FIRMS IN COMPETITIVE MARKETS

1
FIRMS IN COMPETITIVE MARKETS

• Chapter 14

2
The Meaning of Competition

• A perfectly competitive market has the following
  characteristics
• ä There are many buyers and sellers in the
  market.
• ä The goods offered by the various sellers are
  largely the same.
• ä Firms can freely enter or exit the market.

3
The Meaning of Competition

• A perfectly competitive market has the following
  outcomes
• ä The individual firm produces a small portion
  of total market output.
• ä The firm cannot have any influence over the
  price it charges.

4
The Meaning of Competition

• The individual firm in a perfectly competitive
  market is a price taker.
• ä It takes the price determined by the market
  as the price that it will receive for its output.

5
Revenue of a Competitive Firm

• Total revenue for a firm is the selling price
  times the quantity sold.
• TR (P X Q)

6
Revenue of a Competitive Firm

• Total revenue is proportional to the amount of
  output.

7
Revenue of a Competitive Firm

• Average revenue tells us how much revenue a firm
  receives for the typical unit sold.

8
Revenue of a Competitive Firm

• In perfect competition, average revenue equals
  the price of the good.

9
Revenue of a Competitive Firm

• In perfect competition, average revenue equals
  the price of the good.

10
Revenue of a Competitive Firm

• Marginal revenue is the change in total revenue
  from an additional unit sold.
• MR DTR/DQ

11
Revenue of a Competitive Firm

• For competitive firms, marginal revenue equals
  the price of the good.

12
Quick Quiz!

• When a competitive firm doubles the amount it
  sells, what happens to the price of its output
  and its total revenue?

13
Profit Maximization for the Competitive Firm

• The goal of a competitive firm is to maximize
  profit.
• ä This means that the firm will want to
  produce the quantity that maximizes the
  difference between total revenue and total
  cost.

14
Profit Maximization for the Competitive Firm

• Profit maximization occurs at the quantity where
  marginal revenue equals marginal cost.
• If MR gt MC, increase Q to increase profit.
• If MR lt MC, decrease Q to increase profit.
• If MR MC, profit is maximized.

15
Profit Maximization for the Competitive Firm
0
Quantity
16
Profit Maximization for the Competitive Firm
ATC
AVC
0
Quantity
17
Profit Maximization for the Competitive Firm
MC
ATC
AVC
0
Quantity
18
Profit Maximization for the Competitive Firm
MC
ATC
P
P AR MR
AVC
0
Quantity
19
Profit Maximization for the Competitive Firm
The firm maximizes profit by producing the
quantity at which marginal cost equals marginal
revenue.
MC
ATC
P
P AR MR
AVC
0
QMAX
Quantity
20
Profit Maximization for the Competitive Firm

• A competitive firm will adjust its production
  level until quantity reaches QMAX where profit is
  maximized.

21
Profit Maximization for the Competitive Firm
MC
ATC
P
P AR MR
AVC
0
QMAX
Quantity
22
Profit Maximization for the Competitive Firm
MC
ATC
P MR1
P AR MR
AVC
MC1
0
Q1
QMAX
Quantity
23
Profit Maximization for the Competitive Firm
MC
ATC
P MR1
P AR MR
AVC
MC1
MR gt MC, increase Q
0
Q1
QMAX
Quantity
24
Profit Maximization for the Competitive Firm
MC
MC2
ATC
P MR2
P AR MR
AVC
0
Q2
QMAX
Quantity
25
Profit Maximization for the Competitive Firm
MC
MC2
ATC
P MR2
P AR MR
AVC
MR lt MC, decrease Q
0
Q2
QMAX
Quantity
26
The Firms Decision to Shut Down

• A shutdown refers to a short-run decision not to
  produce anything during a specific period of
  time.
• Exit refers to a long-run decision to leave the
  market.

27
The Firms Decision to Shut Down

• The firm considers its sunk costs when deciding
  to exit, but ignores them when deciding whether
  to shut down.
• ä Sunk costs are costs that have already been
  committed and cannot be recovered.

28
The Firms Decision to Shut Down

• The firm shuts down if the revenue it gets from
  producing is less than the variable cost of
  production.
• Shut down if TR lt VC
• Shut down if TR/Q lt VC/Q
• Shut down if P lt AVC

29
The Firms Decision to Shut Down
Costs
Quantity
0
30
The Firms Decision to Shut Down
Costs
MC
ATC
AVC
Quantity
0
31
The Firms Decision to Shut Down
Costs
If P gt ATC, keep producing at a profit.
MC
ATC
AVC
Quantity
0
32
The Firms Decision to Shut Down
Costs
If P gt ATC, keep producing at a profit.
MC
ATC
If P gt AVC, keep producing in the short run.
AVC
Quantity
0
33
The Firms Decision to Shut Down
Costs
If P gt ATC, keep producing at a profit.
MC
ATC
If P gt AVC, keep producing in the short run.
AVC
If P lt AVC, shut down.
Quantity
0
34
The Firms Decision to Shut Down

• The portion of the marginal-cost curve that lies
  above average variable cost is the competitive
  firms short-run supply curve.

35
The Firms Decision to Shut Down
Costs
If P gt ATC, keep producing at a profit.
MC
ATC
If P gt AVC, keep producing in the short run.
AVC
If P lt AVC, shut down.
Quantity
0
36
The Firms Decision to Shut Down
Costs
MC
ATC
AVC
Quantity
0
37
The Long-Run Decision to Exit an Industry

• In the long-run, the firm exits if the revenue it
  would get from producing is less than its total
  cost.
• Exit if TR lt TC
• Exit if TR/Q lt TC/Q
• Exit if P lt ATC

38
The Long-Run Decision to Enter an Industry

• A firm will enter the industry if such an action
  would be profitable.
• Enter if TR gt TC
• Enter if TR/Q gt TC/Q
• Enter if P gt ATC

39
The Competitive Firms Long-Run Supply Curve
40
The Competitive Firms Long-Run Supply Curve
Costs
Quantity
0
41
The Competitive Firms Long-Run Supply Curve
Costs
MC
ATC
AVC
Quantity
0
42
The Competitive Firms Long-Run Supply Curve
Costs
MC
Firm enters if P gt ATC
ATC
AVC
Quantity
0
43
The Competitive Firms Long-Run Supply Curve
44
The Competitive Firms Long-Run Supply Curve

• The competitive firms long-run supply curve is
  the portion of its marginal-cost curve that lies
  above average total cost.

45
The Competitive Firms Long-Run Supply Curve
46
The Competitive Firms Long-Run Supply Curve
Costs
MC
ATC
AVC
Quantity
0
47
The Firms Short-Run and Long-Run Supply Curves

• Short-Run Supply Curve
• ä The portion of its marginal cost curve that
  lies above average variable cost.
• Long-Run Supply Curve
• ä The marginal cost curve above the minimum
  point of its average total cost curve.

48
Profit as the Area Between Price and Average
Total Cost
49
Profit as the Area Between Price and Average
Total Cost
Price
Quantity
0
50
Profit as the Area Between Price and Average
Total Cost
Price
ATC
MC
Quantity
0
51
Profit as the Area Between Price and Average
Total Cost
Price
ATC
MC
P
P AR MR
Quantity
0
52
Profit as the Area Between Price and Average
Total Cost
Price
ATC
MC
P
P AR MR
ATC
Profit-maximizing quantity
Quantity
0
Q
53
Profit as the Area Between Price and Average
Total Cost
Price
ATC
MC
Profit
P
P AR MR
ATC
Profit-maximizing quantity
Quantity
0
Q
54
Loss as the Area Between Price and Average Total
Cost
55
Loss as the Area Between Price and Average Total
Cost
Price
ATC
MC
Quantity
0
56
Loss as the Area Between Price and Average Total
Cost
Price
ATC
MC
P
P AR MR
Quantity
0
57
Loss as the Area Between Price and Average Total
Cost
Price
ATC
MC
ATC
P
P AR MR
Loss-minimizing quantity
Quantity
0
Q
58
Loss as the Area Between Price and Average Total
Cost
Price
ATC
MC
ATC
P
P AR MR
Loss
Loss-minimizing quantity
Quantity
0
Q
59
Quick Quiz!

• How does the price faced by a profit-maximizing
  competitive firm compare to its marginal cost?

60
Quick Quiz!

• When will a profit-maximizing firm decide to shut
  down?

61
Supply in a Competitive Market

• Market supply equals the sum of the quantities
  supplied by the individual firms in the market.

62
Supply in a Competitive Market

• Market Supply with a Fixed Number of Firms
• ä For any given price, each firm supplies a
  quantity of output so that price equals its
  marginal cost.
• ä The market supply curve reflects the
  individual firms marginal cost curves.

63
Supply in a Competitive Market

• Market Supply with Entry and Exit
• ä Firms will enter or exit the market until
  profit is driven to zero.
• ä In the long-run, price equals the minimum
  of average total cost.
• ä The long-run market supply curve is
  horizontal at this price.

64
The Supply Curve in a Competitive Market
(a) Firms Zero-Profit Condition
(b) Market Supply
Price
Price
MC
ATC
P minimum ATC
Supply
Quantity (firm)
0
Quantity (market)
0
65
Increase in Demand in the Short Run

• An increase in demand raises price and quantity
  in the short run.
• Firms earn profits because price now exceeds
  average total cost.

66
Initial Condition
Market
Firm
Price
Price
Quantity (firm)
0
Quantity (market)
0
67
Initial Condition
Market
Firm
Price
Price
ATC
S
MC
1
A
Long-run supply
P1
P1
D1
Quantity (firm)
0
Quantity (market)
0
Q1
68
Short-Run Response
Market
Firm
Price
Price
B
S
ATC
MC
1
A
Long-run supply
P1
P1
P1
D
2
D
1
Quantity (firm)
0
Quantity (market)
0
Q1
69
Short-Run Response
Market
Firm
Price
Price
ATC
S
MC
B
1
P2
P2
A
Long-run supply
P1
P1
D
2
D
1
Quantity (firm)
0
Quantity (market)
0
Q1
Q2
70
Short-Run Response
Market
Firm
Price
Price
Profit
ATC
S
MC
B
1
P2
P2
A
Long-run supply
P1
P1
D
2
D
1
Quantity (firm)
0
Quantity (market)
0
Q1
Q2
71
Increase in Demand in the Long Run

• Over time, the short-run supply curve shifts as
  profits encourage new firms to enter the market.

72
Increase in Demand in the Long Run

• Price falls as new firms enter the market.

73
Increase in Demand in the Long Run

• In the new long-run equilibrium profits return to
  zero and price returns to minimum average total
  cost.

74
Increase in Demand in the Long Run

• The market has more firms to satisfy the greater
  demand.

75
Long-Run Response
Market
Firm
Price
Price
Profit
ATC
S
MC
B
1
P2
P2
A
Long-run supply
P1
P1
D
2
D
1
Quantity (firm)
0
Quantity (market)
0
Q1
Q2
76
Long-Run Response
Market
Firm
Price
Price
Profit
ATC
S1
MC
B
P2
P2
S2
A
Long-run supply
P1
P1
D2
D1
Quantity (firm)
0
Quantity (market)
0
Q1
Q2
77
Long-Run Response
Market
Firm
Price
Price
ATC
S1
MC
B
P2
S2
A
Long-run supply
P1
P1
D2
D1
Quantity (firm)
0
Quantity (market)
0
Q1
Q2
78
Increase in Demand in the Short and Long Run
Market
Firm
Price
Price
ATC
S1
MC
B
S2
A
C
Long-run supply
P1
P1
D2
D1
Quantity (firm)
0
Quantity (market)
0
Q1
Q2
Q3
79
Why the Long-Run Supply Curve Might Slope Upward

• Some resources used in production may be
  available only in limited quantities.
• Firms may have different costs.

80
Conclusion

• 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 firms
  average revenue and its marginal revenue

81
Conclusion

• To maximize profit a firm chooses the quantity of
  output where marginal revenue equals marginal
  cost.
• This is also the quantity at which price equals
  marginal cost.

82
Conclusion

• In the short run, the firm will choose to shut
  down temporarily if the price of the good is less
  than average variable cost.
• In the long run, it will choose to exit if the
  price is less than average total cost.

83
Conclusion

• If firms can freely enter and exit the market,
  the price also equals the lowest possible average
  total cost of production in the long run.
• The number of firms adjusts to drive the market
  back to the zero-profit equilibrium.

84
Conclusion

• Because firms can enter and exit more easily in
  the long run than the short run, the long-run
  supply curve is typically more elastic than the
  short-run supply curve.

85
FIRMS IN COMPETITIVE MARKETS

• End of Chapter 14

86
(No Transcript)
87
Figure 14-1
88
Price
MC
P2
ATC
P1
AVC
Q1
Q2
Quantity
0
Figure 14-2
89
Figure 14-3
90
Figure 14-4
91
(a) A Firm with Profits
Figure 14-5a
92
(b) A Firm with Losses
Figure 14-5b
93
(a) Individual Firm Supply
(b) Market Supply
Price
Price
MC
Supply
2.00
2.00
1.00
1.00
Quantity (firm)
0
100
200
Quantity (market)
0
100,000
200,000
Figure 14-6
94
(a) Firm
s Zero-Profit Condition
(b) Market Supply
Price
Price
MC
ATC
P
P minimum
Supply
ATC
Quantity (firm)
0
Quantity (market)
0
Figure 14-7
95
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
Short-run supply
A
Long-run
P
P
P
P
1
1
supply
Demand
Quantity (firm)
0
Quantity (market)
0
Q
1
(b) Short-Run Response
Market
Firm
Price
Price
Profit
B
MC
ATC
S
1
P
P
2
2
A
P
Long-run
P
1
supply
1
D
2
D
1
Quantity (firm)
0
Quantity (market)
0
Q
Q
1
2
(c) Long-Run Response
Firm
Market
Price
Price
S
MC
1
ATC
B
S
P
2
2
C
A
P
Long-run
P
1
1
supply
D
2
D
1
Quantity (firm)
0
Q
Q
Quantity (market)
0
Q
1
2
3
Figure 14-8
96
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
Short-run supply, S1
A
Long-run supply
P1
P
P1
P
Demand, D1
0
0
Q1
Quantity (market)
Quantity (firm)
Figure 14-8a
97
(b) Short-Run Response
Figure 14-8b
98
(c) Long-Run Response
Firm
Market
Price
Price
MC
S1
B
ATC
S2
P2
C
A
P1
P1
Long-run
supply
D2
D1
0
Q1
Q2
0
Q3
Quantity (firm)
Quantity (market)
Figure 14-8c