Competitive firms and markets

Competitive firms and markets

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Introduction

Profit maximization

Behavior of a firm in a competitive market:In the short run (SR)

In the long run (LR)

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Profit maximization

π(q) = R(q) – C(q)

2 steps:What is the output level, q*, which

maximizes profits (minimises losses) ?

Is the firm better off producing q* or shutting down?

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Output decision

What do you think is the typical shape of a profit curve?

At q*, what is the slope of this curve?

Conclusions?

π

qq*

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A firm maximizes profits when:

MC = MR

If MC < MR, how can the firm increase its profits?

What if MC > MR?

The single MOST important thing

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Perfect competition

A competitive firm is said to be a « price taker »

Explain.

A competitive firm faces a demand curve which is perfectly elastic.

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Conditions for perfect competition

Five conditions:

Large number of firms and consumers

Identical product sold across firms

Free entry and exit in the market

Perfect information

No transaction costs

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Competition in the short run

MC = MR

Yet, R = p x q

and « price taker »

Hence, profit is max if:

MC = _____

firm’s internal structure

market structure

MR = ____

Profit maximization (graph.)

Shade the area corresponding to the firm’s maximum profit.

Compute the value of this maximum profit?

q

$/q

MR=P

MC

q*=280

P=8

AC

0

6.5

6

q

$R

q*

C

π

Firm behavior in a competitive market

1. Short-run behavior

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Shutdown decision

Should a firm shut down if π(q*) < 0 ?

Ex1: At q*, R = $2,000, VC = $1,000 and F = $3,000

Ex2: At q*, R = $500, VC = $1,000 and F = $3,000

Conclusion ?

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Output decision (cont.)

A firm should continue to operate in the short run if its revenue covers its variable cost.

Shutdown if: R < VC

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Shutdown if R < VC P x q < VC

P < VC / q

Therefore:

Shutdown if P < AVC

Shutdown decision

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Shutdown decision (graph.)

If the firm produces q* units, what will be its profit (or its loss)?

If the firm shuts down, what will it lose?

q

$/qMC

q*

P

AC

0

AVCA

B

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Three regions

q

p MC AC

0

AVC

π > 0

π < 0

π < 0

oper

ate

shut

dow

n

break-even point

shutdown point

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Firm’s supply curve

Draw the firm’s supply curve.

Explain

q

$/qMC AC

AVC

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Market supply curve

Horizontal sum of individual firms’ supply curves (like D)

Ex: 2 firms, Q = q1 + q2.

q1

s1

q2

s2

Q

S = s1 + s2

100 100 200400 300 700

p p p

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Price-elasticity of supply

Similar to the price elasticity of demand:

Interpretation: The price elasticity of supply represents the percentage change in Qs when P changes by 1%.

% change in Qs ∆Qs/Qs

Esp = --------------------------- = ----------------

% change in P ∆P/P

Firm behavior in a competitive market

2. Long-run behavior

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Competition in the long run

Recall: all costs are variable Profit maximization: MC = MR MC = P Shutdown decision: R < C,

(selling below cost is not sustainable in the long-run).

Hence, shutdown if R < C π < 0.

In the LR, a firm only produces if it does not incur any losses

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LR firm supply curve

Draw.

q

$/qMCLR ACLR

AVCLR

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LR market supply curve

As before: horizontal sum of individual curves…

BUT… how many firms are there?

If the market is profitable (π > 0 p > AC), what will happen?

Else, if π < 0 (LR loss), describe the sequence of events.

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Graphically

q

$/q MCLR ACLRp

Q

SLR

p = min ACLR

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Zero profits in the long run ???

Recall: We’re talking about economic profit

(π = πaccounting – Copportunity)

π < 0 I could earn more money elsewhere

Hence, when π = 0, the firm « makes money » (πaccounting > 0), but no more than it would if it utilized its resources differently: it is making normal profits.

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Conclusion

Behavior of a competitive firm

MC = MR : Reconciling the internal structure of the firm with current market conditions

Next: Supply and demand, a cooperative process

Example (1)A pizza shop in a perfectly competitive environment with the following total costs produces six pizzas.

Quantity Total Costs ($)0 101 152 253 404 605 856 1157 150

What is the price of a a pizza in this industry?

Example (1)

Perfect competition Firm is a price taker so it sets q such that MC=P

Quantity Total Costs ($) MC0 10 ---1 15 52 25 103 40 154 60 205 85 256 115 307 150 35

At q=6, MC=30, the price is 30$

Example (2)You operate Econsultants. One of your clients, Handspring, has recently decided to start a cell phone division in addition to producing handheld personal organizers. Unfortunately, this division of the company is not doing as well as they had hoped and has asked you to assess whether or not they should continue to operate in the short run. The current market price for a cell phone is $100/phone and at this price, Handspring would like to supply 100 phones. However, at a quantity of 100 phones, Handspring has an ATC of $110/phone and an AVC of $75/phone. Starting a cell phone division involved many one-time costs (i.e. the building of factories). In the short run, would you suggest that Handspring continue to operate this division of the company? Explain your answer.

Example (2)

Operate in SR or not? Represent graphically.

P=100$ q=100 ATC=110$ AVC=75$

The question assumes that q is such that P=MC, the firm is optimizeing.

SR decision is P > than AVC?

Yes Operate in the short run to eat some of the fixed costs.

Example (3)

The owner of a firm wants to know if it should change the level of output and/or if it should stay in the business in the short and long run. You are given the following information.

Rev=3,000$ AVC is @ min

FC=500$ TC=3125$ P=40$

Example (3)1. Is P=MC?

MC=AVC because it is @ min. We need AVC.

VC=TC-FC 3125$-500$=2625$.

AVC=VC/Q, We need Q.

Rev=P*Q 3,000$=Q*40$

Q=3,000$/40$=75

AVC=2625$/75$=35$

P (40$) > AVC (35$)!!!!! This means that the level of output is not chosen optimally. Output needs to be raised before decisions about SR and LR are to be taken.