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

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Presentation on theme: "FIRMS IN COMPETITIVE MARKETS. Overview Now that we understand firm production and costs, we will examine how firms make decisions regarding prices and."— Presentation transcript:

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

3 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.

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: Petes Coffee The following table gives total, average, and marginal revenue for Petes Coffee that sells pounds of coffee and operates in a competitive coffee market Note that in a competitive market, AR=MR=P

7 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: Petes Coffee

9 Profit Maximization Quantity 0 Costs and Revenue MC ATC AVC MC 1 Q 1 2 Q 2 The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. Q MAX P = MR 1 = 2 P = AR = MR

10 Maximizing Profit Q MC Q1Q1 P1P1 ATC ATC x Q = TC Total Revenue = P x Q Profit

11 Maximizing Profit Q MC P2P2 ATC Q2Q2 Profit … a higher price leads to higher profit and higher output

12 Maximizing Profit Q MC P3P3 ATC Q3Q3 … a lower price leads to lower profit and lower output Profit

13 Maximizing Profit Q MC P 4 = ATC Q4Q4 Profit equals zero when price equals ATC. ATC

14 Maximizing Profit Q MC P5P5 ATC Q5Q5 Profit is negative when price is less than ATC Profit < 0

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 firms short-run supply curve.

16 When Should a Firm Shut Down in the Short-Run? Copyright © 2004 South-Western MC Quantity ATC AVC 0 Costs Firm shuts down if P < AVC Firms short-run supply 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.

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 Firms Long-Run Supply Curve Copyright © 2004 South-Western Quantity 0 Price MC ATC P 1 Q 1 P 2 Q 2 This section of the firms MC curve is also the firms long-run supply curve.

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 Q Q Q P P P MC 1 MC 2 SmSm Constructing Market Supply Using Firm MC Curves Firms 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 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 Quantity MC P1P1 ATC In the long-run, the entry and exit of firms leads to zero economic profits. Price equals minimum ATC Q1Q1 Price

24 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 P 1 1 Q A MC Initial Equilibrium in a Market

25 From the Short- to the Long-Run Copyright © 2004 South-Western Market Firm (b) Short-Run Response Quantity (firm) 0 Price MC ATC Profit P 1 Quantity (market) Long-run supply Price 0 D 1 D 2 P 1 S 1 P 2 Q 1 A Q 2 P 2 B An Increase in Demand

26 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 P 1 P 2 Q 1 Q 2 Long-run supply B D 1 D 2 S 1 A S 2 Q 3 C Positive economic profits causes entry into the market driving down price so that economic profits are once again zero.


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