Pure Competition

A perfectly competitive market is rare, but those that exist are very large, such as the markets for agricultural products, stocks, foreign exchange, and most commodities. Pure competition also offers a simplified economic market model that yields useful insights into the nature of competition and how it provides the greatest value to consumers.

Perfectly competitive markets have 4 essential qualities:

  1. large number of firms supplying the product
  2. standardized or homogeneous products
  3. low entry and exit costs for firms entering or leaving the industry, and
  4. for any market for which the above qualities are true, then suppliers are price takers in that no individual supplier has any influence on the market price

A competitive market exists because the product is standardized or homogeneous and the costs to enter or leave the industry are low, allowing many firms to compete in supplying a product or service. A high barrier to entry would otherwise limit the number of suppliers in the market. Hence, there will be many suppliers for standard products as long as the market price is above the average total cost of supplying the products.

The suppliers of a competitive market are price takers — they have no influence whatsoever on the market price because each supplier has only a tiny share of the total market. If some suppliers try to raise their price by even a few pennies, then consumers will simply buy from other suppliers. On the other hand, for the individual seller, market demand is completely elastic, so there is no reason for any supplier to sell even a penny less than the market price, since they can sell all that they want for the market price.

2 graphs showing the difference between demand, supply, and price for the market and for the individual competitive firm.
For an industry, the market price declines with increasing supply, but for the individual firm, demand is perfectly inelastic, so the competitive firm can supply any amount of product without affecting the market price. Thus, the firm can maximize its own profits by supplying the amount when its marginal cost, which is the cost for producing an additional product, equals the market price.

If the products were differentiated to some degree, then the market would be a monopolistic competition, by definition, which would allow some suppliers to charge a slightly higher market price if they can convince consumers, through advertising or other methods, that their product is worth the higher price.

Economics of a Purely Competitive Seller

Few markets as a whole are perfectly elastic, where consumers would buy whatever quantity was supplied without affecting the market price. However, sellers in a purely competitive market see a perfectly elastic demand — they can sell any quantity of the product at the market price. This makes both the average revenue, which is the average price of all products sold, and marginal revenue, equal to the price of the last item sold, equal to the market price.

Average Revenue = Marginal Revenue = Market Price

This, in turn, means the total revenue of the seller equals the market price multiplied by the number of units sold.

Revenue = Price × Quantity

Short-Run Profit Maximization

Since the competitive seller cannot charge anything but the market price, it can only maximize profits or minimize losses by minimizing costs. However, in the short run, suppliers can only minimize variable costs, not fixed costs. There are 2 methods to determine at what output a seller would maximize profits or minimize losses:

Total Revenue and Total Cost Approach

Under the total-revenue — total-cost approach, maximum profits occur when total costs reach a minimum.

A firm has both fixed and variable costs. If the firm produces only a few units, then costs will be high relative to revenue, because the fixed costs must be covered by the few units produced. As more units are produced, average fixed costs will decline, which will also decrease the total cost/total revenue ratio. Because a firm has fixed resources in the short run, there will be a point where increasing the quantity becomes more costly because of the law of diminishing marginal returns with fixed assets. Hence, at some point, the total cost/total revenue ratio will rise, leading to losses above the 2nd break-even point.

Graph showing the relation between total revenue and total cost for a firm under pure competition.
A breakeven point is achieved when the total cost curve becomes less than total revenue for the first time (#1 in the graph). There is a 2nd breakeven point that occurs as the total cost increases and the total cost curve again crosses the total revenue line (#2). Between these 2 breakpoints, the difference between total revenue and total cost yields profits (#3) for any quantity of products produced between the 2 breakeven points. Note that there is a specific quantity that maximizes profit, equal to the quantity where the tangent to the total cost curve is parallel to the slope of the total revenue line.

Marginal-Revenue — Marginal-Cost Approach

This approach compares how each additional unit of output adds to the total revenue and total cost. The additional revenue from the unit is the marginal revenue (MR) and the additional cost is the marginal cost (MC). A firm maximizes output when marginal revenue equals marginal cost.

MR = MC = Market Price

As long as the marginal revenue exceeds the marginal cost, the firm is profiting from producing that unit. Once marginal revenue = marginal cost, additional units will incur a marginal cost exceeding the marginal revenue for that unit, causing total profits to decline from diminishing marginal product. This relationship is true for all firms, whether they are purely competitive, monopolistically competitive, oligopolistic, or monopolistic. The firm will maximize profit or minimize loss as long as producing is better than shutting down.

Because, for purely competitive firms, marginal revenue = price, maximum revenue is also earned when the marginal cost of producing the last unit equals the market price. This makes sense since, if the marginal cost exceeded the price, then the firm would incur losses for each additional unit. Note that by producing until marginal cost = market price maximizes total profit, but not per unit profit.

A diagram of the short-run supply curve showing the relationship among average variable cost, average total cost, marginal cost, and marginal revenue, and the prices and quantities supplied, ranging from the shutdown point to economic profits.

This diagram of the short-run supply curve shows the relationship among average variable cost, average total cost, marginal cost, and marginal revenue, and the prices (P) and quantities (Q) supplied, ranging from the shutdown point to economic profits.

If the market price is less than average total cost, then the firm cannot make a profit, but if it is higher than the minimum average variable cost (AVC), then the firm can at least minimizes losses, because the amount of marginal revenue exceeding the variable cost can be used to lower losses from fixed costs.

If the price is less than the minimum AVC, then the firm has reached the shutdown point: it can minimize losses in the short run by shutting down completely; otherwise, the firm would lose more money if it produced any output, thereby increasing its losses. Thus, its total loss will equal its total fixed costs. To summarize:

  • The portion of the MC curve above the shut-down point is the supplier's short-run supply curve.
  • Below the shut-down point, no product is produced, since marginal revenue is less than average fixed costs.
  • Between the shut-down point and the break-even point, the firm is losing money, but it minimizes losses by producing product, because marginal revenue exceeds the AVC.
  • At the break-even point, the firm earns a normal profit.
  • Above the break-even point, the firm earns an economic profit.

Marginal Cost and the Short Run Supply

The above discussion leads to the following conclusions regarding the relationship between marginal cost and the short run supply.

Note that the supply curve of an individual firm is different than for the industry. For the individual firm in a competitive market, demand is completely elastic, so the firm can sell all that it produces for the market price, so it will sell as many units as possible until marginal cost = marginal revenue. On the other hand, the supply curve of the industry slopes upward as in the classical case, wherein increased supply causes a decrease in the market price.