14 Firms Competitive
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1414Firms in Competitive Markets
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.
2CHAPTER 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’
3CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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 given—like the weather—and charges that price.
4CHAPTER 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 TR = P Q Q
• We saw this in Chapters 5 and 13We saw this in Chapters 5 and 13
5CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Average Revenue of a Competitive Firm
• Average revenue is the revenue per unit sold • P = AR.• This is simply because all units sold are sold at the
same price.
A v erag e R ev en u e =T o ta l rev en u e
Q u an tity
P rice Q u an tity
Q u an tity
P rice
6
Marginal Revenue of a Competitive Firm
• Marginal Revenue is the increase (Δ) in total revenue when an additional unit is sold.
MRMR = = TRTR / / QQ
7CHAPTER 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
8CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Table 1 Total, Average, and Marginal Revenue for a Competitive Firm
Note: (a) P = AR = MR(b) P does not fall as Q increases
9
Demand curves for the firm and the market (industry)
Jones and Peters, a firm
Quantity (firm)0
Price
Market
Quantity (market)
Price
0
Demand, P = AR
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 demanded.
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.
Demand, P = AR = MR
10
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
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 11
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.
12CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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
13CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
THE FIRM AND THE INDUSTRY IN THE SHORT RUN
14
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.
15CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firm’s 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 firm’s decision on
whether to stay open or shut down
16CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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.
17CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firm’s 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 paid—because it is sunk!—and the loss will then be even higher, $400 per month.
18CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firm’s 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 …19CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firm’s 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.
20CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
A Firm’s Shut Down Decision
Quantity
AVC
0
$
The firm shuts down because P < Minimum AVC
The firm stays open because P > Minimum AVC
Minimum AVC Minimum AVC
PH
PL
21
Table 2 Profit Maximization: A Numerical Example
Is it possible to figure out the profit-maximizing output from just the MR and MC numbers?
Yes, it is where MR = MC.
22
Figure 1 Profit Maximization for a Competitive Firm
Quantity0
Costsand
Revenue
MC
ATC
AVC
MC1
Q1
MC2
Q2
The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.
QMAX
P = MR1 = MR2 P = AR = MR
23CHAPTER 14
Therefore, P = AR = MR = MC is the fingerprint of perfect competition
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.
PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S 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
24CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
• When MR > MC increase Q• When MR < MC decrease Q• WhenWhen MR = MC MR = MC Profit is maximized; Profit is maximized;
stick with this stick with this Q.Q.
25CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Recall: The Supply Curve
Quantity0
Price
Supply
P1
Q1
P2
Q2 26
Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve
Quantity0
Price
MC
ATC
AVC
P1
Q1
P2
Q2
This section of thefirm’s MC curve isalso the firm’s supplycurve.
27
Figure 3 The Competitive Firm’s Short Run Supply Curve
MC
Quantity
ATC
AVC
0
Costs
Firmshutsdown ifP< AVC
Firm’s short-runsupply curve
If P > AVC, firm will continue to produce in the short run.
If P > ATC, the firm will continue to produce at a profit.
28CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
What can shift the supply curve to the right?
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.
29CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply
Quantity (firm)0
Price
MC
1.00
100
$2.00
200
(b) Market Supply (# of firms fixed)
Quantity (market)0
Price
Supply
1.00
100,000
$2.00
200,000
Q: What is the number of firms?
30CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Short-Run Equilibrium: back where we began!
(a) Individual Firm Supply
Quantity (firm)0
Price
MC
1.00
100
$2.00
200
(b) Market Supply (# of firms fixed)
Quantity (market)0
Price
Supply
1.00
100,000
$2.00
200,000
31CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
DemandL
DemandH
THE LONG RUN
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
32
The Firm’s 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.
33CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firm’s 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
34CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Entry and Exit of Firms in the Long-Run
Quantity
ATC
0
$
Minimum ATC Minimum ATC
Existing firms will exit because P < Minimum ATC
The number of firms will stabilize when P = Minimum ATC. This is the long run price!
New firms will enter because P > Minimum ATC
PH
PL
35
This is the efficient scale output. This is each firm’s long-run equilibrium output!
Figure 4 The Competitive Firm’s Long-Run Supply Curve
MC = long-run S
Firmexits ifP < ATC
Quantity
ATC
0
CostsFirm’s long-runsupply curve
Firmenters ifP > ATC
36CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
ATC
THE SUPPLY CURVE IN A COMPETITIVE MARKET
• A Firm’s Short-Run Supply Curve• The portion of its (short run)
marginal cost curve that lies above the (short run) average variable cost curve.
• A Firm’s Long-Run Supply Curve• The portion of its (long run)
marginal cost curve that lies above the (long run) average total cost curve.
37CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
MC
ATC
AVC
Long-Run Equilibrium
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? 38
ATC
PricePrice
Quantity (industry)
Quantity (firm)
6,000200 (efficient
scale)
$1.50$1.50 P = Minimum ATC =
Market Demand
P = AR = MR = MC = ATC is the fingerprint of perfect competition in the long run.
A Firm’s 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
39CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 5 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
40
Figure 5 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
41CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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.
42CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 7 Market Supply with Entry and Exit
(a) Firm’s Zero-Profit Condition
Quantity (firm)0
Price
(b) Market Supply (# of firms variable)
Quantity (market)
Price
0
P = minimumATC
Supply
MC
ATC
43CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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, don’t feel sorry for the owners!44
Recap: Economic and Accountants
Revenue
Totalopportunitycosts
How an EconomistViews a Firm
How an AccountantViews a Firm
Revenue
Economicprofit
Implicitcosts
Explicitcosts
Explicitcosts
Accountingprofit
45
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Application
• We will now work through what happens when the demand for a product increases.
46
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 firm’s output is unchanged, the number of firms increases, industry output increases.
47
Figure 8 An Increase in Demand in the Short Run and Long Run
Firm
(a) Initial zero-profit long-run equilibrium
Quantity (firm)0
Price
Market
Quantity (market)
Price
0
DDemand, 1
SShort-run supply, 1
P1
ATC
Long-runsupply
P1
1Q
A
MC
q1
48CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 8 An Increase in Demand in the Short Run and Long Run
MarketFirm
(b) Short-Run Response to an increase in demand
Quantity (firm)0
Price
MC ATCProfit
P1
Quantity (market)
Long-runsupply
Price
0
D1
D2
P1
S1
P2
Q1
A
Q2
P2
B
q1 q2
49CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 8 An Increase in Demand in the Short Run and Long Run
P1
Firm
Quantity (firm)0
Price
MC ATC
Market
Quantity (market)
Price
0
P1
P2
Q1 Q2
Long-runsupply
B
D1
D2
S1
A
S2
Q3
C
(c) Long-Run Response to positive short-run profits: new firms enter, pushing the short-run market supply to the right.
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 firm’s output will return to q1. The only long-run effect of demand will be to increase the number of firms.
q1
50
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Any Questions?
51
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 firm’s average revenue and its marginal revenue.
52CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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 firm’s marginal cost curve is its supply curve.
53CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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.
54CHAPTER 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.
55CHAPTER 14 FIRMS IN COMPETITIVE MARKETS