The Meaning of Competition A perfectly competitive market has the following characteristics: ä There are many buyers and sellers in the market. ä The goods offered by the various sellers are largely the same. ä Firms can freely enter or exit the market. 2

The Meaning of Competition A perfectly competitive market has the following outcomes: ä The individual firm produces a small portion of total market output. ä The firm cannot have any influence over the price it charges. 3

The Meaning of Competition The individual firm in a perfectly competitive market is a price taker. ä It takes the price determined by the market as the price that it will receive for its output. 3

Revenue of a Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR = (P X Q) 5

Revenue of a Competitive Firm Total revenue is proportional to the amount of output. 5

Revenue of a Competitive Firm Average revenue tells us how much revenue a firm receives for the typical unit sold. 8

Revenue of a Competitive Firm In perfect competition, average revenue equals the price of the good. 8

Revenue of a Competitive Firm In perfect competition, average revenue equals the price of the good. 8

Revenue of a Competitive Firm Marginal revenue is the change in total revenue from an additional unit sold. MR = TR / Q 9

Revenue of a Competitive Firm For competitive firms, marginal revenue equals the price of the good. 9

Quick Quiz! When a competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue? 11

Profit Maximization for the Competitive Firm The goal of a competitive firm is to maximize profit. ä This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. 12

Profit Maximization for the Competitive Firm Profit maximization occurs at the quantity where marginal revenue equals marginal cost. If MR > MC, increase Q to increase profit. If MR < MC, decrease Q to increase profit. If MR = MC, profit is maximized. 12

Profit Maximization for the Competitive Firm Costs and Revenue Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue ATC AVC Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue MC ATC AVC Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue MC ATC P P = AR = MR AVC Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC ATC P P = AR = MR AVC QMAX Quantity 20

Profit Maximization for the Competitive Firm A competitive firm will adjust its production level until quantity reaches QMAX where profit is maximized. 27

Profit Maximization for the Competitive Firm Costs and Revenue MC ATC P P = AR = MR AVC QMAX Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue MC ATC P = MR1 P = AR = MR AVC MC1 Q1 QMAX Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue MC ATC P = MR1 P = AR = MR AVC MC1 MR > MC, increase Q Q1 QMAX Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue MC MC2 ATC P = MR2 P = AR = MR AVC QMAX Q2 Quantity 20

Profit Maximization for the Competitive Firm Costs and Revenue MC MC2 ATC P = MR2 P = AR = MR AVC MR < MC, decrease Q QMAX Q2 Quantity 20

The Firm’s Decision to Shut Down A shutdown refers to a short-run decision not to produce anything during a specific period of time. Exit refers to a long-run decision to leave the market. 28

The Firm’s Decision to Shut Down The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down. ä Sunk costs are costs that have already been committed and cannot be recovered. 10

The Firm’s Decision to Shut Down The firm shuts down if the revenue it gets from producing is less than the variable cost of production. Shut down if…………TR < VC Shut down if………..TR/Q < VC/Q Shut down if………..P < AVC 28

The Firm’s Decision to Shut Down Costs Quantity 28

The Firm’s Decision to Shut Down Costs MC ATC AVC Quantity 28

The Firm’s Decision to Shut Down Costs If P > ATC, keep producing at a profit. MC ATC AVC Quantity 28

The Firm’s Decision to Shut Down Costs If P > ATC, keep producing at a profit. MC ATC If P > AVC, keep producing in the short run. AVC Quantity 28

The Firm’s Decision to Shut Down Costs If P > ATC, keep producing at a profit. MC ATC If P > AVC, keep producing in the short run. AVC If P < AVC, shut down. Quantity 28

The Firm’s Decision to Shut Down The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve. 28

The Firm’s Decision to Shut Down Costs If P > ATC, keep producing at a profit. MC ATC If P > AVC, keep producing in the short run. AVC If P < AVC, shut down. Quantity 28

The Firm’s Decision to Shut Down Costs MC Firm’s short-run supply curve ATC AVC Quantity 28

The Long-Run Decision to Exit an Industry In the long-run, the firm exits if the revenue it would get from producing is less than its total cost. Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC 41

The Long-Run Decision to Enter an Industry A firm will enter the industry if such an action would be profitable. Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC 41

The Competitive Firm’s Long-Run Supply Curve 35

The Competitive Firm’s Long-Run Supply Curve Costs Quantity 35

The Competitive Firm’s Long-Run Supply Curve Costs MC ATC AVC Quantity 35

The Competitive Firm’s Long-Run Supply Curve Costs MC Firm enters if P > ATC ATC AVC Quantity 35

The Competitive Firm’s Long-Run Supply Curve Firm enters if P > ATC Firm exits if P < ATC Quantity MC ATC AVC Costs 35

The Competitive Firm’s Long-Run Supply Curve The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost. 35

The Competitive Firm’s Long-Run Supply Curve Firm enters if P > ATC Firm exits if P < ATC Quantity MC ATC AVC Costs 35

The Competitive Firm’s Long-Run Supply Curve Costs MC Firm’s long-run supply curve ATC AVC Quantity 35

The Firm’s Short-Run and Long-Run Supply Curves Short-Run Supply Curve ä The portion of its marginal cost curve that lies above average variable cost. Long-Run Supply Curve ä The marginal cost curve above the minimum point of its average total cost curve. 35

Profit as the Area Between Price and Average Total Cost

Profit as the Area Between Price and Average Total Cost Quantity

Profit as the Area Between Price and Average Total Cost MC ATC Quantity

Profit as the Area Between Price and Average Total Cost MC ATC P P = AR = MR Quantity

Profit as the Area Between Price and Average Total Cost MC ATC P P = AR = MR ATC Profit-maximizing quantity Q Quantity

Profit as the Area Between Price and Average Total Cost MC ATC Profit P P = AR = MR ATC Profit-maximizing quantity Q Quantity

Loss as the Area Between Price and Average Total Cost

Loss as the Area Between Price and Average Total Cost MC ATC Quantity

Loss as the Area Between Price and Average Total Cost MC ATC P P = AR = MR Quantity

Loss as the Area Between Price and Average Total Cost MC ATC ATC P P = AR = MR Loss-minimizing quantity Q Quantity

Loss as the Area Between Price and Average Total Cost MC ATC ATC P P = AR = MR Loss Loss-minimizing quantity Q Quantity

Quick Quiz! How does the price faced by a profit-maximizing competitive firm compare to its marginal cost? 42

Quick Quiz! When will a profit-maximizing firm decide to shut down? Oil in the news 42

Supply in a Competitive Market Market supply equals the sum of the quantities supplied by the individual firms in the market.

Supply in a Competitive Market Market Supply with a Fixed Number of Firms ä For any given price, each firm supplies a quantity of output so that price equals its marginal cost. ä The market supply curve reflects the individual firms’ marginal cost curves. 43

Supply in a Competitive Market Market Supply with Entry and Exit ä Firms will enter or exit the market until profit is driven to zero. ä In the long-run, price equals the minimum of average total cost. ä The long-run market supply curve is horizontal at this price. 44

The Supply Curve in a Competitive Market (a) Firm’s Zero-Profit Condition (b) Market Supply Price Price MC ATC P = minimum ATC Supply Quantity (firm) Quantity (market) 44

Increase in Demand in the Short Run An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost. 44

Initial Condition Firm Market Price Price Quantity (firm) Quantity Quantity (firm) Quantity (market) 44

Initial Condition Firm Market Price Price MC ATC S 1 P1 P1 Long-run supply D1 Quantity (firm) Q1 Quantity (market) 44

Short-Run Response Firm Market Price Price MC ATC S 1 P1 P1 P1 B S 1 A P1 P1 P1 Long-run supply D 2 D 1 Quantity (firm) Q1 Quantity (market) 44

Short-Run Response Firm Market Price Price MC ATC S 1 P2 P2 P1 P1 B S 1 P2 P2 A P1 P1 Long-run supply D 2 D 1 Quantity (firm) Q1 Q2 Quantity (market) 44

Short-Run Response Firm Market Price Price Profit MC ATC S 1 P2 P2 P1 B S 1 P2 P2 A P1 P1 Long-run supply D 2 D 1 Quantity (firm) Q1 Q2 Quantity (market) 44

Increase in Demand in the Long Run Over time, the short-run supply curve shifts as profits encourage new firms to enter the market. 44

Increase in Demand in the Long Run Price falls as new firms enter the market. 44

Increase in Demand in the Long Run In the new long-run equilibrium profits return to zero and price returns to minimum average total cost. 44

Increase in Demand in the Long Run The market has more firms to satisfy the greater demand. 44

Long-Run Response Firm Market Price Price Profit MC ATC S 1 P2 P2 P1 B S 1 P2 P2 A P1 P1 Long-run supply D 2 D 1 Quantity (firm) Q1 Q2 Quantity (market) 44

Long-Run Response Firm Market Price Price Profit MC ATC S1 P2 P2 P1 P1 B S1 P2 P2 S2 A P1 P1 Long-run supply D2 D1 Quantity (firm) Q1 Q2 Quantity (market) 44

Long-Run Response Firm Market Price Price MC ATC S1 P2 P1 P1 Long-run B S1 P2 S2 A P1 P1 Long-run supply D2 D1 Quantity (firm) Q1 Q2 Quantity (market) 44

Increase in Demand in the Short and Long Run Firm Market Price Price MC ATC B S1 S2 A C P1 P1 Long-run supply D2 D1 Quantity (firm) Q1 Q2 Q3 Quantity (market) 44

Why the Long-Run Supply Curve Might Slope Upward Some resources used in production may be available only in limited quantities. Firms may have different costs. 45

Shifts in Cost Curves Change in resource price Change in technology or productivity Is it a change in a fixed cost or variable cost? Fixed = change ATC, but leave MC and AVC Variable = change AVC, ATC, and MC Lump sum vs per unit 45

Shifts in Cost Curves Suppose the book-printing industry is competitive and begins in LR equilibrium. Draw a diagram describing the typical firm in the industry. Hi-Tech Printing Co. invents a new process that sharply reduces the cost of printing books. What happens to Hi-Tech’s profits and the price of books in the short run when Hi-Tech’s patent prevents other firms from using the new technology? What happens in the long-run when the patent expires? 45

Conclusion Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm’s average revenue and its marginal revenue 45

Conclusion To maximize profit a firm chooses the quantity of output where marginal revenue equals marginal cost. This is also the quantity at which price equals marginal cost. Allocative Efficiency

Conclusion In the short run, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run, it will choose to exit if the price is less than average total cost.

Conclusion If firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production in the long run. Productive Efficiency The number of firms adjusts to drive the market back to the zero-profit equilibrium. Invisible Hand 45

Conclusion Because firms can enter and exit more easily in the long run than the short run, the long-run supply curve is typically more elastic than the short-run supply curve. Constant-cost Increasing-cost Decreasing costs 45