Chapter 7 Competition Competitive Firm

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Chapter 7Competition Competitive Firm

• Sell any quantity it wants at the going market
  price
• Classic example farm
• Serve a small part of market
• Horizontal demand curve
• Products are interchangeable
• Buyers can easily buy from another producer

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Revenue

• TR P X Q
• MR P
• MR curve is flat
• MR curve coincides with demand curve

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Firms Supply Decision

• Produce good until MR MC
• Competitive firm produces a quantity where P MC
• Note P MR
• Supply curve
• MC and supply are inverse functions
• Supply curve looks like upward sloping portion of
  MC curve as long as MC curve upward sloping
• SR and LR supply curves exist for the firm

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Shutdowns and Exits

• Does the producer want to produce the good?
• Two distinctions
• Shutdown firm stops producing the good but still
  pays fixed costs
• Exit firm leaves the industry entirely and no
  longer faces any costs
• In SR, can shutdown but not exit
• Firms remains operational if P gt AVC
• In LR, can exit

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EXHIBIT 7.6 The Competitive Firms Short-Run
Supply Curve
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Short-Run Supply Curve

• SR supply curve identical to part of SRMC curve
  that lies above AVC curve
• Firm shutdown otherwise
• Upward slope due to average and marginal cost
  U-shape
• Diminishing marginal returns to variable factors
  of production
• Elasticity of supply
• Percent change in quantity supplied resulting
  from a 1 change in price

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Competitive Industry in the SR

• All firms in industry competitive
• Defining the SR
• Period of time in which no firm can enter or exit
  the industry
• Number of firms cannot change
• LR is a period of time in which any firm that
  wants to can enter or leave the industry
• Industrys SR supply curve
• Sum together SR supply curves of individual firms
  within the industry
• More elastic than individual supply curves

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Supply, Demand, and Equilibrium

• Each firm operates where supply equals demand
• Industrywide supply equals industrywide demand
• Industry equilibrium consequence of optimizing
  behavior on part of individuals and firms

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Competitive Equilibrium

• Firms produces where supply (or MC) curve crosses
  horizontal line at market going price
• Increase in FC
• Price and quantity remain unchanged
• Increase in VC
• Raises firms MC curve
• Causes some firms to shutdown
• Higher market equilibrium price
• Firms output could go up or down
• Increase in industry demand
• Higher market equilibrium price
• Increase in firms output

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Industrys Costs

• Sum of total cost of all individual firms
• To minimize cost of all firms, use equimarginal
  principle
• Insure that MC same for all producers in industry
• Automatic because all firms have same price

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Competitive Firm in the LR

• Some fixed cost in SR become variable cost in the
  LR
• Firms can enter and exit in the LR

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LRMC and Supply

• Operate where P LRMC
• If firm remains in industry, LR supply curve
  identical to LRMC curve
• Firm remains as long as earn positive profit

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Profit and the Exit Decision

• Profit TR TC
• Costs includes all foregone opportunities
• SR versus LR supply response
• LR supply curve more elastic than SR supply curve
• Firm shuts down if price of output falls below
  average variable cost
• Firm exits if price of output falls below average
  cost

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Competitive Industry in the LR

• Firms that wish to enter or exit the market can
  do so in the LR
• Link between entry and exit and industrys LR
  supply curve
• LR competitive equilibrium

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Zero Profit Condition

• Laverne and Shirley
• Economic versus accounting profit
• Newspaper carrier versus lemonade stand
• All firms earn zero economic profit in the LR
• All firms equally efficient
• Firms produce at the lowest possible average cost

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Industrys LR Supply Curve

• All firms identical
• Industry supply curve flat at the break-even
  price
• Break-even price and the LR supply
• Break-even price (P AC) at which a seller earns
  zero profit
• Changes if anything changes costs
• P gt AC, firm earns positive profit
• Remains in industry
• P lt AC, firm earns negative profit
• Leaves industry
• LR supply curve identical with part of firms
  LRMC curve that lies above its LRAC curve

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Flat LR Supply Curve

• Flatness based on entry and exit
• P lt AC, all firms exit
• P gt AC, unlimited number of firms enter
• LR zero profit equilibrium almost never reached
• Demand and cost curves shift so often that entry
  and exit never settles down
• Approximation to the truth

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Equilibrium

• LR same as SR between firm and industry
• Market price determined by intersection of
  industrywide demand and supply
• Firms face flat demand curves at market price
• Analysis of changes to equilibrium
• Changes in FC
• Changes in VC
• Changes in demand

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Application Government as a Supplier

• In SR, government policy to build and operate
  apartment complex increasing housing
• LR supply curve does not shift
• Determined by break-even price
• Number of privately owned apartments withdrawn
  from the market equals number of apartments built
  by government

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Relaxing the Assumptions

• Assumption 1 All firms are identical, have
  identical cost curves
• True in industries that do not require unusual
  skills
• Assumption 2 Cost curves do not change as
  industry expands or contracts
• True in industries not large enough to affect
  input prices
• Without these assumptions, all firms do not have
  the same break-even price

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Relaxing the Assumptions Continued

• Constant cost industry
• Satisfies assumptions
• Increasing cost industry
• Break-even price for new entrants increases as
  industry expands
• Assumption 1 violated Less-efficient firms
• Assumption 2 violated Factor-price effect
• LR industry supply curve slopes upward
• Decreasing cost industry
• Break-even price for new entrants decreases as
  industry expands
• LR industry supply curve slopes downward

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Using the Competitive Model

• Fundamentals of competitive analysis
• Industry versus firm demand and supply
• SR versus LR
• Entry and exit decisions