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Four market models

(cont.)
A. Pure competition entails a
large number of firms,
standardized product, and easy
entry (or exit) by new (or
existing) firms.
B. 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.
Four market models
(cont.)
C.Monopolistic competition is
close to pure competition, except
that the product is differentiated
among sellers rather than
standardized, and there are fewer
firms.

D.An oligopoly is an industry in


which only a few firms exist, so each
is affected by the price‑output
decisions of its rivals.
Four Market Models
Imperfect Competition
Pure Monopolistic Oligopoly Pure
Competition Competition Monopoly

Market Structure Continuum


Pure Competition:
Characteristics and Occurrence
A.The characteristics of pure
competition.
1.Many sellers means that there are
enough so that a single seller has no
impact on price by its decisions
alone.
2.The products in a purely competitive
market are homogeneous or
standardized; each seller’s product
is identical to its competitor’s.
Pure Competition:
Characteristics and Occurrence
A.The characteristics of pure
competition.(cont.)
3.Individual firms must accept the
market price; they are price
takers and can exert no
influence on price.
4.Freedom of entry and exit
means that there are no
significant obstacles preventing
firms from entering or leaving the
industry.
Pure Competition:
Characteristics and Occurrence
(Cont.)
5. Pure competition is rare in the real world,
but the model is important.
a. The model helps analyze industries with
characteristics similar to pure competition.
b. The model provides a context in which to
apply revenue and cost concepts developed
in previous chapters.
c. Pure competition provides a norm or
standards against which to compare and
evaluate the efficiency of the real world.
Pure Competition:
Characteristics and Occurrence
(Cont.)
B.There are four major objectives in 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
4. To evaluate the efficiency of competitive
industries
Demand from the Viewpoint of
aA.The
Competitive Seller
individual firm will view its demand as
perfectly elastic.
1. see slides for illustrations
2. The demand curve is not perfectly elastic for
the industry: It only appears that way to the
individual firm, since it must take the market
price no matter what quantity it produces.
3. Note that a perfectly elastic demand curve
is a horizontal line at the price.
Demand from the Viewpoint of
a Competitive Seller (Cont.)
B.Definitions of average, total, and marginal
revenue.
1. Average revenue (AR) is the price per
unit for each firm in pure competition.
2. Total revenue (TR) is the price
multiplied by the quantity sold.
3. Marginal revenue (MR) is the change
in total revenue and will also equal the
unit price in conditions of pure competition.
Table Representation
Product Price Quantity Total Marginal
($) Demanded Revenue (TR) Revenue (MR)
(Average ($) ($)
Revenue) AR (PXQ)
(Change in TR)

2 0 0 2
2 1 2
2
2 2 4
2
2 3 6 2
2 4 8 2
2 5 10
Graphical Representation
Pure Competition $1179
Firm’s Firm’s TR
Demand Revenue 1048
Schedule Data
(Average
Revenue) 917
P QD TR MR

Price and Revenue


786
$131 0 $0
] $131 655
131 1 131
] 131
131 2 262
] 131
131 3 393 524
] 131
131 4 524
] 131
131 5 655 393
] 131
131 6 786
] 131 262
131 7 917
] 131 D = MR = AR
131 8 1048
] 131 131
131 9 1179
131 10 1310
] 131

2 4 6 8 10 12
Quantity Demanded (Sold)
Questions
a. What can youto Ponder
conclude about the
structure of the industry in which this firm
is operating? Explain.
b. Graph the demand, total‑revenue, and
marginal‑revenue curves for this firm.
c. Why do the demand and
marginal‑revenue curves coincide?
d. “Marginal revenue is the change in
total revenue associated with additional
units of output.” Explain verbally and
graphically, using the data in the table.
Profit Maximization in the Short
Run: Two Approaches
A.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.
- Two ways to determine the level of output
1) Compare TR and TC
2) Compare MR and MC Applicable to all firm in all
Market conditions
Profit Maximization in the Short
Run
Total Revenue-Total Cost Approach

Consider:
Should Product Be
Produced?
If So, In What Amount?
What Economic Profit
(Loss) Will Be Realized?
Profit Maximization in the Short
Run
Approach 1 Compare TR and TC
Total Revenue-Total Cost Approach

Price = $131
(1) (2) (3) (4) (5) (6)
MR-MC Total Product Total Fixed Total Variable Total Cost Total Revenue Profit (+)
(Output) (Q) Cost (TFC) Cost (TVC) (TC) (TR) or Loss (-)
TABLE
0 $100 $0 $100 $0 $-100
1 100 90 190 131 -59
2 100 170 270 262 -8
3 100 240 340 393 +53
4 100 300 400 524 +124
Do You 5 100 370 470 655 +185
See Profit 6 100 450 550 786 +236
Maximization? 7 100 540 640 917 +277
8 100 650 750 1048 +298
9 100 780 880 1179 +299
10 100 930 1030 1310 +280

Now Let’s Graph The Results…


Muhammad Hasib Difari
Profit Maximization in the Short
Run
Total Revenue-Total Cost Approach

$1800
1700 Break-Even Point
1600 (Normal Profit)

Total Revenue and Total Cost


1500
1400 Total Revenue, (TR)
1300
1200
1100 Maximum
1000 Economic
Total Cost,
900 Profit
800 $299 (TC)
700
600
500 P=$131
400
300 Break-Even Point
200 (Normal Profit)
100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Total Economic

Quantity Demanded (Sold)


$500
Total Economic $299
Profit

400
300 Profit
200
100
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)
Muhammad Hasib Difari
Profit Maximization in the Short
Run: Two Approaches (Cont.)
Approach 1 - Compare TR and TC
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
it 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. A graphical representation is shown
Note: The firm has no control over the market price.
Profit Maximization in the Short
Run: Two Approaches (Cont.)
Approach 2 - Compare MR and MC
1. The 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.
a. The rule assumes that marginal revenue must be
equal to or exceed minimum-average-variable cost or
firm will shut down.
b. The rule works for firms in any type of industry,
not just pure competition.
c. 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.
Profit Maximization in the Short
Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule

Important Features:
• Firm Will Shut Down Unless
MR at Least Meets MC
• Profit Maximization in All
Market Structures
• Can Be Restated P = MC
Profit Maximization in the Short
Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule

TR-TR (2) (3) (4) (6)


TABLE (1) Average Average Average (5) Marginal
Total Fixed Variable Total Marginal Revenue (7)
Product Cost Cost Cost Cost (MR) Profit (+)
(Output) (AFC) (AVC) (ATC) (MC) (P) or Loss (-)
mr1
Shut down 0 mr2 $90 $-100
1 $100.00 $90.00 $190.00 $71 80 $81 $131 -59
2 50.00 85.00 135.00 $71 70 $81 131 -8
3 33.33 80.00 113.33 $71 60 $81 131 +53
Do You $81 131
4 25.00 75.00 100.00 $71 70 +124
See Profit 5 20.00 74.00 94.00 $71 80 $81 131 +185
Maximization 6 Loss 16.67 75.00 91.67 $71 90 $81 131 +236 64.02
Now? 7 Min. 14.29 77.14 91.43 $71110 $81 131 +277
8 12.50 81.25 93.75 $71130 $81 131 +298
9 11.11 86.67 97.78 $71150 $81 131 +299
10 10.00 93.00 103.00 $71 $81 131 +280

No Surprise - Now Let’s Graph It…


Profit Maximization in the Short
Run: Two Approaches (Cont.)
Approach 2 - Compare MR and MC
(cont.)
3. See slide as an illustration

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.
Profit Maximization in the Short
Run: Two
 Approach Approaches
2 - Compare MR and MC (cont.) (Cont.)
 Profit-maximizing case:
The level of profit = $1179 - $880.02
Economic Profit
= $299 MR=MC
P=$131 MC
Step 1
ATC x Qty MR = P
Cost &
97.78 x 9 = $880.02
Revenue ATC
Step 2 $97.78
TR = P x Q
= $131 x 9
= $1179
Alternatively, output 9
Economic profit = (P – ATC) Q
= ($131 - $97.78) 9
= $299
23022011 (TOPIC5) Muhammad Hasib Difari
Profit Maximization in the Short
Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule

$200

P=$131 MR = MC MC
Cost and Revenue

150

Economic Profit MR = P
ATC
100
AVC
A=$97.78

50

0
1 2 3 4 5 6 7 8 9 10
Output
Profit Maximization in the Short
Run: Two Approaches (Cont.)
 Approach 2 - Compare MR and MC (cont.)
FC
 Loss-minimising case:
< $100
The level of Loss = $550.02 - $486
= $64.02
A=$91.67 MC=MR MC
Economic loss
Step 1 Cost & ATC
ATC x Qty Revenue AVC
91.67 x 6 = $550.02
P=$81
Step 2 V=$75 MR=P
TR = P x Q
= $81x6
= $486 output 6
Profit Maximization in the Short
Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule
Loss Minimizing Case
$200
Loss =
$91.67 x 6 - $81x6 Lower the Price to $81 and
= $550.02 -$486 Observe the Results! MC
Cost and Revenue

=$64.02 150

Loss
A=$91.67
ATC
100 AVC
MR = P
P=$81

V = $75
50

0
1 2 3 4 5 6 7 8 9 10
Output
Profit Maximization in the Short
Run: Two Approaches (Cont.)
 Approach 2 - Compare MR and MC (cont.)
FC it will lose
Shut-down case :
The smallest loss = $100 MC=MR MC

Even at MC=MR, the Cost & ATC

firm will lose at a total Revenue AVC


loss of $115.
Hence in the SR it is best
to shut down if the P<AVC MR=P
P=$71

output 6
Profit Maximization in the Short
Run
Marginal Revenue-Marginal Cost Approach
MR = MC Rule
Short-Run Shut Down Case
$200

Lower the Price Further to


$71 and Observe the Results!MC
Cost and Revenue

150

ATC
V = $74
100 AVC

MR = P
P=$71
50 Short-Run
Shut Down Point
P < Minimum AVC
$71 < $74
0
1 2 3 4 5 6 7 8 9 10
Output
Profit Maximization in the Short
Run: Two Approaches (Cont.)
MC and SR Supply
Marginal cost and the short‑run supply curve
can be illustrated by hypothetical prices such
as those in Table of the next slide. At a price
of $151 profit will be $480; at $111 the profit
will be $138 ($888‑$750); at $91 the loss will
be $3.01; at $61 the loss will be $100 because
the latter represents the close-down case.
Marginal Cost and Short-Run
Supply
Continuing the Same Numeric Example…
Supply Schedule of a Competitive Firm
Quantity Maximum Profit (+)
Price Supplied or Minimum Loss (-)
$151 10 $+480
131 9 +299
111 8 +138
91 7 -3
81 6 -64
71 0 -100
61 0 -100
The Schedule Shows the Quantity a Firm
Will Produce at a Variety of Prices and Results
Profit Maximization in the Short
Run: Two Approaches (Cont.)
MC and SR Supply
1. Note that the Table from the previous
slide gives us the quantities that will be
supplied at several different price levels in
the short-run.
2. 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 AVC will be the short‑run supply
for this firm
Marginal Cost and Short-Run
Supply
Generalizing the MR=MC Relationship and its Use
Cost and Revenues (Dollars)

MC
e
P5 MR5
d
ATC
P4 MR4
c AVC
P3 MR3
b
P2 MR2
a
P1 MR1

This Price is Below AVC


And Will Not Be Produced

0 Q2 Q3 Q4 Q5
Quantity Supplied
Marginal Cost and Short-Run
Supply
Generalizing the MR=MC Relationship and its
Use
Examine the MC for the Competitive Firm

MC Above AVC Becomes


Cost and Revenues (Dollars)

the Short-Run Supply Curve S


Break-even MC
(Normal Profit) Point e
P5 MR5
d
ATC
P4 MR4
c AVC
P3 MR3
b
P2 MR2
a
P1 MR1

Shut-Down Point
This Price is Below AVC (If P is Below)
And Will Not Be Produced

0 Q2 Q3 Q4 Q5
Quantity Supplied
Profit Maximization in the Short
Run: Two Approaches (Cont.)
MC and SR Supply
F. Changes in prices of variable inputs or in technology
will shift the marginal cost or short-run supply curve
in
1. A wage increase would shift the supply curve
upward.
2. Technological progress would shift the marginal
cost curve downward.
3. Using this logic, a specific tax would cause a
decrease in the supply curve (upward shift in MC),
and a unit subsidy would cause an increase in the
supply curve (downward shift in MC).
Marginal Cost and Short-Run
Supply
Cost and Revenues (Dollars)

Decrease S2
Changes in S
the Short-Run Supply Curve
S1

Increase

P1

Quantity Supplied
Profit Maximization in the Short
Run: Two Approaches (Cont.)
MC and SR Supply
G. 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. (See Table 21-7.)
see slide 35
2.Figure 21-7a and b shows this analysis
graphically; individual firm supply curves are
summed horizontally to get the total-supply
curve S in Figure 21-7b. If product price is $111,
industry supply will be 8000 units, since that is
the quantity demanded and supplied at $111.
This will result in economic profits similar to
those portrayed in Figure 21-3.
3.A loss situation similar to Figure 21-4 could
result from weaker demand (lower price and MR)
or higher marginal costs.
Profit Maximization in the Short
Run: Two Approaches (Cont.)
MC and SR Supply
H.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.
Changes in Supply
Firm and Industry
Equilibrium Price
Market Price and Profits
Firm Versus Industry
Graphically…
Changes in Supply
p
Single Firm
P
Industry W 21.3

S = ∑ MC’s

s = MC

Economic
Profit ATC
d $111
$111
AVC

0 8 p 0 8000 P

Competitive Firm Must Take the Price that is


Established By Industry Supply and Demand
Profit Maximization in the
Long Run
A. Several assumptions are made.
1. The entry and exit of firms are the only
long‑run adjustments.
2. Firms in the industry have identical cost
curves.
3. The industry is a constant‑cost industry,
which means that the entry and exit of firms
will not affect resource prices or location of
unit‑cost schedules for individual firms.
Profit Maximization in the Long
Run (cont.)
B. The basic conclusion to be explained is
that after long‑run equilibrium is
achieved, the product price will be exactly
equal to, and production will occur at,
each firm’s point of minimum average
total cost.
1. Firms seek profits and shun losses.
2. Under competition, firms may enter
and leave industries freely.
3. If short‑run losses occur, firms will
leave the industry; if economic profits
occur, firms will enter the industry.
Profit Maximization in the Long
Run (cont.)
C. The model is one of zero economic profits, but
note that this allows for a normal profit to be made
by each firm in the long run.
1. If economic profits are being earned, firms
enter the industry, which increases the market
supply, causing the product price to gravitate
downward to the equilibrium price where zero
economic profits are earned (Figure 21-8).
2. If losses are incurred in the short run, firms will
leave the industry; this decreases the market
supply, causing the product price to rise until losses
disappear and normal profits are earned (Figure 21-
9).
Profit Maximization in the Long
Run (cont.)
D. Long‑run supply for a constant cost industry
will be perfectly elastic; the curve will be
horizontal. In other words, the level of output
will not affect the price in the long run.
1. In a constant‑cost industry, expansion or
contraction does not affect resource prices or
production costs.
2. The entry or exit of firms will affect quantity
of output, but will always bring the price back to
the equilibrium price (Figure 21-10).
Profit Maximization in the Long
Run (cont.)
E. Long‑run supply for an increasing cost industry will be
upward sloping as the industry expands output.
1. Average‑cost curves shift upward as the industry
expands and downward as the industry contracts, because
resource prices are affected.
2. A two‑way profit squeeze will occur as demand
increases because costs will rise as firms enter, and the new
equilibrium price must increase if the level of profit is to be
maintained at its normal level. Note that the price will fall if
the industry contracts as production costs fall, and
competition will drive the price down so that individual firms
do not realize above‑normal profits (see Figure 23-11).
Profit Maximization in the Long
Run (cont.)
F. Long‑run supply for a decreasing-cost
industry will be downward sloping as the
industry expands output. This situation is the
reverse of the increasing‑cost industry.
Average‑cost curves fall as the industry
expands and firms will enter until price is
driven down to maintain only normal profits
Profit Maximization in the Long
Run
Assumptions
Entry and Exit Only
Identical Costs
Constant-Cost Industry
Goal of the Analysis
Long-Run Equilibrium
Entry Eliminates Profits
Exit Eliminates Losses
Supply Readjustment
Single Firm Industry
p P
S1

MC

ATC S2
$60 $60

50 50
MR
40 40 D2

D1

0 100 p 0 80,000 90,000 100,000 P


An Increase in Demand Temporarily Raises Price
Higher Prices Draw in New Competitors
Increased Supply Returns Price to Equilibrium
Supply Readjustment
Single Firm Industry
p P
S3

MC

ATC S1
$60 $60

50 50
MR
40 40 D1

D3

0 100 p 0 80,000 90,000 100,000 P

A Decrease in Demand Temporarily Lowers Price


Lower Prices Drive Away Some Competitors
Decreased Supply Returns Price to Equilibrium
Long-Run Supply Curve
Constant-Cost Industry
P

P1
$50 S
P2 Z3 Z1 Z2

P3

D3 D1 D2

0 Q3 Q1 Q2 Q
90,000 100,000 110,000
Long-Run Supply Curve
Increasing-Cost Industry
P

S
P2 $55
Y2
P1 $50
Y1
P3 $40
Y3
D2

D1
D3
0 Q3 Q1 Q2 Q
90,000 100,000 110,000

How Would a Decreasing-Cost Industry Look?


Pure Competition and
Efficiency
A. Whether the industry is one of constant, increasing,
or decreasing costs, the final long‑run equilibrium will
have the same basic characteristics (Figure 23-12).
1. Productive efficiency occurs where P =
minimum AC; at this point firms must use the
least‑cost technology or they won’t survive.
2. Allocative efficiency occurs where P = MC,
because price is society’s measure of relative worth of a
product at the margin or its marginal benefit. And the
marginal cost of producing product X measures the
relative worth of the other goods that the resources
used in producing an extra unit of X could otherwise
have produced. In short, price measures the benefit
that society gets from additional units of good X, and the
marginal cost of this unit of X measures the sacrifice
or cost to society of other goods given up to produce
more of X.
Pure Competition and
Efficiency
(Cont.)
3. If price exceeds marginal cost, then
society values more units of good X more
highly than alternative products the
appropriate resources can otherwise
produce. Resources are underallocated to
the production of good X.
4. If price is less than marginal cost, then
society values the other goods more highly
than good X, and resources are
overallocated to the production of good X.
Pure Competition and
Efficiency
(Cont.)
5. Efficient allocation occurs when price and
marginal cost are equal. Under pure competition
this outcome will be achieved.
6. Dynamic adjustments will occur automatically
in pure competition when changes in demand or
in resource supplies or in technology occur.
Disequilibrium will cause expansion or contraction
of the industry until the new equilibrium at P = MC
occurs.
7. “The invisible hand” works in a competitive
market system since no explicit orders are given
to the industry to achieve the P = MC result
Pure Competition and Efficiency
Productive Efficiency
P = Minimum ATC
Allocative Efficiency
P = MC
Maximum Consumer and
Producer Surplus
Dynamic Adjustments
“Invisible Hand” Revisited
Long-Run Equilibrium
Competitive Firm and Market

Single Firm Market


P=MC=Minimum MC S
ATC (Normal Profit)
ATC
Price

Price
P MR P

D
0 Qf 0 Qe
Quantity Quantity
Productive Efficiency: Price = Minimum ATC
Allocative Efficiency: Price = MC
Pure Competition Has Both in
Its Long-Run Equilibrium
LAST WORD: Pure Competition
and Consumer Surplus
A.In almost all markets, consumers collectively
obtain more utility (total satisfaction) from
their purchases than the amount of their
expenditures (product price x quantity).
B.Since pure competition establishes the lowest
price consistent with continued production, it
yields the largest sustainable amount of
consumer surpluses.
LAST WORD: Pure Competition
and Consumer Surplus (cont.)
Arises because some
Consumers are willing to pay more
$20 Than the equil. P but need not do so
Consumer surplus
$16 S (ΣMC)

$12
At the lowest price (P=$8)
$8 Pure Competition yields
the largest sustainable
Amount of consumer surplus

Q1
Efficiency
st
Gains From Entry:
La
ord The Case of Generic Drugs
W
Competitive Model Predicts Lower Price and
Greater Output With Increased Efficiency
When New Producers Enter Market
Example is Patented Drugs
Patents Enable Greater Profits in Support of
R&D and Accelerated Cost Recovery
After Patent Period Generics Enter Market
Profits Decrease and Quantities Increase
Combined Consumer and Producer Surpluses
Increase
Efficiency Gains From Entry:
The Case of Generic Drugs
as t
L New Producers Enter Market
o rd
W • a
As Price Initial Patent Price
S
Decreases to f, b c
• Consumer P 1

Surplus abc d

Price
Increases to P 2
f

adf
• Producer and
Consumer
Surplus is D
Maximized
Together as Q 1 Q2
Quantity
Shown by
the Gray Results: Greater Quantity at Lower Prices
as Predicted by the Competitive Model
Triangle