Pure Competition; Competitive Markets

Concepts you should know

  • Characteristics of perfect competition
    • Perfect competition – A name given to an industry (market) structure with the following characteristics
    • 1. Large number of buyers and sellers such that no single buyer or seller can influence or control the market price. To the individual buyer or seller, the price is given. They are price takers, not price makers. Ed = 8 (perfectly elastic) – Demand is given to us by the market, but we still have to calculate Q that the firm will produce.
    • 2. Buyers and sellers are engaged in the purchase and sale of homogeneous (same kind) commodities. The buyers perceive the products offered by the sellers to be identical.
    • 3. There are no barriers to entry or exit.
    • 4. There is perfect knowledge of market prices and quantities.
    • 5. No discrimination. Buyers want the best products at low prices and nothing can get in the way. Sellers want to make the most money and nothing can get in the way.
  • Economic profit, accounting profit, normal profit
    • TR – Accounting costs = accounting profit
    • Accounting profit – opportunity cost = economic profit
    • If economic profit is greater than 0, NR is greater than 0, super profit, or super normal profit.
    • If economic profit is 0, NR is 0, normal profit (covering accounting and opportunity costs only). This point where NR=0 is also known as a break-even point.
    • If NR is less than 0, there is a loss
  • Shutdown point, P=AVC
    • At P=AVC, the firm is making just enough money to cover the variable costs, but not the fixed costs. It is losing money, but would lose more if it shut down.
    • When PThat is why the point where P=AVC is the shutdown point – everything below this point, the firm shuts down the plant.
  • Short run versus long run
    • Short, short run – Price is set by the market, and the firm can decide whether to produce or not. Firm can have a super normal profit.
    • Long, short run – Others will enter the industry, increasing supply, driving down the price, and getting rid of super normal profit. Firms can only make a normal profit. Normal profit made at point where P=ATC.
    • D1=AR1=MR NR>0 Super profit, firms will enter the market and bring down the price.
    • D2=AR2=MR NR=0 Normal profit, at equilibrium, but firms will continue to enter
    • D3=AR3=MR NR<0 Loss
    • D4=AR4=MR Below shutdown point, firms will leave the market driving the price up
    • For a firm under Perfect Competition, MC = the supply curve above the shut down point.
    • Long Run: - There are three assumptions that must be made.
      • The only long-run adjustment is the entry or exit of firms.
      • All firms in the industry have identical cost curves.
      • The industry is a constant-cost industry. This means that the entry and exit of firms does not affect resource prices or the locations of the ATC curves of individual firms.
    • P1: Firm 1=normal profit, firms 2&3=super profit, firm 4=slight profit, firm 5=loss
    • P2: Firm 1&4&5=loss, firm 2=normal profit, firm 3=super profit
    • P3: Firm 3=normal profit, all other firms at loss. Firms 1 and 2 are too small, and firms 4 and 5 are too big – they go out of business.
    • Competition eliminates super normal profits and inefficient plants (those that are too small or too large).
    • At E: D=AR=MR=P=ATC=LRATC=MC
      • 1. MR=MC: The firm tries to maximize profits by producing where MR=MC
      • 2. AR=ATC=P: The firm earns normal profit; NR=0
      • 3. D=AR=MP=P: The firm is a price taker; Ed=8
      • 4. MC=ATC: The firm uses the plant in the most efficient way; minimizes ATC
      • 5. ATC=LRATC: The firm uses the most efficient size plant
      • 6. MC=ATC=LRATC: In the long run above, this is where the firm uses the most efficient size plant in the most efficient way
      • 7. P=MC: The firm is allocatively efficient.
  • Profit per Unit
    • Profit per unit = P – ATC
    • Profit = (P – ATC)*Q
    • Calculate by graph shown below
  • MR=MC Rule, P=MC
    • If MR > MC, keep producing you dummy, it’s pulling up the NR
    • If MC > MR, stop producing, cut back you dummy, hurting you.
    • Profit maximization rule – A firm will maximize profits or minimize losses by producing at that output where MR=MC (as long as producing is preferable to shutting down).
    • For most sets of MR and MC data, MR will equal MC at a fractional level of output (8.3 for example). In such cases, the firm should produce the last complete unit for which MR exceeds MC (8 in this example).
  • TR, TC, ATC, AVC, MC, MR, AR
    • Rectangle calculations from graphs are below
    • TR = Price * Quantity (P*Q)
      • TR curve always is a straight line that slopes up and to the right, because each extra unit of sales increases TR by P, and P is constant.
    • TC = Accounting Costs + Opportunity Costs
      • Include both fixed and variable costs = TFC + TVC
    • NR = Net Revenue = TR - TC
    • ATC = TC/Q
    • AVC = TVC/Q
    • MC = ?TC/?Q
    • MR (Marginal Revenue) = ?TR/?Q
      • When output is measured by 1 unit in pure competition, as in example below, MR will always equal the unit price (MR=P=D=AR)
    • AR (Average Revenue) = TR/Q
      • TR = P*Q, so AR = (P*Q)/Q, so AR = P
      • AR=MR=D=P
  • Allocative Efficiency
    • P=MC – The firm is allocative efficient.
    • Cost is equal to benefit.
    • Consumers get as much of the product for the price they are willing to pay.
    • This is achieved when it is impossible to obtain any net gains for society by simply altering the combination of goods and services that are produced from society’s limited supply of resources.
    • Going back to the first part of the book, this is the point on the production curve that indicates the best possible balance, so that the right amount is produced for what the consumers are demanding.
  • Production Efficiency
    • P=minimum ATC
    • MC=ATC=LRATC – In the long run above, this is where the firm uses the most efficient size plant in the most efficient way.
    • Going back to the first part of the book, this is where the firm is producing on the production curve.

Other possible useful knowledge

  • Firm – An institution that hires the factors of production and organizes them to produce goods and services for profit.
  • Institution consists of firm (profit) and non-firms (church, school, etc.)
  • The goal of a firm is profit maximization.
  • Firms can be classified three ways
    • By Industry – Industry is a group of firms that produce a similar product or service – US Dept of Commerce Standardized Industry List
    • By Legal Form
      • Sole Proprietorship – Individual owner
      • Partnerships – 2 or more people get together
      • Corporations – As an Inc, it is a person in the eyes of the law – “legal fiction”
    • By degree of competition (this is the one focused on by economists)
  • A firm’s choice of production methods is guided by economic efficiency.
  • Efficiency
    • Economic efficiency – The cost of producing a given output is as cheap as possible.
    • Technological (engineering) efficiency – You get the most output with the least input, or can’t increase output without increasing input.
    • Example – out of 10 production methods, 3 may be technologically efficient. However, of the three, only 1 will be economically efficient.
  • The boundaries of the firm
    • A firm coordinates the factors of production, but this coordination could also be done by the market
    • All – one big circle, the firm coordinates everything.
    • Market coordination – small circle in center for the firm, many more small circles surrounding it for other companies it has contracts with.
    • Why have employees?
      • Lower transaction costs
      • Economies of Scale
      • Team Production Loyalty
  • Firms must ask three questions once they know the P of their product to determine the Q:
    • Should we produce the product?
    • If so, in what amount?
    • What economic profit (or loss) will we realize?

Example and illustrative view of Perfect Competition

  • At 8units, profit is maximized, so that is where the firm will produce. At some point between units 8 and 9, MR=MC.
  • At points A and B, TR=TC, NR=0, firm is only making a normal profit.
  • To the left of A and right of B: TC > TR, firm has a loss, NR < 0
  • Between A and B, TR > TC, NR > 0, firm has a super normal profit.
  • At 8, the gap between TR and TC is largest, there is the most profit.
  • At E: MR=MC
  • To the left of E, MR>MC, keep producing
  • To the right of E, MC>MR, stop producing, cut back
  • AT A & B, as above, NR=0
  • To the left of A and right of B: ATC>AR, NR<0
  • Between A&B: AR>ATC, NR>0
  • Where MC=ATC, ATC is at minimum; Where MC=AVC, AVC is at minimum
  • Graph calculations:
  • TR = rectangle OPEN
  • ATC = line FN
  • TC = rectangle OGFN
  • NR = rectangle OPEN – rectangle OGFN = rectangle GPEF
  • Price = line EN
  • Profit/Unit = line EN – line FN = line EF
  • AVC = line HN
  • TVC = rectangle OJHN
  • AFC = line FH
  • TFC = rectangle JGFH