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Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker.

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Presentation on theme: "Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker."— Presentation transcript:

1 Firms and Competitive Markets

2 Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker – Free entry/exit of the market

3 Goal is to maximize profit – ∏ = TR - TC Total Revenue – Price time quantity: TR = P x Q Average Revenue – Total Revenue divided by quantity sold Marginal Revenue – Change in revenue from additional unit sold For competitive firms – Average Revenue = P – Marginal Revenue = P

4 Profit Max Profit Maximization – Produce at the quantity that maximizes the difference between TR and TC – Compare marginal revenue with marginal cost If MR > MC increase production If MR < MC decrease production If MR = MC profit maximized

5 Costs and Revenue Quantity MC ATC AVC P = MR = AR Q* Profit Max Decision Producing here MC > MR so don’t Producing here MC < MR so produce more MC = MR so profit maxed

6 Marginal Cost Curve (MC) determines the quantity a firm would be willing to supply at a given price Therefore it is the firms supply curve

7 Costs and Revenue Quantity MC ATC AVC P1 Q1Q2 P2 MC Curve as Supply Curve

8 Shut down and Exit Shut Down – Short Run decision not to produce – Still have to pay fixed costs though Exit (don’t Enter) – Long Run decision – No costs

9 Short Run Decision Focus on – Total Revenue – Variable costs (fixed costs are fixed, so ignore) Decision – Shut down if TR < VC ( or MR/AR < AVC ) Competitive Firms Short Run Supply Curve – MC curve above the AVC curve

10 MC ATC AVC Costs Quantity In short run firms produce on the MC curve if P > AVC In short run firms shut down if P < AVC Short Run Supply Curve

11 Long Run Decision Exit Market if: – TR < TC – Or P < ATC Enter Market if: – TR > TC – Or P > ATC Competitive Firms Long Run Supply Curve – Portion of the MC curve above the ATC curve

12 MC ATC Costs Quantity In long run firms produce on MC curve if P > ATC Firms exit market if P

13 Profit If P > ATC – Positive profits – ∏ = TR – TC = (P – ATC) x Q If P < ATC – Negative profits (losses) – Loss = TC – TR = (ATC – P) x Q

14 P AVC Q* Profit Profit Maximizing Q Q* Loss Cost Minimizing Q MC AVC P Firm with ProfitsFirm with Losses

15 Market Supply Curve In short run # of firms fixed Each firm supplies where P = MC Each firms supply curve is the MC curve above their AVC curve (otherwise 0) For market supply just add up horizontally += S1S2S - Market

16 In long run # of firms not fixed – Free entry/exit If P > ATC – Profits are positive – Firms enter market If P < ATC – Firms taking losses – Firms exit the market This means all firms (assuming identical cost curves) will produce at MC = ATC (efficient pt) – So MKT supply curve will be horizontal at that point (perfectly elastic)

17 P = Min ATC MC ATC Supply Price Quantity Multiple Firms with identical cost curves Add up supply at MC = ATC level for each to get Market Supply Long Run Market Supply

18 Some Caveats P Q Actual Supply would be more like this, with holes and dots denoting when different firms enter. That is it would not be a smooth line. And perhaps it could still slope up if by increasing market size they bid up the cost of inputs. This would cause latte entering firms to have higher cost curves. P Q Or some firms could just be better at it, thus having lower cost curves. But either way LR flatter than SR.

19 So why stay in business if making zero profit? Profit = Total Revenue – Total Costs Total Costs include opportunity costs Zero Profit Equilibrium – Zero economic profit – Positive accounting profit

20 Shift in Demand and LR and SR supply response Market in long run eq. – P = ATC – Zero economic profit Increase in demand – Demand shifts out – Short Run Higher quantity, higher price P > ATC Positive economic profit

21 Because of positive profits Firms enter in the long run SR supply curve shifts right Price falls back to low point on ATC Quantity increases (because of more firms) Back to efficient scale

22 Market Firm DSR Supply LR Supply MC ATC P P Q Q Initial State of Equilibrium P’ Q’

23 Market Firm DSR Supply LR Supply MC ATC P P Q Q Demand Shifts, + Profits P’’ Price increases Which leads to + profits

24 Market Firm D SR Supply MC ATC P P Q Q Supply Shifts, 0 Profits P’’’ Profits induce firms to enter market Restoring Long Run Equilibrium, but with more firms Price falls back

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