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Chapter 14 notesWHAT IS A COMPETITIVE MARKET?A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker.Buyers and sellers must accept the price determined by the market.A perfectly competitive market has the following characteristics:There are many buyers and sellers in the market.The goods offered by the various sellers are largely the same.Firms can freely enter or exit the market.

Perfectly Competitive MarketAs a result of its characteristics, the perfectly competitive market has the following outcomes:The actions of any single buyer or seller in the market have a negligible impact on the market price.Each buyer and seller takes the market price as given. The Revenue of a Competitive FirmTotal 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 tells us how much revenue a firm receives for the typical unit sold.Average revenue is total revenue divided by the quantity sold.

The Revenue of a Competitive FirmIn perfect competition, average revenue equals the price of the good.

The Revenue of a Competitive FirmMarginal revenue is the change in total revenue from an additional unit sold.MR =TR/QFor competitive firms, marginal revenue equals the price of the good.

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

Profit MaximizationProfit maximization occurs at the quantity where marginal revenue equals marginal cost.When MR > MC, increase QWhen MR < MC, decrease QWhen MR = MC, profit is maximized.Table 2 Profit Maximization: A Numerical Example

Figure 1 Profit Maximization for a Competitive FirmQuantity0CostsandRevenueMCATCAVCMC1Q1MC2Q2The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.QMAX P = MR1 = MR2 P = AR = MRIf the firm produces Q1, marginal cost is MC1.If the firm produces Q2, marginal cost is MC2.Suppose the market price is P.MC curve as the Supply curveBecause the marginal-cost curve determines the Q of the good the firm is willing to supply at any price, the MC curve is also the competitive firms supply curveFigure 2 Marginal Cost as the Competitive Firms Supply CurveQuantity0PriceMCATCAVCP1Q1P2Q2So, this section of thefirms MC curve isalso the firms supplycurve.As P increases, the firm will select its level of output along the MC curve.The Firms Short-Run Decision to Shut DownA shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.The firm shuts down if the revenue it gets from producing is less than the variable cost of production.Shut down if TR < VCShut down if TR/Q < VC/QShut down if P < AVC

Sunk costs have already been committed and cant be recovered (fixed costs) So, we ignore these costs in the short run.Firms short run S curve = MC curve ABOVE AVCFigure 3 The Competitive Firms Short-Run Supply CurveMCQuantityATCAVC0CostsFirmshutsdown ifP AVC, firm will continue to produce in the short run.If P > ATC, the firm will continue to produce at a profit.The Firms Long-Run Decision to Exit or Enter a MarketIn the long run, the firm exits if the revenue it would get from producing is less than its total cost.Exit if TR < TCExit if TR/Q < TC/QExit if P < ATCThe Firms Long-Run Decision to Exit or Enter a MarketA firm will enter the industry if such an action would be profitable. Enter if TR > TCEnter if TR/Q > TC/QEnter if P > ATCFigure 4 The Competitive Firms Long-Run Supply CurveMC = long-run SFirmexits ifP < ATC QuantityATC0CostsFirms long-runsupply curveFirmenters ifP > ATC THE SUPPLY CURVE IN A COMPETITIVE MARKETShort-Run Supply CurveThe portion of its marginal cost curve that lies above average variable cost.Long-Run Supply CurveThe marginal cost curve above the minimum point of its average total cost curve.Market supply equals the sum of the quantities supplied by the individual firms in the market.

Measuring Profit in Our Graph for the Competitive FirmProfit = TR TCProfit = (TR/Q TC/Q) x QProfit = (P ATC) x QFigure 5 Profit as the Area between Price and Average Total Cost(a) A Firm with ProfitsQuantity0PriceP = AR = MRATCMCPATCQ(profit-maximizing quantity)ProfitFigure 5 Profit as the Area between Price and Average Total Cost(b) A Firm with LossesQuantity0PriceATCMC(loss-minimizing quantity)P = AR = MRPATCQLossThe Short Run: Market Supply with a Fixed Number of FirmsFor any given price, each firm supplies a quantity of output so that its marginal cost equals price. The market supply curve reflects the individual firms marginal cost curves. Figure 6 Short-Run Market Supply(a) Individual Firm SupplyQuantity (firm)0PriceMC1.00100$2.00200(b) Market SupplyQuantity (market)0PriceSupply1.00100,000$2.00200,000If the industry has 1000 identical firms, then at each market price, industry output will be 1000 times larger than the representative firms output.The Long Run: Market Supply with Entry and ExitFirms will enter or exit the market until profit is driven to zero.The process of entry and exit ends only when price and average total cost are driven to equality.At the end of the process of entry and exit, firms that remain must be making zero economic profit.In the long run, price equals the minimum of average total cost or the efficient scaleThe long-run market supply curve is horizontal at this price.Long-run equilibrium must have firms operating at their efficient scale.

Figure 7 Long-Run Market Supply(a) Firms Zero-Profit ConditionQuantity (firm)0Price(b) Market SupplyQuantity (market)Price0P = minimumATCSupplyMCATCWhy Do Competitive Firms Stay in Business If They Make Zero Profit?Profit equals total revenue minus total cost.Total cost includes all the opportunity costs of the firm.In the zero-profit equilibrium, the firms revenue compensates the owners for the time and money they expend to keep the business going.Also, remember that economists and accountants see profit differently.So, even when economic profit is 0, accounting profit is positiveA Shift in Demand in the Short Run and Long RunAn increase in demand raises price and quantity in the short run.Firms earn profits because price now exceeds average total cost.Figure 8 An Increase in Demand in the Short Run and Long RunFirm(a) Initial ConditionQuantity (firm)0PriceMarketQuantity (market)Price0DDemand, 1SShort-run supply, 1P1ATCLong-runsupplyP11QAMCA market begins in long run equilibrium.And firms earn zero profit.Figure 8 An Increase in Demand in the Short Run and Long RunMarketFirm(b) Short-Run ResponseQuantity (firm)0PriceP1Quantity (market)Long-runsupplyPrice0D1D2P1S1P2Q1AQ2P2BATCMCAn increase in market demandraises price and output.The higher P encourages firms to produce moreand generates short-run profit.Figure 8 An Increase in Demand in the Short Run and Long RunP1Firm(c) Long-Run ResponseQuantity (firm)0PriceMCATCMarketQuantity (market)Price0P1P2Q1Q2Long-runsupplyBD1D2S1AS2Q3CProfits induce entry and market supply increases.The increase in supply lowers market price.In the long run market price is restored, but market supply is greater.Why the Long-Run Supply Curve Might Slope UpwardSome resources used in production may be available only in limited quantities.Firms may have different costs.Marginal FirmThe marginal firm is the firm that would exit the market if the price were any lower.This firm earns 0 profit, but firms with lower costs earn positive profit even in the long runSo, the LR supply curve may be upward sloping, indicating that a higher price is necessary to induce a larger Qs. But, because firms can enter and exit more easily in the long run than in the short run, the LR supply curve is typically more elastic than the SR supply curve.