficient use of society's resources.

Productive Efficiency: P = Minimum ATC

Goods are produced in the least costly way.

Firms produce at the minimum average total cost of production and charge a price consistent with that cost.

Allocative Efficiency: P = MC

Society's scarce resources produce the goods and services people most want to consume.

Allocative efficiency occurs when it is impossible to produce any net gains for society by altering the combination of goods and services that are produced from society's limited resources.
Marginal benefit equals marginal cost for every unit.

Maximum Consumer and Producer Surplus

P = MC gives allocative effeciency; where combined amount of consumer surplus and producer surplus is maximised.

Dynamic Adjustments

Purely competitive markets restore efficiency when disrupted by changes in the economy.
A change in consumer tastes, resource supplies, or technology will automatically set in motion the appropriate realignments of resources.

"Invisible Hand" Revisited

The competitive system maximizes profits for individual producers and creates a pattern of resource allocation that maximizes consumer satisfaction.

Technological Advance and Competition

Firms have a profit incentive to develop better ways of making existing products and totally new products.

Creative Destruction

New products and new production methods destroy the market positions of firms committed to existing products and old ways of doing business.