[Eng.economics] Lecture #9

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(ECEN 4503) Engineering EconomicsLecture #9:Firms in Competitive MarketsJune 06th 2015Lecturer: Nguyen Minh Y, Ph.D.Thai Nguyen UniversityThai Nguyen University of TechnologyFaculty of International TrainingReviewing6/4/2015Department of Electrical Engineering taught in English2Introduction 6/4/2015Department of Electrical Engineering taught in English3Competitive marketFirms in the market?Market power?

Firm behaviorHow firms make production decision in competitive market?Which types of cost are important:Fixed costsVariable costsAverage total costMarginal cost1. What is Competitive Market?6/4/2015Department of Electrical Engineering taught in English41.1 The meaning of competitionCompetitive market a market with many buyers and sellers trading identical products so that each buyer and seller is a price-taker.

Property of perfectly competitive marketMany buyers and sellersThe goods offered by the various sellers are largely the sameFirms can freely enter or exist the marketExample:Market for milk:Sellers: diary farmersBuyers: population1. What is Competitive Market?6/4/2015Department of Electrical Engineering taught in English51.2 The revenue of a competitive firmCompetitive firms:Objective of a competitive firmMaximize the profitProfit = Total revenue Total cost

Example: The Vaca Family Diary FarmPrice-takerTotal revenue = Price Quantity

Average revenue the total revenue divided by the quantity sold.Marginal revenue the change in total revenue from an additional unit sold.2. Profit Maximization and The Competitive Firms Supply Curve6/4/2015Department of Electrical Engineering taught in English62.1 An example of profit maximization (Vaca Diary Farm)Quantity (Q)Total revenue (TR)Total cost (TC)Profit (TR-TC)Marginal revenue (MR=TR/Q)Marginal cost (MC=TC/Q)Change in profit (MR-MC)0 gallons12345678$0612182430364248$358121723303847$314677641$66666666$23456789$432101232. Profit Maximization and The Competitive Firms Supply Curve6/4/2015Department of Electrical Engineering taught in English7Other way: Think at margin?Comparing marginal revenue and marginal cost?Quantity (Q)Total revenue (TR)Total cost (TC)Profit (TR-TC)Marginal revenue (MR=TR/Q)Marginal cost (MC=TC/Q)Change in profit (MR-MC)0 gallons12345678$0612182430364248$358121723303847$314677641$66666666$23456789$432101232. Profit Maximization and The Competitive Firms Supply Curve6/4/2015Department of Electrical Engineering taught in English8Think at margin?

If marginal revenue is greater than marginal costThe firm should increase its output.If marginal cost is greater than marginal revenueThe firm should decrease its output.Marginal revenue and marginal cost are exactly equalThe profit-maximizing level of outputProfit Maximization Problem6/4/2015Department of Electrical Engineering taught in English9General problemThere is a firm in competitive marketTotal costTC(Q)Market pricePrice-takerProblem is to determine the production (Q) to maximize the profit

Proof?

2. Profit Maximization and The Competitive Firms Supply Curve6/4/2015Department of Electrical Engineering taught in English102.2 The marginal-cost curve and the firms supply decisionCost curves

Because the firms marginal-cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firms supply curve.The marginal cost (MC) curve is upward sloping.The average total cost (ATC) curve is U-shaped.The market price is a horizontal line with the price P (i.e., price taker)2.3 The Firms Short-run Decision to Shut Down6/4/2015Department of Electrical Engineering taught in English11Some circumstance, the firm may decide to shut down?Temporary shut down a short-run decision not to produce anything during a specific period of time.Exist from the market a long-run decision to lease the market.

What cost incur with different shut down?Fixed costsE.g., farmer: Land for farmingVariable costsE.g., farmer: Fertilizer, pesticide, etc.

Sunk cost a cost that has already been committed and cannot be recovered.

2.3 The Firms Short-run Decision to Shut Down6/4/2015Department of Electrical Engineering taught in English12Some circumstance, the firm may decide to shut down?The firm shuts down if the revenue that it would get from producing is less than its variable costs of production.

Shut down if TR < VC

Or

Shut down if P < AVR

Price2.3 The Firms Short-run Decision to Shut Down6/4/2015Department of Electrical Engineering taught in English13Competitive firms short-run supply curvesThe competitive firms short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.

In the short run, the firm produces on the MC curve if P > AVC, but shuts down if P < AVC.

2.4 The Firms Long-term Decision to Shut Down6/4/2015Department of Electrical Engineering taught in English14Some circumstance, the firm may decide to shut down?The firm exist the market if the revenue it would get from producing is less than its total costs of production.

Exit if TR < TCOrShut down if P < ATC

That is the firm chooses to exit if the price of its good is less than the average total cost of production.

2.4 The Firms Long-term Decision to Shut Down6/4/2015Department of Electrical Engineering taught in English15A competitive firms long-run profit maximization strategy:If the firm is in the market, it produces the quantity at which marginal cost equals the price of the good.

MC = P

If the price is less than average total cost at that quantity, the firm chooses to exit the market.

P < ATC

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

2.5 Measuring Profit in Graph for the Competitive Firms6/4/2015Department of Electrical Engineering taught in English16The profit equal total revenue (TR) minus total cost (TC):

Profit = TR TC = (P ATC) Q

16Practice6/4/2015Department of Electrical Engineering taught in English17Ex3. Ball Bearing Inc. faces cost of production as follows:Calculate the companys average fixed cost, average variable cost, average total cost, and marginal cost.The price of a case of ball bearing is $50. Seeing that she cannot make a profit, the chief executive officer (CEO) decides to shut down operation. What are the firms profit/losses? Was this a wise decision? Explain.Vaguely remembering his introductory economics course, the Chief Financial Officer tell the CEO it is better to produce 1 case of ball bearing, because marginal revenue equals marginal cost at the quantity. What are the firms profit/losses at that level of production? Was this the best decision? Explain.QuantityTotal fixed costTotal variable cost0123456$100100100100100100100$05070901402003603. The Supply Curve in a Competitive Market6/4/2015Department of Electrical Engineering taught in English18Short term:It is difficult for new firms to enter or exit the marketMarket with fixed number of firmsLong-term:The number of firms can changeOld firms exit, new firms enter the market3.1 The Short-run: Market supply with fixed number of firmsEach firm supplies a quantity at which marginal cost (MC) equals the price (P)Quantity output of the market equals the sum of the quantities supplied by each individual firm.3. The Supply Curve in a Competitive Market6/4/2015Department of Electrical Engineering taught in English193.2 The Long-run: Market supply enter and exitSuppose that everyone has the same access toTechnology to produce goods and serviceInput for productions

The same cost curves.

If firms already in the market are profitableNew firms will have incentive to enter the marketThe number of firms increasesThe quantity supplied increasesThe marker price and profit reduce

3. The Supply Curve in a Competitive Market6/4/2015Department of Electrical Engineering taught in English203.2 The Long-run: Market supply enter and exitIf firms already in the market are losingSome firms will choose to exit the marketThe number of firms reducesThe quantity supplied reducesThe marker price and profit increase

At the end, firms that remains in the market must be making zero profit.Profit = (P ATC) Q

The price and average total cost are driven to equality.

3. The Supply Curve in a Competitive Market6/4/2015213.2 The Long-run: Market supply enter and exitThus, in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale.

In markets with entry and exit, there is only one price consistent with zero profit the minimum of average total cost. As a result, the long-run market supply curve must be horizontal at this price.Practice6/4/2015Department of Electrical Engineering taught in English22Ex6. Analyze the two following situations for firms in competitive markets:Suppose that TC = 100 + 15q, where TC is total cost and q is the quantity produced. What is the minimum price necessary for this firm to produce any output in the short run?Suppose that MC = 4q, where MC is marginal cost. The perfectly competitive firm maximizes profits by producing 10 units of output. At what price does it sell these units?Conclusion6/4/201523Firms objectiveProfit maximization

Optimality condition:

P = MC

Firm decisionsShut down the production or exit the marketP < AVC ?P < ATC ?

Market supplyShort-runFixed number of firmsLong-runFree enter and exit the market