Chapter 9 - Chapter 9 explains the profit maximizing/ loss minimizing behavior of a firm producing and selling a good in pure competition.

Pure Competition:   Pure competition is the first of four (4) industry models that we will study.  For discussion purposes, we group all business firms into four groups with pure competition at one end of the continuum and pure monopoly (no competition) at the other.  Then, in Chapter 11 we will focus on two models that lie in between:  monopolistic competition and oligopoly.

Characteristics of Pure Competition:

   (a)    A very large number of independently acting buyers and sellers.

   (b)    These firms produce a standardized or homogeneous product.  By definition, consumers cannot distinguish one sellers widgets from another.  Therefore, competition is based solely on price.

   (c)    Sellers are price takers.  They must sell at the market price or not at all.  I cannot overstate the importance of this point.  It means that each seller faces a demand schedule for her output which is perfectly elastic (horizontal demand curve) at the market price.  Because each is so small relative to the market, each can sell as much as it wants at the market price.  Therefore, there is no incentive to sell at a lower price.  And, if any seller raises the price of her output above the market price, she will sell none.

   (d)    Perfect ease of entry or exit from the industry.  Absolutely no barriers.    

Demand for the purely competitive sellers output:

   The market demand for a good sold in pure competition is inversely related to price.  The market demand schedule is down-sloping.  However, each firm in this industry does not see the market demand.  It sees only a demand for its output which is perfectly elastic at the market price.  The following points are crucial:

   (a)    In pure competition, price remains constant for any level of output/sales.

   (b)    Price will always be equal to average revenue  (P  =  AR).

   (c)    Only in pure competition, price will be equal to marginal revenue (P  =  MR).

Profit Maximization in the Short-run:  There are two ways to view profit maximization/ loss minimization in the short run.  In each, the competitive producer must answer three (3) questions:

    (a)    Should we produce?

    (b)    If so, what quantity?    

    (c)    What economic profit or loss will result?

Total-revenue - Total Cost Approach:  Pay close attention to Table 9.2 and Figure 9.2.

    The competitive producer will choose a quantity which results in the greatest positive difference between total revenue and total cost.  Note that she can earn an economic profit at any output where TR > TC, i.e. between the break-even points.  But she is a maximizer, and will choose that output which results in the greatest positive difference between TR and TC.  That can be viewed as that output where the slope of the total cost curve is equal to the slope of the total revenue curve.  And the slope of the respective curves is MR and MC.  So, another way of viewing the profit maximizing decision is that output where MR = MC.

Marginal Revenue-Marginal Cost Approach: 

    In pure competition, the firm is a price taker,  and therefore does not have a pricing policy.  In order to maximize profits, the firm only has an output decision.  Always remember that only in pure competition, P = MR.  Therefore, we can restate the profit maximizing/loss minimizing rule:   When producing is preferable to shutting down, the competitive firm should produce that output closest to where       P = MC, but never a level of output at which MC > P.

    Study carefully pp. 171-175, paying particular attention to Table 9-3 and Figure 9.4.  You should be able to explain three (3) situations related to short-term decision making for the competitive firm:  (1) profit maximizing,  (2) loss-minimizing, and (3) shut-down.

    Be able to explain why the firm's short-run supply curve is that portion of the marginal cost curve above the shut down point.

Long-run Equilibrium:

    Study carefully pp. 178-181, paying particular attention to Figures 9.8 and 9.9.  Here is the key point.  If firms in a competitive industry are earning economic profits in the short run, those profits will attract new producers into the industry.  More sellers will increase market supply and cause the market price to fall until the economic profits dissipate.  If firms are suffering economic losses in the short run, it will cause firms to exit the industry.  As the number of sellers falls, market supply decreases and market price rises, eliminating the losses.  So, in long-run equilibrium, firms remaining in the industry will be neither earning an economic profit or suffering an economic loss.  Recall, however, that each will still be earning a normal profit.

    Read pages 181 and 182.  We will talk about this topic in class, but you need not worry about it for test purposes.

Pure Competition and Efficiency:

    This is a crucial idea!  Understand it!  Recall from your macro course (Chapter 2) that efficient use of society's resources involves both allocative efficiency and productive efficiency.  And, the reason we put so much emphasis on competition in our market economy is that more competition means greater efficiency. So, it is important to understand the argument your author makes at the end of Chapter 9 that only in pure competition can we expect both allocative and productive efficiency.  We will finish Chapter 10 with the argument that in pure monopoly (no competition), we lose the efficiency of the competitive market.  Here is the core of the argument!

    Productive Efficiency:    Study carefully Figure 9.12  In long-run equilibrium, all firms will be producing a level of output which is at the minimum ATC.  Stated differently, it means that the minimum amount of society's resources will be used to produce any particular output.  And consumers benefit by paying the lowest price consistent with cost conditions.  P = MC

    Allocative Efficiency:    This one is a little more abstract, but a little common sense will help!  See, first, Chapter 1, pages 13 & 14.  Allocative efficiency is achieved in the production of any good when the additional cost to society of producing the last unit (MC) is equal to the additional benefit to society of consuming the last unit (MB).  Also, Recall from Chapter 7 that in maximizing utility (satisfaction) consumers will consume any good up to a point where MB = P. And,  in maximizing profits, producers will produce an output up to a point where MR = MC.  But only in competition will P = MR. Therefore, in a competitive market:

                    Consumers                            Producers                    

                     MB  =  P                             P  =  MC

                                    MB  =  P  =  MC

                                        MB  =  MC

Applications:  

1.    Complete Chapter 9, Key Question 4, parts a, b, and c. on Page 187.

2.    Complete Chapter 9, Key Question 7 on Page 188.

3.    An airline is flying between two cities. The airline has the following costs associated with the flight:

    Crew            $4,000                Plane daily depreciation    $2,000

    Fuel              $1,000                Plane daily insurance         $2,000

    Landing fee   $1,000

The airline has an average of 40 passengers paying an average of $200 for this flight.  Do you think the airline should be flying between these two cities?  Evaluate from a short-run and long-run perspective.

4.    "Pure competition provides consumers with the largest utility surplus."   Agree or disagree and explain your choice.  You may want to go back and read pages 118-120 near the end of Chapter 6.