Presentation on theme: "Firms in Competitive Markets"— Presentation transcript:
1 Firms in Competitive Markets 14Firms in Competitive Markets
2 What is a Competitive Market? The meaning of competitionCompetitive marketMarket with many buyers and sellersTrading identical productsEach buyer and seller is a price takerFirms can freely enter or exit the market
3 What is a Competitive Market? The revenue of a competitive firmMaximize profitTotal revenue minus total costTotal revenue = price times quantity = P x QProportional to the amount of outputAverage revenueTotal revenue divided by the quantity sold
4 What is a Competitive Market? The revenue of a competitive firmMarginal revenueChange in total revenue from an additional unit soldFor competitive firmsAverage revenue = PMarginal revenue = P
6 Profit Maximization& Competitive Firm’s Supply Curve A simple example of profit maximizationMaximize profitProduce quantity where total revenue minus total cost is greatestCompare marginal revenue with marginal costIf MR > MC – increase productionIf MR < MC – decrease production
7 Profit maximization: A numerical example 2Profit maximization: A numerical exampleQuantity(Q)Total revenue(TR)Total cost(TC)Profit(TR-TC)MarginalRevenue(MR=ΔTR/ΔQ)Cost(MC=ΔTC/ΔQ)Changein profit(MR-MC)0 gallons12345678$012182430364248$317233847-$3$66$2345789$421-1-2-3
8 Profit Maximization& Competitive Firm’s Supply Curve The marginal-cost curve and the firm’s supply decisionMC curve – upward slopingATC curve – U-shapedMC curve crosses the ATC curve at the minimum of ATC curveP = AR = MR
9 Profit Maximization& Competitive Firm’s Supply Curve The marginal-cost curve and the firm’s supply decisionThree general rules for profit maximization:If MR > MC - firm should increase outputIf MC > MR - firm should decrease outputIf MR = MC - profit-maximizing level of output
10 Profit maximization for a competitive firm 1Profit maximization for a competitive firmCostsandRevenueThe firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.ATCMCMC2Q2P=AR=MRP=MR1=MR2QMAXAVCMC1Q1QuantityThis figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-variable-cost curve (AVC). It also shows the market price (P), which equals marginal revenue (MR) and average revenue (AR). At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production increases profit. At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so reducing production increases profit. The profit-maximizing quantity QMAX is found where the horizontal price line intersects the marginal-cost curve.
11 Profit Maximization& Competitive Firm’s Supply Curve The marginal-cost curve and the firm’s supply decisionMarginal-cost curveDetermines the quantity of the good the firm is willing to supply at any priceIs the supply curve
12 Marginal cost as the competitive firm’s supply curve 2Marginal cost as the competitive firm’s supply curvePriceMCATCP2Q2P1AVCQ1QuantityAn increase in the price from P1 to P2 leads to an increase in the firm’s profit-maximizing quantity from Q1 to Q2. Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it is the firm’s supply curve.
13 Profit Maximization& Competitive Firm’s Supply Curve ShutdownShort-run decision not to produce anythingDuring a specific period of timeBecause of current market conditionsFirm still has to pay fixed costsExitLong-run decision to leave the marketFirm doesn’t have to pay any costs
14 Profit Maximization& Competitive Firm’s Supply Curve The firm’s short-run decision to shut downTR = total revenueVC = variable costsFirm’s decision:Shut down if TR<VC (P<AVC)Competitive firm’s short-run supply curveThe portion of its marginal-cost curveThat lies above average variable cost
15 The competitive firm’s short-run supply curve 3The competitive firm’s short-run supply curveCostsMC1. In the short run, thefirm produces on theMC curve if P>AVC,...ATCAVC2. ...butshuts downif P<AVC.QuantityIn the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down.
16 Profit Maximization& Competitive Firm’s Supply Curve Spilt milk and other sunk costsSunk costHas already been committedCannot be recoveredIgnore them when making decisions
17 Near-empty restaurants and off-season miniature golf Restaurant – stay open for lunch?Fixed costsNot relevantAre sunk costs in short runVariable costs – relevantShut down if revenue from lunch < variable costsStay open if revenue from lunch > variable costsOperator of a miniature-golf courseIgnore fixed costsStay open if revenue > variable costs
18 Profit Maximization& Competitive Firm’s Supply Curve Firm’s long-run decision to exit/enter a marketExit the market ifTotal revenue < total costs; TR < TCSame as: P < ATCEnter the market ifTotal revenue > total costs; TR > TCSame as: P > ATCCompetitive firm’s long-run supply curveThe portion of its marginal-cost curveThat lies above average total cost
19 The competitive firm’s long-run supply curve 4The competitive firm’s long-run supply curveCostsMC1. In the long run, thefirm produces on theMC curve if P>ATC,...ATC2. ...butexits if P<ATCQuantityIn the long run, the competitive firm’s supply curve is its marginal-costcurve (MC) above average total cost (ATC). If the price falls below average total cost, the firm is better off exiting the market.
20 Profit Maximization& Competitive Firm’s Supply Curve Measuring profitIf P > ATCProfit = TR – TC = (P – ATC) x QIf P < ATCLoss = TC - TR = (ATC – P) x Q= Negative profit
21 Profit as the area between price and average total cost 5Profit as the area between price and average total cost(a) A firm with profits(b) A firm with lossesPricePriceMCMCATCATCProfitLossP=AR=MRPQ(profit-maximizing quantity)ATCATCQ(loss-minimizing quantity)P=AR=MRPQuantityQuantityThe area of the shaded box between price and average total cost represents the firm’s profit. The height of this box is price minus average total cost (P – ATC), and the width of the box is the quantity of output (Q). In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm has losses.
22 Supply Curve in a Competitive Market Short run: market supply with a fixed number of firmsShort run – number of firms is fixedEach firm – supplies quantity where P = MCFor P > AVC: supply curve is MC curveMarket supplyAdd up quantity supplied by each firm
23 Short-run market supply 6Short-run market supply(a) Individual firm supply(b) Market supplyPricePriceMCSupply$2.00$2.00200200,0001.001.00100100,000Quantity(firm)Quantity(market)In the short run, the number of firms in the market is fixed. As a result, the market supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the quantity supplied by each firm.
24 Supply Curve in a Competitive Market Long run: market supply with entry and exitLong run – firms can enter and exit the marketIf P > ATC – firms make positive profitNew firms enter the marketIf P < ATC – firms make negative profitFirms exit the marketProcess of entry and exit ends whenFirms still in market: zero economic profit (P = ATC)Because MC = ATC: Efficient scaleLong run supply curve – perfectly elasticHorizontal at minimum ATC
25 Long-run market supply 7Long-run market supply(a) Firm’s Zero-Profit Condition(b) Market supplyPricePriceMCATCP=minimumATCSupplyQuantity(firm)Quantity(market)In the long run, firms will enter or exit the market until profit is driven to zero. As a result, price equals the minimum of average total cost, as shown in panel (a). The number of firms adjusts to ensure that all demand is satisfied at this price. The long-run market supply curve is horizontal at this price, as shown in panel (b).
26 Supply Curve in a Competitive Market Why do competitive firms stay in business if they make zero profit?Profit = total revenue – total costTotal cost – includes all opportunity costsZero-profit equilibriumEconomic profit is zeroAccounting profit is positive
27 Supply Curve in a Competitive Market A shift in demand in the short run & long runMarket – in long run equilibriumP = minimum ATCZero economic profitIncrease in demandDemand curve – shifts outwardShort runHigher quantityHigher price: P > ATC – positive economic profit
28 Supply Curve in a Competitive Market A shift in demand in the short run & long runBecause: positive economic profit in short runLong run – firms enter the marketShort run supply curve – shifts rightPrice – decreases back to minimum ATCQuantity – increasesBecause there are more firms in the marketEfficient scale
29 An increase in demand in short run and long run (a) 8An increase in demand in short run and long run (a)(a) Initial ConditionMarketFirmPricePriceA1. A market begins inlong-run equilibrium…2. …with the firmearning zero profit.MCATCShort-run supply, S1Demand, D1P1Long-runsupplyP1Q1Quantity(market)Quantity(firm)The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost.
30 An increase in demand in short run and long run (b) 8An increase in demand in short run and long run (b)(b) Short-Run ResponseMarketFirmPricePrice3. But then an increase in demand raises the price…4. …leading toshort-run profits.MCS1D2ATCD1BP2P2AP1Long-runsupplyQ2P1Q1Quantity(market)Quantity(firm)Panel (b) shows what happens in the short run when demand rises from D1 to D2. The equilibrium goes from point A to point B, price rises from P1 to P2, and the quantity sold in the market rises from Q1 to Q2. Because price now exceeds average total cost, firms make profits, which over time encourage new firms to enter the market
31 An increase in demand in short run and long run (c) 8An increase in demand in short run and long run (c)(c) Long-Run ResponseMarketFirmPricePrice6. …restoring long-run equilibrium.5. When profits induce entry, supply increases and the price falls,…MCS1D2ATCS2D1BP2ACP1Long-runsupplyQ2P1Q1Q3Quantity(market)Quantity(firm)This entry shifts the short-run supply curve to the right from S1 to S2, as shown in panel (c). In the new long-run equilibrium, point C, price has returned to P1 but the quantity sold has increased to Q3. Profits are again zero, price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand.
32 Supply Curve in a Competitive Market Why the long-run supply curve might slope upwardSome resource used in production may be available only in limited quantitiesIncrease in quantity supplied – increase in costs – increase in priceFirms may have different costsSome firms earn profit even in the long runLong-run supply curveMore elastic than short-run supply curve