Lecture_01.

PURE COMPETITION
Firm’s decisions concerning price and production depend greatly on the character of
the industry in which it is operating. There is no “average” or “typical” industry. At one
extreme is a single producer that dominates the market; at the other extreme are industries
in which thousands of firms each produces a tiny fraction of market supply. Between these
extremes are many other industries. We will focus on four basic models of market
structure. Together, these models will help us understand how price and output are
determined in the many product markets in the economy, evaluate the efficiency or
inefficiency of those markets and provide a crucial background for assessing public
policies (such as antitrust policy) relating to certain firms and industries.
1. Four market models (review)
Economists group industries into four distinct market structures: pure competition, pure
monopoly, monopolistic competition, and oligopoly. These market models differ in several
respects: the number of firms in the industry, the type of product, price control, conditions
of entry and presence of nonprice competition. These factors sometimes are referred to as
structural variables.
Characteristics of the four basic market models
Market model Pure competition Monopolistic Oligopoly Pure monopoly
competition
Number of firms A very large number Many Few One

Type of product Standardized Differentiated Standardized or Unique (no close

differentiated substitutes)

Control over price None Some, but within Complicated be mutual Considerable
rather narrow limits interdependence;
considerable under
collusion

Conditions of entry Very easy, no Relatively easy Significant obstacles Blocked

obstacles present

Nonprice None Considerable, Considerable, Public relations

competition emphasis on particularly with
advertising product differentiation

Examples Stock exchange, Retail trade, Steel, cement, Local utilities

currency exchange, clothes, shoes automobiles, household
agricultural products appliances

Pure competition involves a very large number of firms producing a standardized

product (product identical to that of other producers).
Pure monopoly – one firm is the sole seller of a product or service (for example, a
local electric utility). Since the entry of additional firms is blocked, one firm constitutes
the entire industry.
Monopolistic competition – relatively large number of sellers producing differentiated
products (clothing, furniture, books). Widespread nonprice competition, a selling strategy
in which one firm tries to distinguish its product or service from all competing products
based on attributes like design and workmanship (product differentiation).
Oligopoly involves only a few sellers of a standardized or differentiated product, so
each firm is affected by the decisions of its rivals.
The last three are called imperfect competition.

2. The features of pure competitive markets

Key characteristics:
✓ Very large numbers.
✓ Standardized product.
✓ “Price takers”. Each firm produces such a small fraction of total output that
increasing or decreasing its output will not influence total supply or, therefore,
product price. The competitive firm is a price taker: it cannot change market price;
it can only adjust to it (clause: until its size is comparable with that of others).
✓ Free entry and exit.
Why study pure competition that is relatively rare in the real world?
1) This market model is highly relevant to several industries (markets for agricultural
goods, fish products, foreign exchange, basic metals, and stock shares).
2) Pure competition is a convenient starting point for any discussion of price and output
determination.
3) The operation of a purely competitive economy provides a standard, or norm, for
evaluating the efficiency of the real-world economy.
Demand to a competitive seller. We begin by examining demand from a competitive
seller’s viewpoint. This seller might be a wheat farmer, a strawberry grower, a sheep
rancher. Because each purely competitive firm offers only a negligible fraction of total
market supply, it must accept the price determined by the market. As a result, the demand
schedule faced by the individual firm in a purely competitive industry is perfectly elastic at
the market price (graph). However, market demand graphs as a down sloping curve.
The firm’s demand schedule is also its average-revenue schedule. Price per unit to the
purchaser is also average revenue to the seller. The total revenue for each sales level is
found by multiplying price by the corresponding quantity the firm can sell. Analogy:
y=kx; graph.
Marginal revenue is the change in total revenue (or the extra revenue) that results from
selling one more unit of output. In differential form it’s simply derivative of total revenue.
Graph shows the purely competitive firm’s total revenue, demand, marginal-revenue,
and average-revenue curves. Total revenue (TR) is a straight line that slopes upward to the
right. Its slope is constant. The demand curve (D) is horizontal, indicating perfect price
elasticity. The marginal-revenue (MR) curve coincides with the demand curve because the
product price (and hence MR) is constant. The average revenue (AR) curve equals price
and therefore also coincides with the demand curve.
 3. Profit maximization in the short run: total-revenue – total-cost approach
Because the purely competitive firm is a price taker, it can maximize its economic
profit (or minimize its loss) only by adjusting its output. And, in the short run, the firm has
a fixed plant. It adjusts its variable resources to achieve the output level that maximizes its
profit.
There are two ways to determine the level of output. One method is to compare total
revenue and total cost; the other is to compare marginal revenue and marginal cost.
Must be remembered: costs in the short run.
We begin by examining profit maximization using the total-revenue–total-cost
approach. Confronted with the market price of its product, the competitive producer will
ask three questions: (1) Should we produce this product? (2) If so, in what amount? (3)
What economic profit (or loss) will we realize?
Let’s demonstrate how a pure competitor answers these questions, given certain cost
data and a specific market price. See the graph.
Should the firm produce? Definitely. It can obtain a profit by doing so. How much
should it produce? It is the output at which total economic profit is at a maximum. The
graph compares total revenue and total cost for this profit-maximizing case.
Observe again that the total-revenue curve for a purely competitive firm is a straight
line. Total cost increases with output because more production requires more resources.
But the rate of increase in total cost varies with the relative efficiency of the firm. Total
revenue and total cost are equal where the two curves intersect. Total revenue here covers
all costs (including a normal profit, which is included in the cost curve), but there is no
economic profit. So, economists call this output a break-even point: an output at which a
firm makes a normal profit but not an economic profit.
Any output within the two break-even points will yield an economic profit. The firm
achieves maximum profit, where the vertical distance between the total-revenue and total-
cost curves is greatest.
Two other possibilities – loss-minimizing case and shutdown case are realized under
less favorable conditions in the industry when price of the product goes down (see
graphs).
4. Profit maximization in the short run: marginal-revenue – marginal-cost
approach
In the second approach, the firm compares the amounts that each additional unit of
output would 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.
The firm should produce any unit of output whose marginal revenue exceeds its
marginal cost because the firm would gain more in revenue from selling that unit than it
would add to its costs by producing it. Conversely, if the marginal cost of a unit of output
exceeds its marginal revenue, the firm should not produce that unit.
In the initial stages of production, where output is relatively low, marginal revenue will
usually (but not always) exceed marginal cost. So, it is profitable to produce through this
range of output. But at later stages of production, where output is relatively high, rising
marginal costs will exceed marginal revenue. Separating these two production ranges is a
unique point at which marginal revenue equals marginal cost. This point is the key to the
output-determining rule: In the short run, the firm will maximize profit or minimize loss by
producing the output at which marginal revenue equals marginal cost (as long as
producing is preferable to shutting down). This profit-maximizing guide is known as the
MR = MC rule.
The link between TR–TC and MR–MC approaches.
Keep in mind these features of the MR = MC rule:
1) 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;
2) the rule is an accurate guide to profit maximization for all firms whether they are purely
competitive, monopolistic, monopolistically competitive, or oligopolistic;
3) 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.
Now let’s apply the MR = MC rule first analyzing the profit-maximizing case and then
two others.
1) Profit-maximizing case (graph). 2) Loss-minimizing case (graph). 3) Shutdown case
(graph).
Modified MR = MC rule: a competitive firm will maximize profit or minimize loss in
the short run by producing that output at which MR (= P) = MC, if market price exceeds
minimum average variable cost.
Marginal cost and short-run supply. Question: what quantity the profit-seeking
competitive firm, faced with certain costs, would choose to offer in the market at each
price. This set of product prices and corresponding quantities supplied constitutes part of
the supply schedule for the competitive firm (graph).
Firm and industry: equilibrium price. Graphs. Last figure underscores a point made
earlier: product price is a given fact to the individual competitive firm, but the supply
plans of all competitive producers as a group are a basic determinant of product price.
Although one firm, supplying a negligible fraction of total supply, cannot affect price, the
sum of the supply curves of all the firms in the industry constitutes the industry supply
curve, and that curve does have an important bearing on price.
5. Profit maximization in the long run
In the short run the industry is composed of a specific number of firms, each with a
fixed plant. By contrast, in the long run firms already in an industry have sufficient time
either to expand or to contract their capacities. More important, the number of firms in the
industry may either increase or decrease as new firms enter or existing firms leave.
We make three simplifying assumptions, none of which alters our conclusions:
✓ Entry and exit only. The only long-run adjustment is the entry or exit of firms.
✓ Identical costs. All firms in the industry have identical cost curves. This assumption
lets us discuss an “average,” or “representative,” firm.
✓ Constant-cost industry. The industry is a constant cost industry. This means that the
entry and exit of firms does not affect resource prices or, consequently, the locations
of the average-total-cost curves of individual firms.
The basic conclusion: After all long-run adjustments are completed, product price will
be exactly equal to, and production will occur at, each firm’s minimum average total cost
(graphs).
 This conclusion follows from two basic facts: (1) firms seek profits and evade losses,
and (2) under pure competition, firms are free to enter and leave an industry. If market
price initially exceeds minimum average total costs, the resulting economic profits will
attract new firms to the industry. But this industry expansion will increase supply until
price is brought back down to equality with minimum average total cost. Conversely, if
price is initially less than minimum average total cost, resulting losses will cause firms to
leave the industry. As they leave, total supply will decline, bringing the price back up to
equality with minimum average total cost. So: 1) entry eliminates economic profits; 2) exit
eliminates losses.
We have sidestepped the question of which firms will leave the industry when losses
occur by assuming that all firms have identical cost curves. In the “real world,” of course,
managerial talents differ. Even if resource prices and technology are the same for all firms,
less skillfully managed firms tend to incur higher costs and therefore are the first to leave
an industry when demand declines. Similarly, firms with less productive labor forces or
higher transportation costs will be higher cost producers and likely candidates to quit an
industry when demand decreases.
Pure competition and efficiency (Individual work).
6. Long-run supply curves
Long-run supply for a constant-cost industry. What is the character of the long-run
supply curve of a competitive industry? The crucial factor here is the effect, if any, that
changes in the number of firms in the industry will have on costs of the individual firms in
the industry.
In our analysis of long-run competitive equilibrium we assumed that the industry under
discussion was a constant-cost industry. This means that industry expansion or contraction
will not affect resource prices and therefore production costs. Graphically, it means that
the entry or exit of firms does not shift the long-run ATC curves of individual firms. This
is the case when the industry’s demand for resources is small in relation to the total
demand for those resources. Then the industry can expand or contract without significantly
affecting resource prices and costs.
What does the long-run supply curve of a constant-cost industry look like? We saw that
the entry and exit of firms changes industry output but always brings the product price
back to its original level, where it is just equal to the constant minimum ATC. In other
words, the long-run supply curve of a constant-cost industry is perfectly elastic.
Long-run supply for an increasing-cost industry. Constant-cost industries are a
special case. Most industries are increasing-cost industries, in which firms’ ATC curves
shift upward as the industry expands and downward as the industry contracts. Usually, the
entry of new firms will increase resource prices, particularly in industries using specialized
resources whose long-run supplies do not readily increase in response to increases in
resource demand. Higher resource prices result in higher long-run average total costs for
all firms in the industry. These higher costs cause upward shifts in each firm’s long-run
ATC curve.
Thus, when an increase in product demand results in economic profits and attracts new
firms to an increasing cost industry, a two-way squeeze works to eliminate those profits.
As before, the entry of new firms increases market supply and lowers the market price.
But now each firm’s entire ATC curve also shifts upward. The overall result is a higher-
than-original equilibrium price (graph). The industry produces a larger output at a higher
product price because the industry expansion has increased resource prices and the
minimum average total cost.
Long-run supply for a decreasing-cost industry. In decreasing-cost industries, firms
experience lower costs as their industry expands. The personal computer industry is an
example. As demand for personal computers increased, new manufacturers of computers
entered the industry and greatly increased the resource demand for the components used to
build them (for example, memory chips, hard drives, monitors, and operating software).
The expanded production of the components enabled the producers of those items to
achieve substantial economies of scale. The decreased production costs of the components
reduced their prices, which greatly lowered the computer manufacturers’ average costs of
production. The supply of personal computers increased by more than demand, and the
price of personal computers declined.
Comments on the long run supply curve.
1. Assumptions used during our analysis. 1) We assume technology is constant; a change
in technology will cause the entire supply curve to shift. 2) At all points on the long run
supply curve the supply curves of inputs to the industry remain unchanged. When relevant,
other factors like government regulations or the weather must also be assumed constant
along the supply curve.
2. In reality, an industry is not likely to fully attain a position of long run equilibrium. In
real-world industries input supplies, demand, technology, and government regulations
frequently changed. A long run adjustment takes time, so an industry will find itself
moving toward a long run equilibrium that is continually shifting. However, the tendency
for the industry to move in the indicated direction is what is important, and the outcome is
correctly predicted by the theory.
3. The economic profit is zero along a competitive industry’s long run supply curve. So,
who does benefit? Owners of inputs whose price is bid up by the industry-wide expansion.
4. The tendency toward a zero economic profit means that the rate of return on invested
resources will tend to equalize across the industries. If invested resources yield an annual
return of 10% in some industry, economists regard this 10% return as a cost necessary to
attract resources to that industry (a normal profit).

7. Taxation in the short run and in the long run

Consider an industry that has free entry and exit. Suppose that initially it is a long run
equilibrium. In the short run with a fixed number of firms the supply curve is upward
sloping, while in the long run with variable number of firms the supply curve is flat at
price equals minimum average cost. What happens when we put a tax on industry?
In the short run the industry supply curve is upsloping so that part of the tax falls on the
consumers and part on the firms. The consumers will face a higher price and producers
receive a lower price. But the producers were just breaking even before the tax was
imposed, thus they must be losing money at any lower price, so some firms will leave the
industry. The supply will be reduced and the price for the consumers will rise further. In
the long run the industry supply curve will be horizontal so all the tax falls on the
consumers.
 8. Fixed factors and economic rent
If there is free entry, profits are driven to zero. But not every industry has free entry. In
some industries number of firms is fixed. A common reason for this is that there are some
factors of production that are available in fixed supply; they are fixed for the economy as a
whole in the long run.
The most obvious example of this is in resource-extraction industries (oil, coal, gas,
precious metals). Agriculture gives another example – there is only a certain amount of
land that is suitable for agriculture.
A more subtle example of such a fixed factor is talent (professional athletes, show
business stars). There may be free entry into such fields – but only for those who are good
enough to get in!
There are other cases where the fixed factor is fixed not by nature, but by law. In many
industries it is necessary to have a permit or license, and their number may be fixed by law
(taxicab industry, liquor licenses).
If there are restrictions on the number of firms in the industry, so that there is no free
entry, it may appear that it is possible to have an industry with positive profits in the long
run.
This appearance is wrong. There are economic forces that pushed profits to zero. If a
firm is operating at a point where its profits appear to be positive in long run, it is probably
because we are not appropriately measuring the market value of factors that prevent the
entry. If it appears that a farmer is making positive profits after we have subtracted his
costs of production, it is probably because we have forgotten to subtract the cost of his
land.
Suppose that we managed to value all the inputs to farming except for the land cost,
and we end up with π dollars per year for profits. How much would someone pay to rent
that land for a year? The answer is: π dollars per year. So, the market value of that land –
its competitive rent – is just π.
Whenever there is some fixed factor that is preventing entry into an industry, there will
be an equilibrium rental rate for that factor. Thus, in some sense it is always the possibility
of entry that drives profits to zero. After all there are two ways to enter an industry: you
can form a new firm, or you can buy out an existing firm. If a new firm can buy everything
necessary to produce in industry and still make a profit, it will do so. But if there are some
factors that are in fixed supply, then competition for those factors among potential entrants
will bid the prices of these factors up to the point where the profit disappears.
We just have considered the instances of economic rent. Economic rent is defined as
those payments to a factor of production that are more than the minimum payment
necessary to have factor supplied.
Farmland is a good example of economic rent. In the aggregate, the total amount of
land is fixed, so the payments to land constitute economic rent. On the graph AVC
represents the average cost curve for all factors excluding land costs (we assume the land
to be the only fixed factor). The area of the box represents the economic rent on the land.
Given the definition of rent, it is now easy to see that it is the equilibrium price that
determines rent, not reverse. The firm supplies along its marginal cost curve – which is
independent of the expenditures on the fixed factors. The rent will adjust to drive profits to
zero.