EC 201
Cal Poly Pomona
Dr. Bresnock
Lecture 9
This chapter begins our coverage of 4 market models, or market structures. First we will summarize
the key characteristics of these models in Table 1 below. Then we will begin an in depth analysis of
how each market structure selects its price and output.
Table 1
Market Structure Characteristics
Pure
Competition
Very Large
Market Structure
Monopolistic
Competition
Oligopoly
Many
Few
Type of
Product
Control over
Price
Standardized
Differentiated
None; “price
takers”
Some, but
limited
Conditions of
Entry + Exit
Very easy
Relatively easy
Product rather
than brand use
Considerable
Characteristic
# of Firms
Nonprice
Competition,
i.e. advertising,
brand names,
trademarks
Examples
Differentiated (D) or
Standardized (S)
Mutual
Interdependence to
Considerable
Significant
“barriers to entry”
Monopoly
One
Unique
Considerable;
“price maker”
Substantial
“barriers to
entry”
Great for Differentiated
Trade-oriented for
Standardized
Mostly public
service
EC 201
Dr. Bresnock
Lecture 9
Price and Output Determination: Pure Competition
Characteristics:
1.
2.
3.
4.
5.
Large # of Independent Sellers
Standardized, or Homogeneous, Product – little ability for sellers to differentiate product;
buyers indifferent between sellers
“Price Takers” not “Price Makers – sellers are “quantity adjusters”. **(see below)
No Barriers to Entry or Exit – no significant financial, technological, or legal obstacles
Only “Product” Advertising – i.e. California raisins, California cheese, “pork the other
white meat”, “where’s the beef”
Graph 1 Price Determination for Purely Competitive Firm
INDUSTRY
FIRM
Some Terms:
TR = Total Revenue = Price x Quantity
AR = Average Revenue = Per Unit Revenue = TR
Q
MR = Marginal Revenue = Additional Revenue per an Additional Unit of Output
= TR = TR2 – TR1
Q
Q2 – Q1
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EC 201
Dr. Bresnock
Lecture 9
Example: Assume P = $12 per unit. Price is “parametric”, or given.
Table 2 Revenue Functions for a Purely Competitive Firm
P
Q
0
1
2
3
4
5
6
7
8
Graph 2
Revenue Functions for the Purely Competitive Firm
Note: The demand for the purely competitive firm in Graph 2 shows us that its demand is perfectly
elastic at the price that was determined by the industry. This demand is unique in this respect and
we can see that P = MR = AR at the firm level. Each of the many firms has a negligible impact on
the industry price.
Note: Notice that the MR is the slope of the TR (or first derivative of the TR). In this market
structure, notice also that P is the slope of TR as well, since MR = P.
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EC 201
Dr. Bresnock
Lecture 9
Two Approaches to Profit Maximization: Purely Competitive Firm (SHORT RUN)
(1)
Total Approach -- Pick Q so that the firm will
Max (TR – TC) or Max Total “Economic” Profits
Where TC = Total “Economic” Costs = rent, wages and salaries, interest
and “normal profits”
(2)
expenses,
Marginal Approach -- Pick Q so that
MR = MC or
Marginal Profit = 0
(Necessary condition to Max TOTAL
“Economic” Profits)
and
MC is Rising or MC is ing
(Sufficient condition to Max TOTAL
“Economic” Profits)
Table 3 Total Approach to Profit Maximization (Purely Competitive Firm, Short Run)
P
Q
$12
0
1
2
3
4
5
6
7
8
TR
TFC
TVC
$10
$0
10
19
27
36
46
57
69
82
TC
Total “Economic”
Profit or Loss
Why is this a Short Run analysis?
(1)
(2)
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EC 201
Dr. Bresnock
Lecture 9
Graph 3 Total Approach to Profit Maximization (Purely Competitive Firm, Short Run)
Note: The profit max quantity is QMAX and is found where the TR > TC by the largest amount,
or at 7 units.
Graph 4 Changes in Total Revenue (Purely Competitive Firm)
Note: If TR changes while TC are constant, then there are several outcomes other than profit
maximization that may result. These are shown on the next page.
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EC 201
Dr. Bresnock
Lecture 9
Graph 5 Total Approach : Breakeven (Purely Competitive Firm)
Note: The breakeven quantity is QBE and is found where the TR = TC. If this outcome occurs, the
firm makes only “normal profits” and “economic profits” are zero.
Graph 6 Total Approach: Loss Minimization (Purely Competitive Firm)
Note: The loss minimization quantity is QMIN and is found where the TR < TC by the smallest
amount, and so long as the total loss is less than the TFC.
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EC 201
Dr. Bresnock
Lecture 9
Graph 7 Total Approach: Shut Down (Purely Competitive Firm)
Note: The loss minimization quantity is found where the TR < TC by the smallest amount and
this occurs at Q = 0. Thus, the shut down quantity, QSD, is zero.
Table 4 Marginal Approach to Profit Maximization (Purely Competitive Firm, Short Run)
Q
0
1
2
3
4
5
6
7
8
P
TC
MC
$10
20
29
37
46
56
67
79
92
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EC 201
Dr. Bresnock
Lecture 9
Graph 8 Marginal Approach to Profit Maximization (Purely Competitive Firm, Short Run)
Note: The first step is to select Q where MR = MC and MC is ing. The second step, is to
compare the P=AR and ATC at that Q level. In this case, you will see that the P=AR >
ATC at that quantity. Thus, you have located the quantity that will maximize profits given
the costs and product price, or QMAX.
Graph 9 Marginal Approach: Breakeven (Purely Competitive Firm, Short Run)
Note: The first step is to select Q where MR = MC and MC is ing. The second step, is to
compare the P=AR and ATC at that Q level. In this case, you will see that the P=AR = min
ATC at that quantity. Thus, you have located the quantity that will yield a breakeven given
the costs and product price, or QBE.
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EC 201
Dr. Bresnock
Lecture 9
Graph 10 Marginal Approach: Loss Minimization (Purely Competitive Firm, Short Run)
Note: The first step is to select Q where MR = MC and MC is ing. The second step, is to
compare the AR and ATC at that Q level. In this case, you will see that the P=AR <
ATC and P=AR >AVC at that quantity. Thus, you have located the quantity that will
yield a loss minimization given the costs and product price, or QMIN.
Graph 11 Marginal Approach: Shut Down (Purely Competitive Firm, Short Run)
OUT OF BUSINESS
Note: The first step is to select Q where MR = MC and MC is ing. The second step, is to
compare the P=AR and ATC at that Q level. In this case, you will see that the P=AR <
AVC at that quantity. Thus, you have located the quantity that will cause the firm to shut
down in the short run given the costs and product price, or QSD.
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EC 201
Dr. Bresnock
Lecture 9
Graph 12 Marginal Approach: Shut Down (Purely Competitive Firm, Short Run)
IN BUSINESS
Note: The first step is to select Q where MR = MC and MC is ing. The second step, is to
compare the P=AR and ATC at that Q level. In this case, you will see that the P=AR =
min AVC at that quantity. Thus, you have located the quantity that will cause the firm to
stay in business and minimize losses. Notice that this is the extreme situation for
minimizing losses in the short run. At a price less than the “shut down price”, PSD, or P
= min AVC, the firm would shut down.
Marginal Approach Review Points
(1)
Equilibrium -- the firm selects its quantity so that
MR = MC and MC is ing
Marginal Profits = 0
Total Profit Max (if possible, or breakeven found, or losses minimized, etc.)
No Tendency for the Firm to Alter its Quantity
(2)
Disequilibrium – if the firm selects a quantity that is not at equilibrium then either
MR > MC firm should Q in order to profit maximize (or breakeven, or loss min.)
Marginal Profits > 0 and Total Profit is not maximized (or loss minimized)
or
MR < MC firm should Q in order to profit maximize (or breakeven, or loss min.)
Marginal Profits < 0 and Total Profit is not maximized (or loss minimized)
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EC 201
Dr. Bresnock
(3)
Graph 13
(4)
Lecture 9
Sufficient Condition for Profit Maximization (or Loss Minimization)
Graph 14
Firm’s Short Run Supply Curve
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EC 201
Dr. Bresnock
Lecture 9
Long Run Price and Output Determination: Pure Competition
Remember: Firms can alter all inputs, and can “enter” or “exit” the industry if “economic profits”
or “economic losses” are present.
Assume Initially:
(1)
(2)
(3)
“Entry” and “Exit” constitutes the long run adjustment to changing market circumstances.
Costs are identical for each firm. This is a simplifying assumption so that we can regard
the firm as a “representative firm” of all the other purely competitive firms.
Constant-cost industry is assumed for simplicity so that entry and exit will not affect cost
schedules of the individual firms nor resource prices.
Long Run Equilibrium (Pure Competition)
For the purely competitive firm, the long run equilibrium is found at the Q where
P = AR = MR = MC = min ATC
Thus, entry and exit drive “economic profits” and “economic losses” to zero in the long run. In the
long run, all purely competitive firms break even, or just earn “normal profits”.
Graph 15 Long Run Equilibrium: Entry (Pure Competition)
INDUSTRY
FIRM
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EC 201
Dr. Bresnock
Lecture 9
Graph 16 Long Run Equilibrium: Exit (Pure Competition)
INDUSTRY
FIRM
Long Run Industry Supply (Pure Competition)
(1)
Constant Cost Case – entry and exit of firms does not affect: (a) resource prices, or (b)
other production costs. Ex. manufacturing industries.
Graph 17 Constant Cost Industry
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EC 201
Dr. Bresnock
(2)
Increasing Cost Case – entry and exit of firms causes: (a) resource prices to rise when
demand increases, and vice versa, and (b) other production costs to rise when demand
increases and vice versa. Ex. agriculture, forestry, extractive industries such as minerals,
petroleum.
Graph 18
(3)
Lecture 9
Increasing Cost Industry
Decreasing Cost Case – entry and exit of firms causes: (a) resource prices to fall when
demand increases, and vice versa, and (b) other production costs to fall when demand
increases and vice versa. Ex. firms experiencing “economies of scale” in production as a
result of volume discounts in purchasing materials, volume shipping discounts, preferred
interest rates for borrowing, i.e. “prime rate”
Graph 19 Decreasing Cost Industry
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EC 201
Dr. Bresnock
Lecture 9
ReCap for Purely Competitive Firm
(1)
Short-Run Equilibrium
P = MR = AR = MC
P = MC
(2)
or
Long – Run Equilibrium
P = MR = AR = MC = min ATC
P = MC = min ATC
or
Evaluation of Competitive Pricing
(1)
Productive Efficiency is Achieved -- goods are produced at least-cost in the long run, or
where P = min ATC.
(2)
Allocative Efficiency is Achieved -- goods are produced where P = MC. This allocation
provides what consumers want most with the available resources. Recall from Lecture 2
that allocative efficiency means that the
Value of the Last Unit
or
=
Value of Alternative Goods Sacrificed
or
P = MB
=
MC
where MB = marginal benefit and MC = marginal cost. Thus, P = MC is the allocative
efficiency criterion. Note that if…
P > MC or MB > MC

Underallocation of Resources
 Q so as to  Total Economic Benefits
P < MC or MB < MC

Overallocation of Resources
 Q so as to  Total Economic Benefits
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