The Firm Under Pure Competition
- The Process of Competition
"it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest." Adam Smith.
- Competition as a dynamic process denotes rivalry between firms
- Each seller tries to outperform its competitors.
- Firms use a variety of methods to compete--price, advertising, convenience, quality.
- Competing implies a lack of collusion on behalf of sellers.
- Competition is a force for social good.
Benevolence as a social force is highly overrated. It does not generate information about valuation of goods and services which is necessary if we are to use our scarce resources efficiently.
- Pure Competition Model
- Assumptions of the model
- All firms in the market are producing a homogeneous product.
- A large number of independent sellers produce the product.
- Each buyer is small relative to the total size of the market.
- There are no artificial barriers to entry into or exit from the market.
- Why is the model important?
- It helps us to understand the relationship between the decision-making of individual firms and market supply, even when markets are somewhat less than "purely" competitive.
- The conditions of the model are approximated by some industries--e.g., agricultural commodities.
- Competitive equilibrium in this model produces economic efficiency. Thus, it provides a standard by which we can judge the efficiency of other industries.
- The workings of the competitive model
- Purely competitive firms are price takers and make decisions based on marginal cost.
- Price taker is a seller who must take the market price in order to sell his or her product. Because each price taker's output is small relative to the total market, price takers can sell all of their output at the market price. They sell nothing at higher prices and have no incentive to sell their output for anything less than the market price. This means that the purely competitive firm faces a horizontal demand curve for its product.
- In the short-run, a firm can increase profits if the marginal revenue obtained from selling a product exceeds the marginal cost of making that product.
Profits will be maximized if the firms produces an amount where MR=MC. If the firm is incurring an economic loss, then losses (negative profits) will be minimized if it produces where MR=MC.
For the purely competitive firm which can sell all it produces at the market price, selling one more unit will yield revenue equal to the market price. So, for purely competitive firms, MR=Price.
Graph of profit maximization
- Temporary Shutdown vs. Going out of Business
- Shutdown is a temporary halt to operation. The firm keeps its assets. Variable costs are zero if the firm is shutdown. It still has to pay fixed costs.
- Going out of business indicates that the firm is selling its assets and leaving the industry. If out of business, the firm avoids fixed costs.
- Short-run production decisions
- As long as the market price is above ATC then the firm earns economic profits and will continue to operate.
- If price falls below average total cost, but is a greater than average variable cost, then the firm will continue to operate in the short-run. Even though losses occur, these losses are minimized by this strategy.
- If price falls below average variable cost, then the profit maximizing firm will shutdown. If the price is expected to remain below AVC then the firm may decide to leave the industry by going out of business.
- Thus the short-run supply curve of the firm is the MC Curve which lies above the AVC.
- Long-run production decisions
- Equilibrium price in the market is determined by market supply and demand.
- Purely competitive firms act as price takers and produce where P=MR=MC provided P>AVC.
- If P>ATC then firms earn economic profits. This will attract new firms into the industry. Supply expands, price falls and economic profits are driven to zero.
- If P<ATC and P>AVC, economic losses occur. If price is expected to permanently be below ATC then some firms will shutdown when annual fixed cost must be paid. Market supply falls causing price to rise. Losses are reduced as price rises. Once P=ATC, no more losses occur.
- If P<ATC and P<AVC, economic losses occur. Firms will shutdown. Market supply falls causing price to rise. Losses are reduced as price rises. Once P=ATC, no more losses occur.
- Long-run equilibrium occurs where P=MR=MC=minimum ATC.
- Efficiency and the Competitive Model
- Production Efficiency: P=ATC
In the long-run competition forces firms to minimize average total cost and to charge a price that is just sufficient to cover the production cost. In effect, high-cost producers will confront economic losses and be driven out of business. Only low cost producers will remain.
- Allocative Efficiency: P=MC
Each good in competitively supplied markets is produced as lonf as consumers value it more than the alternative goods that might be produced with the same resources.
No good is produced if a more valuable alternative must be forgone.
In Pure competition, price represents the consumers' valuation of an additional unit of the good. The sellers' marginal cost indicates the value of the resources in alternative uses necessary to produce an additional unit. Profit maximizers in purely competitive industries produce where P=MC.
Return to Notes Page
This page was last modified Tuesday, February 4, 1997.