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.