FIRMS IN COMPETITIVE MARKETS. What Is A Competitive Market? A perfectly competitive market has the...

FIRMS IN COMPETITIVE MARKETS

What Is A Competitive Market?

A perfectly competitive market has the following characteristics:

1) There are many buyers and sellers in the market.

2) The goods offered by the various sellers are the same (identical).

3) Firms can freely enter or exit the market.

4) Information is perfect. Buyers and sellers know all prices offered,...


As a result of these characteristics, the perfectly competitive market has the following outcomes:

The actions of any single buyer or seller in the market have no impact on the market price.Each buyer and seller takes the market price as given.

Ex: Gasoline, fish, eggs, pencils, tomatoes, etc.


Buyers and sellers must accept the price determined by the market. No single seller has market power (the power to influence the market price).

“Demand Faced By A Competitive Firm” versus “Market Demand”

Price

QTY (ones)

Pm

Demand faced by one competitive firm

Market Demand

Price

QTY (millions)

The Revenue of a Competitive Firm

Total revenue for a firm is the market price times the quantity sold.

TR = P TR = P Q Q

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

Copyright©2004 South-Western


Marginal revenue is the change in total revenue when an additional unit is sold.

MR =MR =TRTR / / QQ


1.Only in a competitive market, marginal revenue equals the price of the good. This is because a firm in a competitive market can sell as much as it wants at the constant market price.

2. If a monopolist or oligopolist sells more, this causes the price of the good to fall. Ex1: Think of crude oil price and OPEC. Ex2: Consider a downward sloping demand curve.

Profit Maximization and The Competitive Firm’s Supply Curve

The goal of a competitive firm is to maximize profit.

This means that the firm wants to produce the quantity that maximizes the difference between total revenue and total cost.

Table 2 Profit Maximization: A Numerical Example

Copyright©2004 South-Western

Profit Maximization and The Competitive Firm’s Supply Curve

Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

Profit Maximization And The Competitive Firm’s Supply Curve

When MR > MC, profit is increasing, so must produce more.

When MR < MC, profit is decreasing, so must produce less.

When MR = MC, profit is constant, so this is the point where profit is maximized..

Figure 1 Profit Maximization for a Competitive Firm

Copyright © 2004 South-Western

Quantity0

Costsand

Revenue

MC

MC1

Q1

MC2

Q2

The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.

QMAX

P = MR1 = MR2 P = AR = MR

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.

The Firm’s Short-Run Decision to Shut Down

A shutdown refers to a short-run decision to stop production temporarily because the firm’s revenue cannot even cover variable costs.

Exit refers to a long-run permanent decision to leave the market. A firm exits the market if it makes negative economic profit in the long-term.

The Firm’s Short-term Decision to Shut Down

The firm ignores its fixed costs (= sunk costs) when deciding to shut down or not in the short-term, but considers them when deciding whether to exit or not in the long-term.

Fixed costs are costs that have already been committed and cannot be recovered in the short-term. example: rent and lease contracts.

The Firm’s Short-Run Decision to Shut Down

The firm shuts down if its revenue is less than its variable costs:

Shut down if TR < VC– Shut down if TR / Q < VC / Q– Shut down if P < AVC

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.

The Firm’s Long-Run Decision to Exit or Enter a Market

In the long run, a firm exits the market if the profit is negative .

Exit if TR < TC

if TR/Q < TC/Q

if P < ATC

A new firm Enters the market if profit is positive, or if: P > ATC

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

THE SUPPLY CURVE IN A COMPETITIVE MARKET

The competitive firm’s long-run supply long-run supply curvecurve is the part of its marginal-cost curve that lies above average total cost.

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

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

FIRM VERSUS MARKET SUPPLY

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

The Short Run: Market Supply with a Fixed Number of Firms

For any given price, each firm supplies a quantity of output so that its marginal cost equals price.

The market supply curve adds up the individual firms’ marginal cost curves.

Figure 6: SR Market Supply with a Fixed Number of Firms


(a) Individual Firm Supply

Quantity (firm)0

Price

MC

1.00

100

$2.00

200

(b) Short Run Market Supply

Quantity (market)0

Price

Supply

1.00

100,000

$2.00

200,000

SR

The Long Run: Market Supply with Entry and Exit

Long run equilibrium is reached when there are no more entries or exits in the market. Firms will enter or exit the market until profit approaches to zero. Then long-run equilibrium happens when profit equals zero.Then at the long run equilibrium, price must be equal to the minimum of average total cost.

The Long Run: Market Supply with Entry and Exit

Then long-run market supply curve is horizontal at price = min(ATC).

At the long-run equilibrium, firms operate at their efficient scale (scale that minimizes ATC).

Figure 7 Market Supply with Entry and Exit


(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

(b) Long Run Market Supply

Quantity (market)

Price

0

P = minimumATC

Supply

MC

ATC

LR

SupplySR

DDemand, 1

Why Do Competitive Firms Stay in Business If They Make Zero Profit?

Remember that accounting (nominal) profit is positive even if economic profit is zero.The firm making zero economic profit means the firm is doing the best it can and there is no other alternative that will give better profit. If there was, current economic profit would be negative. See example in notes.

Exercise: A Shift in Demand and Short Run and Long Run

ConsequencesAn 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 Run

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P1

ATC

Long-runsupply

P1

1Q

A

MC



MarketFirm

(b) Short-Run Response

Quantity (firm)0

Price

MC ATCProfit

P1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S1

P2

Q1

A

Q2

P2

B



P1

Firm

(c) Long-Run Response

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

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