1. FIRMS IN COMPETITIVE MARKETS

2. 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 2

3. Competitive Markets
A 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 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.

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

7. Profit is maximized at the output level where:
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

8. Profit Maximization: Pete’s Coffee

9. Profit Maximization = Costs The firm maximizes profit by producing
the quantity at which
marginal cost equals
marginal revenue.
and
Revenue MC MC 2 Q
ATC P = MR 1 2 AR Q
MAX
AVC MC 1 Q
Quantity

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 output MC P2
ATC
Profit
ATC Q Q2

12. … a lower price leads to lower profit and lower output
Maximizing Profit
… a lower price leads to lower profit and lower output MC
ATC P3
Profit
ATC Q3 Q

13. Profit equals zero when price equals ATC.
Maximizing Profit
Profit equals zero when price equals ATC. MC
ATC
P4 =
ATC Q4 Q

14. Profit is negative when price is less than ATC
Maximizing Profit
Profit is negative when price is less than ATC MC
ATC
ATC
Profit < 0 P5 Q5 Q

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.

16. When Should a Firm Shut Down in the Short-Run?
Costs
Firm ’
s short-run
supply curve
If P > ATC, the firm will continue to produce at a profit. MC
ATC
If P > AVC, firm will continue to produce in the short run.
AVC
Firm
shuts
down if P
<
AVC
Quantity
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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

18. The Marginal Cost Curve and the Firm’s Long-Run Supply Curve
Price
This section of the
firm’s MC curve is
also the firm’s long-run
supply curve. MC P 2 Q
ATC P 1 Q
Quantity
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19. 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.

20. 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.

21. Constructing Market Supply Using Firm MC CurvesSm
MC1
MC2 10 10 10 5 5 5 5 10 7 2 18 8 Q Q Q
Firms 1
Firm 2
Market

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 barriers
Result?
Long-Run economic profits are driven toward zero
Thus, 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 ATC MC
ATC P1 Q1
Quantity

24. From the Short- to the Long-Run
(a) Initial Condition
Firm
Market
Price
Price MC
ATC S
Short-run supply, 1 D
Demand, 1 1 Q A P 1 P 1
Quantity (firm)
Quantity (market)
Initial Equilibrium in a Market

25. From the Short- to the Long-Run
(b) Short-Run Response
Firm
Market
Price
Price D 2
ATC MC
Profit S 1 Q 2 P B P 2 D 1 Q 1 A P 1 P
Long-run 1
supply
Quantity (firm)
Quantity (market)
An Increase in Demand
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26. From the Short- to the Long-Run
(c) Long-Run Response
Firm
Market
Price
Price D 2 S MC
ATC 1 S 2 B P 2 A Q 3 C P P
Long-run 1 1
supply D 1
Quantity (firm) Q Q
Quantity (market) 1 2
Positive economic profits causes entry into the market driving down price so that economic profits are once again zero.