PURE COMPETITION IN THE SHORT RUN

Learning objectives – After learning this

chapter, you should be able to:
▪ Give the names and summarize the main characteristics
of the four basic market models.
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▪ List the conditions required for purely competitive markets.
▪ Explain how demand is seen by a purely competitive
seller.
▪ Explain how purely competitive firms can use the
marginal-revenue-marginal cost approach to maximize
profits or minimize losses in the short run.
▪ Explain why the marginal cost curve and supply curve of
competitive firms are identical.

Four Market Models

Market structure models describe the nature or level of
competition and the pricing policy followed in the market.
▪ Pure competition entails a large number of firms, standardized
product, and easy entry (or exit) by new (or existing) firms.

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▪ 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.
▪ Monopolistic competition is close to pure competition, except that
the product is differentiated among sellers rather than standardized,
and there are fewer firms.
▪ An oligopoly is an industry in which only a few firms exist, so each is
affected by the price-output decisions of its rivals.

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Four Market Models: Summary (Table 10.1)

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 Characteristics of pure competition

1. Many sellers mean 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.
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.

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Demand as seen by a Purely Competitive Seller
▪ An individual firm will view its demand as perfectly elastic.
Graphically, a perfectly elastic demand curve is a horizontal
line at the price.
▪ The demand curve is not perfectly elastic for the industry: it
only appears that way to the individual firm, since they must
take the market price no matter what quantity they produce.

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Profit Maximization in the Short-Run

▪ 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.
▪ Three questions must be answered.
1. Should the firm produce?
2. If so, how much?
3. What will be the profit or loss?

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Profit Maximization in the Short-Run Marginal
Revenue—Marginal Cost Approach

1. 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. Rule works for firms in any type of industry, not just
pure competition.
3. In pure competition, price, P = MR, so in purely
competitive industries the rule can be restated as the firm
should produce that output where P = MC, because P =
MR.

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Profit Maximization in the Short-Run Marginal
revenue—marginal cost approach

4. Using the rule, compare MC and MR at each level of

output. At the 10th unit MC exceeds MR (= P). Therefore,
the firm should produce only 9 (not the 10th ) units to
maximize profits.
5. Profit maximizing case:
• The level of profit can be found by multiplying ATC by the
quantity, 9 to get $880 and subtracting that from total
revenue which is $131 x 9 or $1179. Profit will be $299
when the price is $131.
• Profit per unit could also have been found by subtracting
$97.78 from $131 and then multiplying by 9 to get $299.
Figure portrays this situation graphically.
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Profit Maximization in the Short-Run Marginal
revenue—marginal cost approach

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Profit Maximization in the Short-Run Marginal
revenue—marginal cost approach

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6. Loss-minimizing case:
• The loss-minimizing case is illustrated when the price falls to $81.
• Marginal revenue (MR = P) does exceed average variable (AVC)
cost at some levels, so the firm should not shut down.
• Comparing P and MC, the rule tells us to select output level of 6.
• At this level the loss of $64 is the minimum loss this firm could
realize, and the MR of $81 just covers the MC of $80.

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7. Shut-down case:
• If the price falls to $71, this firm should not produce. MR (= P) will
not cover AVC at any output level.
• Therefore, the minimum loss is the fixed cost and production is 0
• The table illustrate this situation, and it can be seen that the $100
fixed cost is the minimum possible loss.

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Marginal revenue—marginal cost approach

8. Consider This … The “Still There” Motel

• Over time a motel might experience a decrease in
demand (and a fall in price)
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• Despite the decrease in demand, it’s still profitable to
remain open rather than shut down (Price is greater than
min AVC).
• To increase the falling profits, the hotel owner cuts back
on maintenance thereby lowering the costs.

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Marginal cost and the short-run supply curve

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 minimum AVC
(shutdown point) will be the short-run supply for this firm.

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Marginal cost and the short-run supply
curve (Table 10.2)

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Marginal cost and the short-run supply curve

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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

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Determining equilibrium price for a firm and an
industry:

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2. Individual firm supply curves are summed horizontally to
get the total-supply curve S. If product price is $111, industry
supply will be 8000 units, since that is the quantity demanded and
supplied at $111.
3. 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.

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PURE COMPETITION IN THE LONG RUN
Learning objectives – After learning this
chapter, you should be able to:

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▪ Explain how the long run differs from the short run
in pure competition.
▪ Describe how profits and losses drive the longrun
adjustment process of pure competition.
▪ Show how long run equilibrium in pure
competition produces an efficient allocation of
resources.
The Long Run in Pure Competition
▪ In the short run firms can shut down, but there’s
insufficient time to go out of business.
▪ In the long run there’s enough time for firms to liquidate
their assets and get out of business.
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 1. There’s no specific time period that makes up the long
run as it varies by industry.
2. The key concept of the long run is how profits or losses
in combination with free entry and exit steer the industry
to use resources efficiently.
The Long-Run Adjustment Process in Pure Competition
A. 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 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.
4. In the long run, firms only earn zero economic profit (just normal
profit)

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The Long-Run Adjustment Process in Pure Competition
B. 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 (note that normal
profit is a cost and therefore incorporated in the cost curves.
1. Economic profits (the shaped area) are being earned (P>ATC). Firms
enter the industry, which increases the market supply from S1 to S2,
causing the product price to gravitate downward to the long run
equilibrium price P2 where zero economic profits are earned at Q2.

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The Long-Run Adjustment Process in Pure Competition
2. Losses (shaped area) are incurred in the short run at P1 ( P1
< ATC) (Original Point: D, S1, P1, Q1, q1).
Firms will leave the industry; this decreases the market supply
from S1 to S2, causing the product price to rise until losses
disappear and normal profits are earned at P2.

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 Pure Competition and Efficiency
1. Productive efficiency occurs where P = minimum ATC(Minimum efficient
scale); at this point firms must use the least-cost technology or they won’t survive

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 2. Allocative efficiency: MB = MC
• Allocative efficiency occurs where P* (=MB) = MC.
• MB Curve is demand Curve, MC curve is supply curve
• Allocative efficiency occurs at Q*, The intersection between the supply and the
demand curve the (competitive) market equilibrium, implying maximum net
benefits / combined consumer and producer surplus.

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SUMMARY

• Four Market Models

• Pure Competition: Characteristics and
Occurrence
• Demand as seen by a Purely Competitive
Seller
• Profit Maximization in the Short-Run
• The Long Run in Pure Competition
• The Long-Run Adjustment Process in Pure
Competition
• Pure Competition and Efficiency