The firm Under Pure Competition

Competition as a process should not be confused with pure competition, a model of industrial structure. Competition as a process implies rivalry. Rival firms use quality, style, location, advertising, and price to attract consumers. Pure competition, on the other hand, is a model of industrial structure that assumes the presence of a large number of small (relative to the total market) firms, each producing a homogeneous product in a market for which there is complete freedom of entry and exit.

The competitive process places producers under strong pressure to operate efficiently and heed the views of consumers. Those who do not offer quality goods at economical prices lose customers to rivals. As Adam Smith recognized long ago, self-interest is a powerful motivator of human beings. If it is bridled by competition, self-interest leads to economic cooperation and productive effort.

Under pure competition, firms are price takers-they face a perfectly elastic demand curve. Profit-maximizing (or loss-minimizing) firms will expand output as long as the additional output adds more to revenues than to costs. Therefore, the competitive firm will produce the output level at which marginal revenue (and price) equals marginal cost.

The firm's short-run marginal cost curve (above its average variable cost) is its supply curve. Under pure competition, the short-run market supply curve is the horizontal sum of the marginal cost curves (when MC is above AVC) for all firms in the industry.

If a firm (a) is covering its average variable cost and (b) anticipates that the price is only temporarily below average total cost, it may operate in the short-run even though it is experiencing a loss. However, even if it anticipates more favorable market conditions in the future, loss minimization will require the firm to shut down if it is unable to cover its average variable cost. If the firm does not anticipate that it will be able to cover its average total cost even in the long-run, loss minimization requires that it immediately go out of business (even if it is covering its average variable cost) so that it can at least avoid its fixed cost.

When price exceeds average total cost, a firm will make economic profits. Under pure competition, profits will attract new firms into the industry and stimulate the existing firms to expand. The market supply will increase, pushing price down to the level of average total cost. Competitive firms will be unable to make long-run economic profits.

Losses exist when the market price is less than the firm's average total cost. Losses will cause firms to leave the industry or reduce the scale of their operations. Market supply will decline until price rises sufFiciently, so firms can earn normal (that is, zero economic) profits.

As the output of an industry expands, marginal costs will increase in the short-run, causing the short-run market supply curve to slope upward lo the right. If cost conditions to the industry remain unchanged, as the market output is expanded, the long-run supply curve will be perfectly elastic. However, as the output of an industry expands, rising factor prices and industrial congestion will normally cause the firm's cost curve to shift upward. The long-run market supply curve for such an increasing cost industry will slope upward to the right.

Within the framework of the purely competitive model, firms that efficiently produce and correctly anticipate those goods for which future demand will be most urgent (relative to costs of production) will make profits. Firms that inefficiently produce and incorrectly allocate resources to the production of goods for which future demand turns out to be weak (relative to costs of production) will be penalized with losses. In the short-run, firms might make either profits or losses, but in the long-run, competitive pressures will eliminate economic profits (and losses).

Economists often argue that pure competition leads to ideal economic efficiency because(a) average costs of production are minimized and (b) output is expanded to the level at which the consumer's evaluation of an additional unit of a good is just equal to its marginal cost.