1. 1 Things to know about all market systems 1. A n equilibrium is where no one has an incentive to change their production.  In market systems:  if a firm can increase their profit by changing the price or quantity of their goods, they will.  They will stop changing these factors when they have reached the maximum amount of profit they possibly can achieve, given the current conditions of the market.  This profit maximizing output and price is the equilibrium.

2. 2 Things to know about all market systems 2. Firms will produce where MC=MR  Recall, Marginal Cost (MC) is the additional cost of producing one more unit of output.  Marginal Revenue (MR) is the additional revenue acquired by producing (and as we assume selling) one more unit of output.  MR= TR/ Q = (TR1-TR2)/(Q1-Q2)  MR=P in a competitive market (we will talk about this more later)  MR<P in a monopoly (we will talk about this more later)

3. 3 Things to know about all market systems 2. Firms will produce where MR=MC: we prove this by eliminating all other possibilities  If MC<MR, a firm can make a higher profit by increasing their output.  The additional revenue from selling one more unit is more than the extra cost to produce that unit.  So, a firm’s profit will increase if output increases, therefore the firm producing where MC<MR has an incentive to change their price and/or output.  If MC>MR, a firm can make a higher profit by decreasing their output.  The additional revenue from selling one more unit is less that the extra cost to produce that unit.  So, a firm’s profit will increase if output decreases, therefore the firm producing where MC>MR has an incentive to change their price and/or output.  If MC=MR, a firm is making the highest profit possible.  At this point, each firm does not have a way to increase profit more, so they have no incentive to change their price and/or output.

4. 4 Competitive Markets

5. 5 By the end of this Section, You should be able to:  Define Competitive Market and describe its properties  Know and use the properties of a competitive firm’s profit maximizing quantity and price  Determine LR and SR choice to enter or exit the market  Display the competitive markets in SR and LR

6. 6 Perfectly Competitive Markets  A perfect competition is a market structure in which the decisions of individual buyers and sellers has no effect on the market.  Each firm and consumer is such a small part of the market, a change in one firm or one consumer’s behavior won’t effect the price  Price is set by market forces (invisible hand)

7. 7 Perfectly Competitive Market Assumptions 1. A competitive firm takes the price as given or they are a price taker. 2. Products sold by the firms in a competitive industry homogenous (the same). They are perfect substitutes. 3. Any firm can enter/exit the market without serious impediments. 4. Both Buyers and Sellers have equal access to information.

8. 8 Perfectly Competitive Firms Maximize Profits in the SR  Note, because the firm is a price taker, a Competitive Firm maximizes profits by choosing the optimal amount to produce.  The Profit Maximizing Quantity is determined by using one of two strategies:  1. TR>TC  Profit maximizing output is where TR exceeds TC the most.  2. MC=MR=P

9. 9 Economic Profit MR = P MC MR = MC ATC Applying MR=MC Rule Graphically LO: 7-3 Price/Costs Quantity P Q* ATC Economic Profit = BH = (Q*)(P-ATC)

10. 10 Entering and Exiting the Market in the Short Run  In the short run,  A firm enters the market by providing output to sell  a firm can not exit the industry as a whole but can shut down, or not manufacture the good for a period of time  If the firm enters the market in the short run:  Profit = TR – VC – FC  In the short run, a firm will ALWAYS incur fixed costs.  Fixed costs in this case are called sunk costs. Sunk costs are costs already committed to.  If a firm shuts down (exits the market) in the SR:  Profit = 0 – 0 – FC  They produces 0 output and incurs a loss equal to its fixed costs.  Shutting down prevents them from losing any more profit.

11. 11 LR Competitive Equilibrium  The long run competitive equilibrium is where economic profit = 0.  Called the Zero Profit Condition  Note this is economic profit.

12. 12 LR Competitive Equilibrium Graphically LR Competitive Equilibrium is where “everything is equal”. Price Quantity LRAC MC SRAC P* Q* Notice, where the set market price (or MR) crosses the MC where the SRAC and the LRAC are at their minimum. This also follows MC=MR=P. MR

13. 13 Entering and Exiting the Market in the Long Run  In the long run,  A firm enters the market by choosing to provide the good to sell.  A firm will enter the market as long as the current firms are making a positive profit.  A firm exits the industry by choosing to not produce a good to sell any more.  Once firms stop making a positive profit, firms will no longer choose to enter the market.  If firms are making a negative profit, firms will exit the market.  They will exit the market until LR profits = 0.