There are four major types of markets. They are: Pure Competition: Large number of buyers and sellers trading a standardized product (corn, wheat); Pure Monopoly: One seller, firm is the industry; Monopolistic Competition: Large number of buyers, large number of sellers each selling a similar but slightly differentiated product (cigarettes); Oligopoly: Very few sellers that acknowledge that decision of one firm affects the others and takes this fact into account when making production or pricing decisions. In pure competition there are a large number of buyers and sellers issuing a standardized product. There are price takers. Meaning no one firm can affect the market price.
Individual competitor is at the mercy of the market also. Besides price takers, there is free entry and exit into the market. The relevance of studying pure competition is that some industries do behave like perfectly competitive firms. Wheat and rice are examples. Studying pure competition also allows us to apply revenue and cost ideas in the simplest possible context. It also provides a standard against which other more realistic markets can be compared.
Demand curves tell us by how much will quantity demanded change if price changes it is a "what if" statement. The demand curve in pure competition as faced by the individual firm is perfectly elastic. If the individual firm raises prices no one will buy from her. If she lowers prices everyone will buy from her but since buyers are willing to pay a higher price and buy the same amount from her she is basically reducing prices for no gain... she will not do this. Demand curves for the entire market are not perfectly elastic.
As far as the entire industry is concerned if all the firms raised prices then buyers would demand less. An entire industry (all firms taken together) could affect prices by changing the industries output. But an individual firm is too smal to be able to do this. The demand curve facing the individual firm is also the firm s average revenue curve and the marginal revenue curve. Profit maximization is when output is low it causes MC to be low (law of diminishing marginal productivity). Each additional unit produced adds more to revenue than to cost.
Production should occur. When output is high MC is high (law of diminishing marginal productivity). Each additional unit produced adds more to revenue than to cost. Production should cease. Optimum production is when MR = MC.
This is when profits are maximized. This rule holds for all market structures. But in the special case of perfect competition, MR = MC = Price. To calculate economic profit, go from the point where P = MR = MC and drop down vertically until you reach the ATC curve.
Then draw a rectangle to the y-axis. The area of this rectangle is economic profit. Perfectly competitive firms will produce as long as average variable costs are being covered (maximizing profits also means minimizing losses). If market prices lie above the ATC curve of the firm then the firm is making positive profits and therefore the firm should produce at the point where MR = MC. If the market price lies below ATC and above AVC, then the firm incurs losses. But at least fixed costs get covered when production happens and therefore the firm should produce production reduces losses.
If the market price lies below AVC then not only does the firm incur losses but also increase in production actually increases losses. So production should cease. Notice that at price $131 the firm supplies 9 units (and we get this number by reflecting off the MC curve). Notice that at price $81 the firm supplies 6 units (again we get this number by reflecting off the MC curve).
Notice that at price $71 (below AVC) the firm supplies 0 units. It makes more sense to shut down the plant rather than produce when market price lies below the AVC. Therefore the portion of the firms MC curve above the AVC curve is also the firms supply curve. Supply curve of the firm shifts whenever marginal costs change for all units produced (e. g. changes in input prices, productivity, tech changes etc.
). The industries supply curve is the horizontal sum of the individual firms supply curves. The industry supply curve and market demand curve (not the demand curve that the individual firm faces! ! ) together determine the market price. Profit maximization in the long run assumes that in the long run, firms can enter or exit the market. All firms in the industry have identical costs allowing us to think of an "average firm." We will assume that entry or exit does not affect resource prices and hence does not shift the ATC curve around.
At a price of $50 the representative individual firm just covers costs (zero profits) and the market is in equilibrium. For some reason demand increases pushing prices up to $60. Now the representative firm makes a positive profit. This attracts firms from outside the industry to enter the industry.
The supply curve shifts out since there is no change in resource prices when more firms enter the market (by assumption) the ATC curve of the representative firm does not shift. As the supply curve shifts out, prices fall till price of $50 is reached again. At this point profits turn to zero again and firms stop entering the market. This is the long run equilibrium. Firms stop entering the market when profits turn to zero the price (determines by demand and supply) that is consistent with zero profits is the long run equilibrium.
In the constant cost case since the ATC curve does not shift around as firms enter or exit the industry, firms supply more (when firms enter the market) or less (when firms exit the market) at the same price... the long run supply curve is perfectly elastic. Therefore, if resource prices increase, the long run equilibrium will happen when zero profits are reached given that ATC has shifted up. (Increasing Cost Industry). But because the zero profit equilibrium is reached at a higher ATC (and hence higher price), the firm will supply more at a higher price. The long run supply curve is upward sloping.
Similarly, if resource prices decrease, the long run equilibrium will happen when zero profits are reached given that ATC has shifted down. (Decreasing Cost Industry). But because the zero profit equilibrium is reached at a lower ATC (and hence lower price), the firm will supply less at a higher price. The long run supply curve is downward sloping. Productive efficiency firms operate at the minimum point of the ATC curve in the long run.
They use the "least cost" combination of inputs for production. In allocative efficiency the price of a commodity is a measure of willingness to pay for an additional unit of the product or the Marginal Benefit. Marginal cost includes opportunity costs and hence is a measure of the cost to society as a whole of producing the commodity. Thus when P = MC, the cost to society for producing the good is equal to the benefit to society from the good. This is the definition of allocative efficiency. The profit motive will be efficient only if the MC that the firm uses to determine its production point embodies all the costs to society.
This is often not the case. When firms pollute, the cost to society is higher than the cost to the firm. In other words, the societal MC curve is different from the firm s MC curve and since the firm does not have to use the societal MC curve to make production decisions, the firms profit maximizing output decision is different from the alloca tively different output decision. Some goods cannot be priced so that the price of these goods does not represent the benefit to society of the good.
This is especially true of goods that once provided can be consumed by everybody (public goods). In some industries the minimum point of the ATC curve of a firm can only be reached at a high level of production. In such industries only a few firms can be supported (utilities etc. ). One of the assumptions of competition is that products are standardized. But consumers may value differentiation in products.
Hence the P = MC decision may not reflect the benefit to society from product differentiation.