Pure or perfect competition is rare in the real world, but the model is important because it helps analyze industries with characteristics similar to pure competition. This model provides a context in which to apply revenue and cost concepts developed in the previous lecture. Examples of this model are stock market and agricultural industries.
1. Many sellers: there are enough so that a single sellerís decision has no impact on market price.
2. Homogenous or standardized products: each sellerís product is identical to its competitorsí.
3. Firms are price takers: individual firms must accept the market price and can exert no influence on price.
4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.
The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firmís demand curve is a horizontal line at the market price.
Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect competition.
Short Run Analysis
In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting output. Firms should produce if the difference between total revenue and total cost is profitable (EP >0), or if the loss is less than the fixed cost (EP> - FC). The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered, then this unit should be produced to minimize the loss. However, if by producing one unit of output, this loss would be higher , then this unit should not be produced. The firm should shut down, just pay for the fixed cost.
If EP< - FC firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < - FC, market price, P, must be lower than the minimum AVC.
If EP>- FC, firm should produce. That is when market price is greater than minimum AVC.
Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.
If MR > MC, then the firm should continue to produce.
If MR = MC, then the firm should stop producing the additional unit. As the additional unitís MC would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm would loss profit by producing additional units. Therefore, this is the profit maximizing output level.
If MR < MC, then the firm should lower its output.
The shutdown point is the level of output and price at which the firm just covers its total variable cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm will shut down because this action minimizes the firmís loss. In this case, the firmís economic loss equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand. Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC, then the firm should produce. Price and MC are compared to find the profit maximizing or loss minimizing output level. The supply curve of the pure competition firms would be the portion of the MC curve above the min AVC.
1. If EP < - FC or Market P < Min AVC, firm should shut down. Output = 0 , and EP = -FC
2. If EP > - FC or Market P > Min AVC, firm should produce. Firm's output level should be at where MR=MC or P=MC. Use EP = TR - TC to get economic profit of the firm.