Firms in Competitive Markets

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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.

CHAPTER 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

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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 givenlike the weatherand charges that price.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Total Revenue of a Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR = P Q
We saw this in Chapters 5 and 13

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Average Revenue of a Competitive Firm

Total revenue Average Revenue = Quantity Price Quantity Quantity Price Average revenue is the revenue per unit sold
P = AR. This is simply because all units sold are sold at the same price.
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Marginal Revenue of a Competitive Firm Marginal Revenue is the increase () in total revenue when an additional unit is sold. MR = TR / Q

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

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

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

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

Note: (a) P = AR = MR 9 (b) P does not fall as Q increases

Demand curves for the firm and the market (industry)

Jones and Peters, a firm Price Price

Market

Demand, P = AR = MR

Demand, P = AR 0

Quantity (firm)

Quantity (market)

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.

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 10 demanded.

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
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

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.

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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
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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.
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The Firms 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 firms decision on whether to stay open or shut down
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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.

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The Firms Short-Run Decision to Shut 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 paidbecause it is sunk!and the loss will then be even higher, $400 per month.

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The Firms Short-Run Decision to Shut Down

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

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The Firms Short-Run Decision to Shut Down 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.

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A Firms Shut Down Decision

$

The firm stays open because P > Minimum AVC

AVC
PH

Minimum AVC PL 0 The firm shuts down because P < Minimum AVC

Minimum AVC

Quantity
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Table 2 Profit Maximization: A Numerical Example

Is it possible to figure out the profitmaximizing output from just the MR and MC numbers?

Yes, it is where MR = MC.

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Figure 1 Profit Maximization for a Competitive Firm

Costs and Revenue 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.

The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.

MC

MC2

ATC
P = MR1 = MR2 AVC Therefore, P = AR = MR = MC is the fingerprint of perfect competition P = AR = MR

MC1

CHAPTER 14

Q1

QMAX

Q2

Quantity
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PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS 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

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PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS SUPPLY CURVE When MR > MC increase Q When MR < MC decrease Q When MR = MC Profit is maximized; stick with this Q.

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Recall: The Supply Curve

Price

Supply
P2

P1

Q1

Q2

Quantity

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Figure 2 Marginal Cost as the Competitive Firms Supply Curve

Price
This section of the firms MC curve is also the firms supply curve.

MC

P2

ATC

P1
AVC

Q1

Q2

Quantity

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Figure 3 The Competitive Firms Short Run Supply Curve

Costs If P > ATC, the firm will continue to produce at a profit. Firms short-run supply curve MC

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

AVC

Firm shuts down if P < AVC 0

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

What can shift the supply curve to the right?

Quantity
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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.

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Figure 6 Market Supply with a Fixed Number of Firms

(a) Individual Firm Supply Price Price

(b) Market Supply (# of firms fixed)

MC

Supply
$2.00

$2.00

1.00

1.00

100

200

Quantity (firm)

100,000

200,000 Quantity (market)

Q: What is the number of firms?

29 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Short-Run Equilibrium: back where we began!

(a) Individual Firm Supply Price Price

(b) Market Supply (# of firms fixed)

MC

Supply
$2.00

$2.00

1.00

1.00 DemandH

DemandL 0 100 200 Quantity (firm) 0 100,000

200,000 Quantity (market)

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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

THE LONG RUN

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The Firms 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.

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The Firms 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

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Entry and Exit of Firms in the Long-Run

$ The number of firms will stabilize when P = Minimum ATC. This is the long run price! New firms will enter because P > Minimum ATC ATC PH Minimum ATC Minimum ATC This is the efficient scale output. This is each firms long-run equilibrium output!

PL 0

Existing firms will exit because P < Minimum ATC

Quantity
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Figure 4 The Competitive Firms Long-Run Supply Curve

Costs Firms long-run supply curve MC = long-run S

Firm enters if P > ATC

ATC

Firm exits if P < ATC

0
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Quantity
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THE SUPPLY CURVE IN A COMPETITIVE MARKET

A Firms Short-Run Supply Curve
The portion of its (short run) marginal cost curve that lies above the (short run) average variable cost curve.
MC ATC AVC

A Firms Long-Run Supply Curve

The portion of its (long run) marginal cost curve that lies above the (long run) average total cost curve.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

ATC

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Long-Run Equilibrium
Price Price

ATC

Market Demand

$1.50

P = Minimum ATC = $1.50

200 (efficient scale)

Quantity (firm)

6,000 Quantity (industry) P = AR = MR = MC = ATC is the fingerprint of perfect competition in the long run.
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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?

A Firms 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

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Figure 5 Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits Price MC Profit P ATC

ATC

P = AR = MR

Quantity Q (profit-maximizing quantity)

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Figure 5 Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses Price

MC

ATC

ATC P Loss P = AR = MR

Q CHAPTER 14 FIRMS IN COMPETITIVE MARKETS (loss-minimizing quantity)

Quantity
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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.

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Figure 7 Market Supply with Entry and Exit

(a) Firms Zero-Profit Condition Price Price

(b) Market Supply (# of firms variable)

MC ATC P = minimum ATC Supply

Quantity (firm)

Quantity (market)

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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, dont feel sorry for the owners!
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Recap: Economic and Accountants

How an Economist Views a Firm How an Accountant Views a Firm

Economic profit Accounting profit Implicit costs Total opportunity costs Explicit costs Explicit costs

Revenue

Revenue

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

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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 firms output is unchanged, the number of firms increases, industry output increases. 46

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

(a) Initial zero-profit long-run equilibrium

Firm Price Price Market

MC

ATC A P1

Short-run supply, S1 Long-run supply Demand, D1

P1

q1

Quantity (firm)

Q1

Quantity (market)

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

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

Price

Price

Profit P2 P1

MC

ATC P2 A P1

S1

D2 D1 0 q1 q2 Quantity (firm) 0 Q1 Q2

Long-run supply

Quantity (market)

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

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

MC P1

ATC P2 A P1

S1 S2 C D2 D1 Long-run supply

q1

Quantity (firm)

Q1

Q2

Q3 Quantity (market)

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 firms output will return to q1. The only long-run effect 49 of demand will be to increase the number of firms.

Any Questions?

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

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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 firms average revenue and its marginal revenue.

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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 firms marginal cost curve is its supply curve.

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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.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

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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