Topic 7 Firms in Competitive Markets_Chapter 14

7/31/2019 Topic 7 Firms in Competitive Markets_Chapter 14

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2007 Thomson South-Western


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Outline

What is a competitive market? Short-run profit maximization

Minimizing short-run losses

The competitive firms supply curve andindustry short-run supply curves

Perfect competition in long-run

Perfect competition and efficiency

Summary


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Market structure

Many of firms decisions depend on the structure of themarket in which it operates.

Market structure describes the important features of a

market such as: number of suppliers/producers product degree of uniformity do firms in the market

produce identical products or differentiated products?

Ease of entry into marketcan new firms enter easily orare they blocked by barriers?

forms of competition among firms do firms competeonly through prices or use advertising & product differences?


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Market equilibrium & Firms Demand Curve

in Perfect Competition

Market price of wheat =$5 is determined by intersection of the market DDand SS curve.

Once market P is established , producers can sell all they wants at themarket P

Perfectly competitive firm so smallhow much the firm produce has noeffect on the market price

Market equilibrium Firms demandPricePrice

Q of wheat Q of wheat

$5 $5

S

D

d

1,0000 5 10 15


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Short-run Profit Maximization

Profit = Total revenue (TR)Total cost

(TC) Total revenue for a firm is the selling price

times the quantity sold.

TR = (P Q) Total revenue is proportional to the

amount of output.

Average revenue (AR) tells how much revenuea firm receives for the typical unit sold.

AR = TR / Q


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The Revenue of a Competitive Firm

In perfect competition, AR= Price

Average Revenue =Total revenue

Quantity

Price Quantity

Quantity

Price

AR


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The Revenue of a Competitive Firm

Marginal revenue is the change in total

revenue from an additional unit sold.

MR = TR/ Q For competitive firms, MR=Price

Thus in perfect competition,P=AR=MR


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Table 1 Total, Average, and Marginal Revenue for a

Competitive Firm

Q Price TR =(PXQ)

AR =TR/Q

MR=TR/ Q

1 gallon $6 $6 $6

2 6 12 6 6

3 6 18 6 6

4 6 24 6 6

5 6 30 6 6

6 6 36 6 67 6 42 6 6

8 6 48 6 6

Price = Average Revenue = Marginal Revenue


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PROFIT MAXIMIZATION AND THE

COMPETITIVE FIRMS SUPPLY CURVE

The goal of a competitive firm is to

maximize profit.

This means that the firm will want toproduce the quantity that maximizes the

difference between total revenue and total

cost. Firm maximizes economic profit when TR

> TC by the greatest amount



The Marginal Cost-Curve and the Firms Supply

Decision

Golden rule of profit maximization:

MR = MC

which holds for all market structure

For perfectly competitive firm,demand curve = P = MR = AR

Firm will expand output as long as MR > MC & stopexpanding output before MC > MR

When MR > MC, increase Q

When MR < MC, decrease Q

When MR = MC, profit is maximized.



Profit Maximization: A Numerical Example (Price = $6)

Q TR =(PXQ)

TC Profit

(TR-TC)

MR

( TR/ Q)

MC

( TC/ Q)

Change inProfit

(MR-MC)

0gallon

$0 $3 -$3

1 6 5 1 $6 $2 $4

2 12 8 4 6 3 3

3 18 12 6 6 4 2

4 24 17 7 6 5 1

5 30 23 7 6 6 0

6 36 30 6 6 7 -1

7 42 38 4 6 8 -2

8 48 47 1 6 9 -3



Short-Run Profit Maximization (TRTC)

TC TR

Q

Total dollars

5

$30

$23

Maximum economicprofit = $7



Short-Run Profit Maximization (MR= MC)

Q

Dollars per unit

5

$6

$5

A

B

MC

ATC

d=MR=ARPROFIT

1. MC curve intersection

with MR at point A whereQ=5

2. Output < 5, MR > MC, socan increase profit byincreasing output

3. Output beyond 5, MC >MR, firm can increaseprofit by reducingoutput

4. Economic profit =rectangle = TR ($6 X 5 )ATC ($5 X 5) = $5


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Profit Maximization for a Competitive Firm

Quantity0

Costs

andRevenue

MC

ATC

AVC

MC

1

Q1

MC2

Q2

The firm maximizesprofit by producingthe quantity at whichmarginal cost equalsmarginal revenue.

QMAX

P= MR1= MR

2 P= AR= MR

If the firm

produces Q1,marginal cost isMC1.

If the firm producesQ2, marginal cost isMC

2

.

Suppose the market price is P.


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Minimizing Short-Run Losses

Sometimes the price that the firm is required totake will be so low that no rate of output will givesprofit

Faced with losses, firm has 2 options:

1. It can produce at a loss or

2. Temporarily shut down In SR firm faces 2 types of cost : FC & VC

A firm that shut down in the SR must still pay FC

The decision to shut down or proceed depends onwhether revenue could cover VC

As long firms revenue cover VC (or price coversAVC) & some portion of FC a firm will produce

and not shut down


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The firm shuts down if the revenue it

gets from producing is less than thevariable cost of production.

Shut down if TR < VC

Shut down if TR/Q < VC/Q Shut down if P < AVC


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Minimizing LossesQ MR or P TR TC MC ATC AVC Profit or

loss

0 - $0 $15.0 - - - -$15

1 $3 3 19.75 $4.75 $19.75 $4.75 -16.75

2 $3 6 23.50 3.75 11.75 4.25 -17.50

3 $3 9 26.50 3.00 8.83 3.83 -17.50

4 $3 12 29.00 2.50 7.25 3.50 -17.00

5 $3 15 31.00 2.00 6.20 3.20 -16.00

6 $3 18 32.50 1.50 5.42 2.92 -14.50

7 $3 21 33.75 1.25 4.82 2.68 -12.75

8 $3 24 35.25 1.50 4.41 2.53 -11.25

9 $3 27 37.25 2.00 4.14 2.47 -10.25

10 $3 30 40.00 2.75 4.00 2.50 -10.0011 $3 33 43.25 3.25 3.93 2.57 -10.25

12 $3 36 48.00 4.75 4.00 2.75 -12.00

13 $3 39 54.50 6.50 4.19 3.04 -15.50

14 $3 42 64.00 9.50 4.57 3.50 -22.00

15 $3 45 77.50 13.50 5.17 4.17 -32.50


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Minimizing Short-Run Losses

TC

TR

Q

Total dollars

10

$40

$30

Q

Dollars per unit

10

$3

$2.50

A

MC

ATC

d=MR=ARLOSSminimumeconomic

loss=$10

AVC$ 4

1. TR lies below TC

2. Vertical distance measures theloss

3. Loss minimized at Q=10

1. P > AVC (MC=MR) .

2. Firm will produce rather thanshut-down even though firm

experiencing loss. Q=10.


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The Firm and Industry Short-Run Supply Curves

As long as P covers AVC, firm will supplythe quantity resulting from the intersectionof its upward-sloping MC curve and its MRor demand curve

The portion of the firms MC curve thatintersects and rises above the lowest pointon its AVC curve becomes short-run firm

SS curve The quantity supplied is determined by theintersection of the firms MC curve and itsdemand or MR curve.


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Figure 2 Marginal Cost as the Competitive Firms Supply

Curve

Quantity0

Price

MC

ATC

AVCP1

Q1

P2

Q2

So, this section of thefirms MCcurve isalso the firms supplycurve.

As P increases, the firm willselect its level of output along

the MC curve.


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Figure 3 The Competitive Firms Short-Run Supply Curve

MC

Quantity

ATC

AVC

0

Costs

Firmshutsdown ifP AVC, firmwill continue toproduce in theshort run.

If P> ATC, thefirm willcontinue toproduce at a

profit.


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Aggregating individual supply to form market supply

P P P P

P P P P

10 20

Sa Sb Sc Sa + Sb +Sc = S

10 1020 20 30 60

1. At price < P, no output supplied

2. At P, each firm supplies 10 units: market supply = 30 units

3. At P, each firm supplies 20 units: market supply = 60 units

4. SR industry supply curve is horizontal sum of all firms SR supplycurves : horizontal summation of the firm level MC curves


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Relationship between SR profit maximization &

Market equilibrium

Q12

$5

$4

A

B

MC=sATC

dPROFIT

Firm

AVC$5

12,000

MC=s

Industry or market

D

1. Market P=$5 and assume there are 1,000 producers, market supply= 12,000. At this price each firm produce 12 unit

2. Each producer earns an economic profit of $12 (TR-TC= $60 - $48)


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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


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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

3 P ibl P fit O t i th Sh t R


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3 Possible Profit Outcomes in the Short Run

P and Cost

Q

$20

8

MC

ATC

AR=MR

a. Normal profit (P=ATC)

P and Cost

Q

$20

9

MC

ATCAR=MR

b. Economic Profit (P>ATC)

$25profit

P and Cost

Q

$17

7

MC

ATC

AR=MR

c. Economic loss (P


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Perfect Competition in Long Run

In the long run:

Firms have time to enter & exit

Can adjust their scale of operations

No distinction between FC and VC because all inputs arevariable in the LR

SR economic profit will encourage new firmsto enter the

market in the LR May encourage some existing firms to expand their scale of

operations

Industry supply curve shifts rightward in the LR driving

down the price This process continues as long as economic profit is greaterthan zero

There is zero economic profit in the LR


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In the long run, the firm exits if the revenue itwould get from producing is less than its total

cost. Exit if TR < TC

Exit if TR/Q < TC/Q

Exit if P < ATC

A firm will enter the industry if such an actionwould be profitable.

Enter if TR > TC

Enter if TR/Q > TC/Q

Enter if P > ATC

Long run equilibrium for the firm and the industry


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Long run equilibrium for the firm and the industry

Qq

p

MC

ATC

d

Firm

p

Q

S

Industry or market

D

1. In the LR market SS adjust as firms enter or leave

2. This continues until market SS intersect the market DD at aP=lowest point on each firms LRAC at point E. (P=ATC) efficient

scale

3. At point E, MC, SRAC and LRAC are all equal.

LRAC

E


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Figure 4 The Competitive Firms Long-Run Supply

Curve

MC = long-run S

Firm

exits ifP< ATC

Quantity

ATC

0

Costs Firms long-runsupply curve

Firmenters if

P> ATC


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Figure 7 Long-Run Market Supply

(a) Firms Zero-Profit Condition

Quantity (firm)0

Price

(b) Market Supply

Quantity (market)

Price

0

P= minimumATC

SS

MC

ATC


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The Long Run: Market Supply with Entryand Exit

At the end of the process of entry and exit,firms that remain must be making zero

economic profit.

The process of entry and exit ends only whenprice and average total cost are driven to

equality.

Long-run equilibrium must have firmsoperating at their efficient scale.


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A Shift in Demand in the Short Run andLong Run

An increase in demand raises price andquantity in the short run.

Firms earn profits because price now

exceeds average total cost.

Figure 8 An Increase in Demand in the Short Run


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Figure 8 An Increase in Demand in the Short Run

and Long Run

Firm

(a) Initial Condition

Quantity (firm)0

Price Market

Quantity (market)

Price

0

P1

ATC

P1

1Q

MC

A market begins in longrun equilibrium.

With firms earn zeroprofit.

D1

Short run supply, S1

Long runsupply

A

Long run adjustment to an increase demand


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Long run adjustment to an increase demand

Qq

p

MC

ATC

d

Firm

p

Q2

S

Industry or market

D

1. Initial market equilibrium at a : firms supplies q & earns normalprofit2. Suppose DD (D to D1), in short run market P to p ; firms output

(q)3. Economic profit attract new , supply (S to S1) .4. New equilibrium at point c & price return to initial level

5. Firms demand curve shift back down from d to d.

LRACE

Q1

pd

P

a

b

c

S1

D1

q

profit

Q3

Long run adjustment to an decrease demand


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Long run adjustment to an decrease demand

Qq

p

MC

ATC

d

Firm

p

Q2

S1

Industry or market

D1

1. Initial LR market equilibrium at a and firms equilibrium at E2. Suppose DD (D to D1), in short run market P to p ; firms demandfall from d to d ; output to q. Market output falls to Q2.

3. Economic loss many firms exit - supply (S to S1) .4. P back to p, new equilibrium at point c5. Market output reduced to Q3 & firms only earns normal profit as

demand shift back to d.

LRACE

Q3

p d P

c

ba

S

D

q

loss

Q1


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Perfect Competition and Efficiency

There are two concepts of efficiency used

to judge market performance- productive efficiency (producer surplus)

- allocative efficiency (consumer surplus)

Perfect competition guarantees bothallocative and productive efficiency in thelong run

Efficiency allocation of resources wheremarginal benefit = marginal cost(MB=MC)


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Productive efficiency

Productivity efficiency occurs when thefirm produces at the minimum point onits long-run average cost curve (LRAC)the market price equals the

minimum average total cost (P=ATC)

The entry & exit of firms and any

adjustment in the scale of each firmensure that each firm produces at theminimum point on its LRAC curve


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Allocative Efficiency

Occurs when firms produce the output

that is most valued by consumers The demand curve reflects the marginal

value that consumers attach to each unit.

-the market price is the amount of money thatpeople are willing & able to pay for the final unitthey consume

In both the SR & LR, the equilibrium

price in perfect competition = marginalcost of supplying the last unit sold(P=MC)


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Consumer surplus (the connection between demand

and marginal benefit) Marginal benefit is the value

of one more unit of a good

MB = the maximum price thatconsumer are willing to payfor another unit of good

DD curve = MB curve

Consumer surplus =difference between value of agood & market price

When consumer buy lessthan it is worth they receive

consumer surplus Represented by area below

DD curve but above marketclearing price

DD= MB

$1

$5

$4

$3

$2

Consumersurplus


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Producer surplus (the connection between supply

and marginal cost)

When firms sells somethingmore than it costs toproduce the firms obtainsa producer surplus

Represented by areaabove supply curve andbelow market clearing price

SS = MC

5

$15

10

Producersurplus


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Consumer surplus and Producer surplus

When marketequilibrium reached atpoint E, productiveefficiency & allocativeefficiency occurs.

the combination of P*and Q* maximizes thesum of consumersurplus & producer

surplus.DD= MB

Consumer

surplusP*

SS= MC

Producersurplus

QQ*

Dollars per unit

E

Maximizing

The social welfare


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Summary


Because a competitive firm is a price taker, itsrevenue is proportional to the amount of outputit produces.

The price of the good equalsboth the firms

average revenue and its marginal revenue.

To maximize profit, a firm chooses the quantityof output such that MR=MC

This is also the quantity at which P=MC Therefore, the firms marginal cost curve is its

supply curve.


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Summary


In the short run, when a firm cannot recover itsfixed costs, the firm will choose to shut down

temporarily if the P < AVC.

In the long run, when the firm can recover bothfixed and variable costs, it will choose to exit if

the P < ATC.

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.


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Topic 7 Firms in Competitive Markets_Chapter 14

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