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Unit 4
Chapter 10
Pure Competition, Between the two extremes of a…
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Between the two extremes of a producer who dominates and thousands of producers who produce the same thing are many other markets.
FOUR BASIC MARKET MODELS
(Based on the number of firms in the industry; whether firms produce standardised or differentiated product; how easy it is for firms to enter the industry; how much control firms have over the price of their product) Table 10.1 page 197
PURE/PERFECT COMPETITION
Demand Curve: perfectly elastic demand
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Demand schedule = average-revenue schedule for purely competitive firm and is horizontal line and indicates perfect price elasticity
Total Revenue = price x quantity
Marginal revenue = the change in total revenue (or the extra revenue) that results from selling one more unit of output
In Pure Competition: marginal revenue = price
AR curve = price and therefor coincides with demand curve
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Price Taker: can not attempt to maximize profits by raising or lowering the price it charges; only variable they can control is the OUTPUT; it can adjust its profits (maximize profits or minimize loss) by adjusting its output
IN the SHORT RUN: firm has a fixed plant; output can only by adjusted by changing the amount of variable resources uses
Two ways to determine the level of output at which a firm will maximize profit/minimize loss:
1) Compare TR and Total Cost (total-revenue-total-cost approach)
2) Compare MR and MC
Total-revenue-total-cost approach
Total Revenue = Multiply output (total product) x price
Profit/Loss = TR - TC
Total cost increases with output because more production requires more resources
At higher levels of output, efficiency falls as crowding causes diminishing returns; once that happens, the firms total cost increases at an increasing rate because additional unit of input yields less output than the previous unit
Break-even point: an output where a firm makes a normal profit but not an economic profit; where TR and TC curves intersect. TR covers all costs
ECONOMIC PROFIT: Any output between the two break-even points will yield an economic profit
Maximum Profit = where the vertical distance between TR and TC is greatest
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In this approach the firm compares the amounts that each additional unit of output will add to the total revenue and to total cost i.o.w. the firm compares MR and MC of each successive unit of output
If MR > MC then firm should produce because the firm will gain more in selling that unit than it will add to cost when producing the unit.
If MC > MR then firm should not produce the unit because producing it will add more to the cost than selling it will add to the revenue and will result in decrease in profit or loss will increase
MR=MC rule
As long as producing some positive amount of output is preferable to shutting down and producing nothing, the firm will maximize profit or minimize loss in the short run by producing the quantity of output at which MR = MC
P=MC rule
This version of the rule tells us that, when producing is preferable over shutting down the competitive firm should produce the quantity of output at which Price is equal to Marginal Cost
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A COMPETITIVE FIRM MAXIMIZES PROFIT/MINIMIZES LOSS IN THE SHORT RUN BY PRODUCING THE OUTPUT AT WHICH MR (= P) = MC PROVIDED THAT MARKET PRICE EXCEEDS MINIMUM AVERAGE VARIABLE COST
- Pure/Perfect Competition
- Pure Monopoly
- Monopolistic Competition
- Oligopoly
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The portion of the firm's marginal-cost curve lying above its average-variable-cost curve is its short-run supply curve
Decrease in supply (MC increase): supply curve moves upward from horizontal axis and leftward from vertical axis
Increase in supply (MC decrease): supply curve moves downward to horizontal axis and rightward from vertical axis
Market Equilibrium Price = the price at which total quantity supplied of the product equals the total quantity demanded
Firm vs Industry competitive equilibrium
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Most industries fall between pure competition and pure monopoly
Monopolistic competition mixes a small amount of monopoly power with a large amount of competition:
-relatively large number of sellers (not thousands as in pure competition)
-differentiated products (monopoly aspect)
-easy entry and exit from industry
Differentiated Products: attributes, service, brand name and packaging, location, some control over price
Easy entry and exit: monopolistic competitors are small firms, small economies of scale, capital requirements are low
Large numbers of sellers:
small market share, independent action, no collusion
Advertising: nonprice competition - makes price less of an issue and real perceived product differences more of a factor;
If advertising successful: demand curve shift to right and steeper, demand less elastic at each price point, results in firm having more pricing power.
Pricing power = less elastic demand implies that any price increase initiated by the monopolistically competitive firm will cause a smaller decrease in sales, other things equal
Advertising is NOT free: it is variable cost that shifts AVC and ATC upwards/left
Monopolistically competitive firm's demand curve is highly but not perfectly elastic; more elastic than pure monopolist because other competitors and less elastic than pure competitor because there are fewer rivals and fewer substitutes because products differentiated.
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Price elasticity of demand faced by monopolistically competitive firm depends on the number of rivals and the degree of product differentiation the more rivals and the weaker the differentiation the closer to pure competition
Short Run - Profit or Loss
Monopolistically competitive firm max profit and min loss with same strategy as pure competitor or monopolist: produce the level of output where MR=MC
Economic profit = (P1-A1)xQ1
Total Loss = (A2-P2)xQ2
Long Run - Only Normal profit
Monopolistically competitive firm enters profitable industry, leave unprofitable industry
Monopolistic competition and efficiency
Economic efficiency requires each firm to produce the amount of output at which
P=MC=minimum ATC
Productive efficiency: P=minimum ATC: goods are being produced in the least costly way and the price is just sufficient to cover average total cost, including a normal profit
Allocative efficiency: P=MC: right amount of output is being produced and thus the right amount of scarce resources is devoted to this specific use
Neither productive nor allocative efficiency occurs in long-run equilibrium
Inefficiency of monopolistic competition