14 Firms in Competitive Markets. WHAT IS A COMPETITIVE MARKET? In a perfectly competitive market...

1414Firms in Competitive Markets

WHAT IS A COMPETITIVE MARKET?

• In a perfectly competitive market• There are many buyers• There are many sellers

• Firms can freely enter or exit the market, in the long run. • In the short run, the number of firms is assumed fixed

(constant).• All sellers sell the same product.

2CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

WHAT IS A COMPETITIVE MARKET?

• As a result:• The actions of any single buyer or seller have a

negligible impact on the market price.• That is, the market price is unaffected by the amount

bought by a buyer or the amount sold by a seller• Therefore, every buyer and every seller takes the

market price as given. • Everybody is a ‘price taker’


Price takers

• A firm in a perfectly competitive market cannot stay in business if its price is higher than what the other firms are charging

• No firm would be able to raise the market price by reducing production and attempting to create a shortage.

• Conversely, there is no danger that a firm would drive the market price down by producing too much.

• Therefore, no firm would want to charge a price lower than what the others are charging.

• In short, each firm takes the prevailing market price as a given—like the weather—and charges that price.


Total Revenue of a Competitive Firm

• Total revenue for a firm is the selling price times the quantity sold.

TR = P TR = P Q Q

• We saw this in Chapters 5 and 13We saw this in Chapters 5 and 13


Average Revenue of a Competitive Firm

• Average revenue is the revenue per unit sold • P = AR.• This is simply because all units sold are sold at the

same price.

A v erag e R ev en u e =T o ta l rev en u e

Q u an tity

P rice Q u an tity

Q u an tity

P rice

6

Marginal Revenue of a Competitive Firm

• Marginal Revenue is the increase (Δ) in total revenue when an additional unit is sold.

MRMR = = TRTR / / QQ


The Revenue of a Competitive Firm

• In perfect competition, marginal revenue equals price: P = MR.

• We saw earlier that P = AR • Therefore, for all firms in perfect competition,

P = AR = MR


Table 1 Total, Average, and Marginal Revenue for a Competitive Firm

Note: (a) P = AR = MR(b) P does not fall as Q increases

9

Demand curves for the firm and the market (industry)

Jones and Peters, a firm

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

Demand, P = AR

P

The market demand curve is negatively sloped, as usual. That is, the market price, which is the lowest prevailing price, is inversely related to the quantity demanded.

The market price is P. No matter what amount Jones and Peters produces, the market price will not change. Therefore, J&P will be able to sell any feasible output if it charges the price P.

Demand, P = AR = MR

10

Supply

• We have just seen the demand curves for a firm and for the entire industry

• Next, we need to work out what the supply curves look like

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 11

Supply: short run and long run

• The analysis of supply in perfect competition depends on whether it is the short run or the long run.


Short run and long run: assumptions

• The quantity of a resource used by a firm may be fixed in the short run but not in the long run.• Example: If a firm currently has three custom-made

machines and if it takes six months to get new machines, then the firm is stuck with its three machines for the next six months.

• All fixed costs are sunk costs in the short run but not in the long run

• The number of firms in an industry is fixed in the short run but not in the long run


THE FIRM AND THE INDUSTRY IN THE SHORT RUN

14

Shut Down and Exit

• Before a firm decides how much to supply, it must decide whether or not to stay in business

• A shutdown refers to a short-run decision to stop production temporarily, perhaps because of poor market conditions.

• Exit refers to a long-run decision to end production permanently.


The Firm’s Short-Run Decision to Shut Down

• A firm will shut down (temporarily) if its variable costs exceed its total revenue, no matter what quantity it produces

• Its fixed costs do not matter!• This is because

• Fixed costs are sunk costs in the short run• sunk costs are defined as costs that will have to be paid

even if the firm shuts down. • Therefore, FC cannot affect a firm’s decision on

whether to stay open or shut down


Sunk Costs

• Sunk costs will have to be paid even when a firm is in a temporary shutdown. • Examples:

• If the firm signs a long-term contract with its landlord, the rent will have to be paid even when the firm is temporarily shut down.

• Some maintenance costs will have to be incurred even when the firm is shut down.

• The firm may be under contract to provide customer service to past customers even after it shuts down.



• Total Revenue = $1000 per month• Variable Cost = $800 per month• Fixed Cost = $400 per month• Profit = –$200 per month (a loss)

• Q: Should this firm stay in business or should it shut down for the time being?

• A: It should stay in business• If it shuts down, the fixed cost (say, rent owed to the landlord) will

still have to be paid—because it is sunk!—and the loss will then be even higher, $400 per month.



• Total Revenue = $1000 per month• Variable Cost = $1200 per month• Fixed Cost = $400 per month• Profit = –$600 per month (a loss)

• Q: Should this firm stay in business or should it shut down for the time being?

• A: It should shut down.• The lesson from this and the previous slide is

that …19CHAPTER 14 FIRMS IN COMPETITIVE MARKETS


• A firm shuts down if total revenue is less than variable cost, no matter what quantity the firm produces. That is,

• A firm shuts down if• TR < VC, no matter what Q is, or• TR/Q < VC/Q, no matter what Q is, or• P < AVC, no matter what Q is.


A Firm’s Shut Down Decision

Quantity

AVC

0

$

The firm shuts down because P < Minimum AVC

The firm stays open because P > Minimum AVC

Minimum AVC Minimum AVC

PH

PL

21

Table 2 Profit Maximization: A Numerical Example

Is it possible to figure out the profit-maximizing output from just the MR and MC numbers?

Yes, it is where MR = MC.

22

Figure 1 Profit Maximization for a Competitive Firm

Quantity0

Costsand

Revenue

MC

ATC

AVC

MC1

Q1

MC2

Q2

The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.

QMAX

P = MR1 = MR2 P = AR = MR

23CHAPTER 14

Therefore, P = AR = MR = MC is the fingerprint of perfect competition

We have seen before that, as firms are price takers in perfect competition, P = AR = MR.

We have also seen that, profit maximization implies MR = MC.

PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE

• Profit maximization occurs at the quantity where marginal revenue equals marginal cost.• This is a crucial principle in understanding the

behavior of firms


PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE

• When MR > MC increase Q• When MR < MC decrease Q• WhenWhen MR = MC MR = MC Profit is maximized; Profit is maximized;

stick with this stick with this Q.Q.


Recall: The Supply Curve

Quantity0

Price

Supply

P1

Q1

P2

Q2 26

Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve

Quantity0

Price

MC

ATC

AVC

P1

Q1

P2

Q2

This section of thefirm’s MC curve isalso the firm’s supplycurve.

27

Figure 3 The Competitive Firm’s Short Run Supply Curve

MC

Quantity

ATC

AVC

0

Costs

Firmshutsdown ifP< AVC

Firm’s short-runsupply curve

If P > AVC, firm will continue to produce in the short run.

If P > ATC, the firm will continue to produce at a profit.


What can shift the supply curve to the right?

The Short Run: Market Supply with a Fixed Number of Firms

• The market supply curve is the horizontal sum of the individual firms’ short run supply curves.


Figure 6 Market Supply with a Fixed Number of Firms

(a) Individual Firm Supply

Quantity (firm)0

Price

MC

1.00

100

$2.00

200

(b) Market Supply (# of firms fixed)

Quantity (market)0

Price

Supply

1.00

100,000

$2.00

200,000

Q: What is the number of firms?


Short-Run Equilibrium: back where we began!

(a) Individual Firm Supply

Quantity (firm)0

Price

MC

1.00

100

$2.00

200

(b) Market Supply (# of firms fixed)

Quantity (market)0

Price

Supply

1.00

100,000

$2.00

200,000


DemandL

DemandH

THE LONG RUN

Price = Minimum ATC; profit = zero; demand has no effect on price, and no effect on the quantity produced by a firm; demand does affect the quantity produced by the industry, and the number of firms in the industry

32

The Firm’s Long-Run Decision to Exit or Enter a Market

• In the long run, the firm exits if it sees that its total revenue would be less than its total cost no matter what quantity (Q) it might produce

• That is, a firm exits if• TR < TC, no matter what Q is.• TR/Q < TC/Q , no matter what Q is.• P < ATC , no matter what Q is.


The Firm’s Long-Run Decision to Exit or Enter a Market

• A new firm will enter the industry if it can expect to be profitable.

• That is, a new firm will enter if• TR > TC for some value of Q• TR/Q > TC/Q for some value of Q• P > ATC for some value of Q


Entry and Exit of Firms in the Long-Run

Quantity

ATC

0

$

Minimum ATC Minimum ATC

Existing firms will exit because P < Minimum ATC

The number of firms will stabilize when P = Minimum ATC. This is the long run price!

New firms will enter because P > Minimum ATC

PH

PL

35

This is the efficient scale output. This is each firm’s long-run equilibrium output!

Figure 4 The Competitive Firm’s Long-Run Supply Curve

MC = long-run S

Firmexits ifP < ATC

Quantity

ATC

0

CostsFirm’s long-runsupply curve

Firmenters ifP > ATC


ATC

THE SUPPLY CURVE IN A COMPETITIVE MARKET

• A Firm’s Short-Run Supply Curve• The portion of its (short run)

marginal cost curve that lies above the (short run) average variable cost curve.

• A Firm’s Long-Run Supply Curve• The portion of its (long run)

marginal cost curve that lies above the (long run) average total cost curve.


MC

ATC

AVC

Long-Run Equilibrium

This is it, as far as long-run equilibrium is concerned!How many firms are there in long-run equilibrium?

What would happen if demand moves left (decreases)?What could cause prices to increase? 38

ATC

PricePrice

Quantity (industry)

Quantity (firm)

6,000200 (efficient

scale)

$1.50$1.50 P = Minimum ATC =

Market Demand

P = AR = MR = MC = ATC is the fingerprint of perfect competition in the long run.

A Firm’s Profit

• Profit equals total revenue minus total costs.• Profit = TR – TC• Profit/Q = TR/Q – TC/Q• Profit = (TR/Q – TC/Q) Q• Profit = (P – ATC) Q


Figure 5 Profit as the Area between Price and Average Total Cost

(a) A Firm with Profits

Quantity0

Price

P = AR = MR

ATCMC

P

ATC

Q(profit-maximizing quantity)

Profit

40

Figure 5 Profit as the Area between Price and Average Total Cost

(b) A Firm with Losses

Quantity0

Price

ATCMC

(loss-minimizing quantity)

P = AR = MRP

ATC

Q

Loss


The Long Run: Market Supply with Entry and Exit

• Firms will enter or exit the market until profit is driven to zero.

• Price equals the minimum of average total cost.• The long-run market supply curve is a

horizontal line at this price.


Figure 7 Market Supply with Entry and Exit

(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

(b) Market Supply (# of firms variable)

Quantity (market)

Price

0

P = minimumATC

Supply

MC

ATC


Why Do Competitive Firms Stay in Business If They Make Zero Profit?

• Profit = TR – TC• Total cost = explicit cost + implicit cost.• Profit = 0 implies TR = explicit cost + implicit

cost• In the zero-profit equilibrium, the firm earns

enough revenue to compensate the owners for the time and money they spend to keep the business going.

• So, don’t feel sorry for the owners!44

Recap: Economic and Accountants

Revenue

Totalopportunitycosts

How an EconomistViews a Firm

How an AccountantViews a Firm

Revenue

Economicprofit

Implicitcosts

Explicitcosts

Explicitcosts

Accountingprofit

45

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Application

• We will now work through what happens when the demand for a product increases.

46

Short Run and Long Run Effects of a Shift in Demand: an application• An increase in demand raises price and quantity (for

each firm and the industry) in the short run.• Firms earn positive profits

• because price now exceeds average total cost.• New firms enter• Market supply increases (shifts right)• Price decreases; gradually returns to minimum ATC• Profits decrease; gradually return to zero• So, the long-run effect of an increase in demand is as

follows: the price is unchanged, each firm’s output is unchanged, the number of firms increases, industry output increases.

47

Figure 8 An Increase in Demand in the Short Run and Long Run

Firm

(a) Initial zero-profit long-run equilibrium

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P1

ATC

Long-runsupply

P1

1Q

A

MC

q1



MarketFirm

(b) Short-Run Response to an increase in demand

Quantity (firm)0

Price

MC ATCProfit

P1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S1

P2

Q1

A

Q2

P2

B

q1 q2



P1

Firm

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P1

P2

Q1 Q2

Long-runsupply

B

D1

D2

S1

A

S2

Q3

C

(c) Long-Run Response to positive short-run profits: new firms enter, pushing the short-run market supply to the right.

An increase in demand leads to an increase in price in the short run. But this price increase will not last. New firms will enter and push the price back to P1, the minimum ATC. Each firm’s output will return to q1. The only long-run effect of demand will be to increase the number of firms.

q1

50

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Any Questions?

51

Summary

• Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces.

• The price of the good equals both the firm’s average revenue and its marginal revenue.


Summary

• To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost.

• This is also the quantity at which price equals marginal cost.

• Therefore, the firm’s marginal cost curve is its supply curve.


Summary

• In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost.

• In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.


Summary

• In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale.

• Changes in demand have different effects over different time horizons.

• In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.


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14 Firms in Competitive Markets. WHAT IS A COMPETITIVE MARKET? In a perfectly competitive market...

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