FIRMS IN COMPETITIVE MARKETS. Overview Now that we understand firm production and costs, we will examine how firms make decisions regarding prices and.

FIRMS IN COMPETITIVE MARKETS

Overview

• Now that we understand firm production and costs, we will examine how firms make decisions regarding prices and quantities and how those decisions depend on market conditions.

• Our analysis will focus on how firms make decisions in three different types of market structures:

– Perfect Competition– Monopoly

Competitive Markets

• 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 largely the same. i.e. firms sell identical products.

3) Firms can freely enter or exit the market. i.e. there are no barriers to entry in the market.

Competitive Markets

• Competitive markets are characterized by 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.

• In short, because a competitive market has many buyers and sellers trading identical products, each buyer and seller is a price taker.

– Buyers and sellers must accept the price determined by the market.

The Revenue of a Competitive Firm

• Total Revenue: the selling price times the quantity sold.

TR = (P Q)

• Average Revenue: total revenue divided by the quantity sold.

• Marginal Revenue: change in total revenue from an additional unit sold.

MR =TR/ Q

PriceQ

QP

Q

TRRevenue Average

An Example: Pete’s Coffee

The following table gives total, average, and marginal revenue for Pete’s Coffee that sells pounds of coffee and operates in a competitive coffee market

Quantity Price/Pound TR AR MR

1 $8 $8 $82 8 16 8 $83 8 24 8 84 8 32 8 85 8 40 8 86 8 48 8 8

Note that in a competitive market, AR=MR=P

Profit Maximization

• The goal of a competitive firm is to maximize profit.

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

• Profit increases when MR > MC, decreases when MR < MC

• Firm should therefore produce as long as MR > MC, stop before MR < MC

Profit is maximized at the output level where:

MR = MC

Profit Maximization: Pete’s Coffee

Quantity TR TC Profit MR MC Change in Profit0 $0 $5 -$51 8 7 1 $8 $2 $62 16 10 6 8 3 53 24 14 10 8 4 44 32 19 13 8 5 35 40 25 15 8 6 26 48 33 15 8 8 07 56 42 14 8 9 -18 64 53 11 8 11 -3

Profit Maximization

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

Maximizing Profit

Q

MC

Q1

P1

ATC

ATC

ATC x Q = TC

Total Revenue = P x Q

Profit

Maximizing Profit

Q

MC

P2

ATC

ATC

Q2

Profit

… a higher price leads to higher profit and higher

output

Maximizing Profit

Q

MC

P3

ATC

ATC

Q3

… a lower price leads to lower profit and lower

output

Profit

Maximizing Profit

Q

MC

P4 =

ATC

Q4

Profit equals zero when price equals

ATC.

ATC

Maximizing Profit

Q

MC

P5

ATC

Q5

ATC

Profit is negative when price is less

than ATC

Profit < 0

The Short-Run Decision to Shut Down

• Fixed costs are “SUNK”: they must be paid even if no output is produced.

– In the short-run, a firm can never escape its fixed cost.

• The firm shuts down if the revenue it gets from producing is less than the variable cost of production.

– A firm should stay in business as long as Price > AVC.

– If Price < AVC, firm should shut down even in the short run.

• The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.

When Should a Firm Shut Down in the Short-Run?

Copyright © 2004 South-Western

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 Long-Run Decision to Shut Down

• In the long run, the firm exits if the revenue it would get from producing is less than its total cost, i.e. if profit is less than zero.

– Therefore as long as Economic Profit > 0 (Price > ATC), a firm should stay in business.

– If Economic Profit < 0 (Price < ATC), a firm should shut down

The Marginal Cost Curve and the Firm’s Long-Run Supply Curve

Copyright © 2004 South-Western

Quantity0

Price

MC

ATCP1

Q1

P2

Q2

This section of thefirm’s MC curve isalso the firm’s long-run supply curve.

The Supply Curve in a Competitive Market

• Short-Run Supply Curve

– The portion of its marginal cost curve that lies above average variable cost.

• Long-Run Supply Curve

– The marginal cost curve above the minimum point of its average total cost curve.

Market Supply

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

• For 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.

Q Q Q

P P P

10

5

10

5

10

5

5 10 2 8 7 18

MC1 MC2

Sm

Constructing Market Supply Using Firm MC Curves

Firms 1 Firm 2 Market

Long-Run Market Supply with Entry and Exit

• Negative economic profit causes firms to “exit” the industry.

• Similarly, positive economic profits draws new firms to the industry.

• In competitive markets, this entry is free of barriers

• Result?

Long-Run economic profits are driven toward zero

• Thus, in the long run, price equals the minimum of average total cost.

Long Run Equilibrium

Quantity

MC

P1

ATC

In the long-run, the entry and exit of firms leads to zero economic profits. Price equals minimum

ATC

Q1

Price

From the Short- to the Long-Run

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P 1

ATC

P1

1Q

A

MC

Initial Equilibrium in a Market

From the Short- to the Long-Run

Copyright © 2004 South-Western

MarketFirm

(b) Short-Run Response

Quantity (firm)0

Price

MC ATCProfit

P 1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S1

P 2

Q1

A

Q2

P2

B

An Increase in Demand

From the Short- to the Long-Run

P 1

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

S 1

A

S2

Q3

C

Positive economic profits causes entry into the market driving down price so that economic profits are once

again zero.