2 OverviewNow 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 CompetitionMonopoly2
3 Competitive MarketsA perfectly competitive market has the following characteristics:There are many buyers and sellers in the market.The goods offered by the various sellers are largely the same. i.e. firms sell identical products.Firms can freely enter or exit the market. i.e. there are no barriers to entry in the market.
4 Competitive MarketsCompetitive 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.
5 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
6 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 marketNote that in a competitive market, AR=MR=P
7 Profit is maximized at the output level where: Profit MaximizationThe 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 < MCFirm should therefore produce as long as MR > MC, stop before MR < MCProfit is maximized at the output level where:MR = MC
9 Profit Maximization = Costs The firm maximizes profit by producing the quantity at whichmarginal cost equalsmarginal revenue.andRevenueMCMC2QATCP=MR12ARQMAXAVCMC1QQuantity
10 Maximizing Profit Profit Total Revenue = P x Q ATC x Q = TC MC ATC P1
11 … a higher price leads to higher profit and higher output Maximizing Profit… a higher price leads to higher profit and higher outputMCP2ATCProfitATCQQ2
12 … a lower price leads to lower profit and lower output Maximizing Profit… a lower price leads to lower profit and lower outputMCATCP3ProfitATCQ3Q
13 Profit equals zero when price equals ATC. Maximizing ProfitProfit equals zero when price equals ATC.MCATCP4 =ATCQ4Q
14 Profit is negative when price is less than ATC Maximizing ProfitProfit is negative when price is less than ATCMCATCATCProfit < 0P5Q5Q
15 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.
17 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
19 The Supply Curve in a Competitive Market Short-Run Supply CurveThe portion of its marginal cost curve that lies above average variable cost.Long-Run Supply CurveThe marginal cost curve above the minimum point of its average total cost curve.
20 Market SupplyMarket 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.
21 Constructing Market Supply Using Firm MC Curves SmMC1MC210101055551072188QQQFirms 1Firm 2Market
22 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 barriersResult?Long-Run economic profits are driven toward zeroThus, in the long run, price equals the minimum of average total cost.
23 Long Run Equilibrium Price In the long-run, the entry and exit of firms leads to zero economic profits. Price equals minimum ATCMCATCP1Q1Quantity
24 From the Short- to the Long-Run (a) Initial ConditionFirmMarketPricePriceMCATCSShort-run supply,1DDemand,11QAP1P1Quantity (firm)Quantity (market)Initial Equilibrium in a Market
26 From the Short- to the Long-Run (c) Long-Run ResponseFirmMarketPricePriceD2SMCATC1S2BP2AQ3CPPLong-run11supplyD1Quantity (firm)QQQuantity (market)12Positive economic profits causes entry into the market driving down price so that economic profits are once again zero.