Pure Competition in the Short Run

Pure competition in the short run Four Market Mode Models ls Economists group industries into 4 distinct market structures. ● 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. ● 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 In discussing these market models, we occasionally distinguish the characteristics of pure competition from those of the three other market structures, which we collectively designate as imperfect competition. Pure Competition: Character Characteriistics and Occurrence Characteristics of pure competition: ● Very large numbers A basic feature of pure competition is the presence of a large number of independently acting sellers, often offering their products in large national or international markets. Examples include the markets for farm commodities, the stock market, and the foreign exchange market. Standardized product Purely competitive firms produce a standardized ● (identical or homogeneous) product. As long as the price is the same, consumers are indifferent about which seller to buy the product from. Buyers view the products of firms B, C, and D as perfect substitutes for the product of firm A. Because purely competitive firms sell standardized products, they make no attempt to differentiate their products and do not engage in other forms of nonprice competition. ● “Price takers” In a purely competitive market, individual firms do not exert control over product price. Each firm produces such a small fraction of total output that increasing or decreasing its output will not perceptibly influence total supply or, therefore, product price. In other words, the competitive firm is a price taker: It cannot change the market price; it can only adjust to it. Thus the individual competitive producer is at the mercy of the market. Charging a price higher than the market price would be futile. Consumers will not buy from firm A at $2.05 when its 9,999 competitors are selling an identical product at $2 per unit. Conversely, because firm A can sell as much as it chooses at $2 per unit, it has no reason to charge a lower price, say, $1.95. Doing that would shrink its profit. ● Free entry and exit New firms can freely enter and existing firms can freely leave purely competitive industries. No significant legal, technological, financial, or other obstacles prohibit new firms from selling their output in a competitive market. Quick Review ● In a purely competitive industry, a large number of firms produce a standardized product, and there are no significant barriers to entry. ● The demand experienced by a purely competitive firm is perfectly elastic— horizontal on a graph—at the market price. ● Marginal revenue and average revenue for a purely competitive firm coincide with the firm’s demand curve; total revenue rises by the product price for each additional unit sold. Demand as Seen by a Pur Purely ely Competitive Seller Because each purely competitive firm offers only a negligible fraction of total market supply, it must accept the price determined by the market. It is a price taker, not a price maker. Perfectly Elastic Dema Demand nd individual firm in a purely competitive industry is The demand schedule faced by the perfectly elastic at the market price. 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. Factors that illustrate that the demand curve for a purely competitive firm is perfectly elastic: ● The firm does not need to lower its price to increase its sales volume. ● The firm cannot obtain a higher price by restricting its output. In pure competition the demand curve faced by an individual firm graphs as a horizontal line and the market demand in pure competition is graphed as a downward sloping curve. Average, Total, aand nd Marginal Revenue In a purely competitive market, price per unit to a buyer equals: average revenue to a seller. In a purely competitive market, price per unit to the purchaser is synonymous with revenue per unit average revenue to a seller. Price and average revenue are the same thing. The total revenue for each sales level is found by multiplying price by the corresponding quantity the firm can sell. Marginal revenue (MR) is the change in total revenue (or the extra revenue) that results from selling one more unit of output. In pure competition, marginal revenue and price are equal. 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 the product price (and hence MR) is constant. The AR curve equals price and therefore also coincides with the demand curve. Profit Maximization in th thee Short Run: Total-Revenu Total-Revenue–Total-Cost e–Total-Cost Approach 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. We find the total revenue for each output level by multiplying output (total product) by price. We find the profit or loss at each output level by subtracting total cost, TC (column 4), from total revenue, TR (column 5). Total revenue and total cost are equal where the two curves in Figure 10.2a intersect (at roughly 2 units of output). Total revenue covers all costs (including a normal profit, which is included in the cost curve), but there is no economic profit. Economists call this output a break-even point: an output at which a firm makes a normal profit but not an economic profit. Profit Maximization in th thee Short Run: Marginal-Revenu Marginal-Revenue–Marginale–MarginalCost Approach In the second approach, the firm compares the amounts that each additional unit of output will add to total revenue and to total cost. In other words, the firm compares 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). Conversely, if the marginal cost of a unit of output exceeds its marginal revenue, the firm should not produce that unit. Because it would add more to costs than to revenue, and profit would decline or loss would increase. In the initial stages of production, when 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. Keep in mind these features of the 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 substitute P 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). The economic profit : ( P - A ) x Q A is average total cost, p is price, q is output