Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Perfectly competitive market u Many buyers and sellers u Sellers offer same goods (homogeneous goods) u Free entry -- or exit -- by firms.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Perfectly competitive market Buyers and sellers in competitive markets are price takers. Buyers and sellers must accept the market price.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Revenue Total revenue for any firm is the selling price times the quantity sold. TR = (P X Q)

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Revenue of a Competitive Firm In perfect competition, average revenue equals the price of the good.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Marginal Revenue Marginal revenue is the change in total revenue from an additional unit sold. MR =  TR/  Q

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Marginal Revenue of a Competitive Firm For competitive firms, marginal revenue equals the price of the good. Selling another unit does not change the price it gets – the market price. n The firm is a price taker.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Total, Average, and Marginal Revenue for a Competitive Firm

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Profit Maximization The firm’s goal is to maximize profit. uThe firm wants to produce the quantity that maximizes the difference between total revenue and total cost. Maximize Profit = P Q - TC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Profit Maximization: A Numerical Example

P = AR = MR P=MR 1 MC Profit Maximization for the Competitive Firm... Quantity 0 Costs and Revenue ATC AVC Q MAX The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue = price. MC 1 Q1Q1 MC 2 Q2Q2 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

Profit Maximization for Competitive Firm: MR = MC = P When MR > MC  increase Q When MR < MC  decrease Q When MR = MC  Profit is maximized.

The Marginal-Cost Curve and the Firm’s Supply Decision... Quantity 0 Costs and Revenue MC ATC AVC Copyright © 2001 by Harcourt, Inc. All rights reserved Q1Q1 P 1 P 2 Q2Q2 This section of the firm’s MC curve is part of the firm’s short run supply curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Short-Run Decision to Shut Down Long-Run Decision to Exit u Shutdown is a decision not to produce anything for a while because of current market conditions. u Exit is a long-run decision to leave the market.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down n The firm ignores sunk costs when deciding whether to shut down for the short run. n The firm considers “sunk costs” (“fixed costs”) when deciding whether to exit in the long run.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Firm’s Short-Run Decision to Shut Down u The firm shuts down if the revenue it gets from producing is less than the variable cost of production. Shut down if TR < TVC Shut down if TR/Q = P < TVC/Q Shut down if P < AVC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Competitive Firm’s Short- Run Supply Curve Quantity ATC AVC 0 Costs MC If P < AVC, shut down. If P > AVC, keep producing in the short run. If P > ATC, keep producing at a profit. Firm’s short-run supply curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Competitive Firm’s Short- Run Supply Curve The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Firm’s Long-Run Decision to Exit or Enter a Market u In the long-run, the firm exits if its revenue from producing is less than its total cost. Exit if TR < TC Exit if TR/Q = P < TC/Q Exit if P < ATC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Firm’s Long-Run Decision to Exit or Enter a Market u A firm will enter the industry if it would be profitable. Enter if TR > TC Enter if TR/Q = P > TC/Q Enter if P > ATC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC = Long-run S ATC AVC 0 Costs Firm enters if P > ATC Firm exits if P < ATC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. 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.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Firm’s Short-Run and Long-Run Supply Curves u Short-Run Supply Curve u The portion of its marginal cost curve that lies above average variable cost. u Long-Run Supply Curve u The marginal cost curve above the minimum point of its average total cost curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC ATC AVC 0 Costs Firm’s long-run supply curve

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Profit Q Measuring Profit in the Graph for the Competitive Firm... Quantity 0 Price P = AR = MR ATCMC P ATC Profit-maximizing quantity a. A Firm with Profits

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Loss Measuring Profit in the Graph for the Competitive Firm... Quantity 0 Price P = AR = MR ATCMC P Q Loss-minimizing quantity ATC b. A Firm with Losses

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Supply in a Competitive Market Market supply equals the sum of the quantities supplied by the individual firms in the market.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Short Run: Market Supply with a Fixed Number of Firms u For any given price, each firm supplies a quantity of output so that its marginal cost equals price. u The market supply curve reflects the individual firms’ marginal cost curves.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Short Run: Market Supply with a Fixed Number of Firms... (a) Individual Firm Supply Quantity (firm) 0 Price (b) Market Supply Quantity (market) Price 0 Supply MC 1.00 $ $ ,000200,000

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit u Firms will enter or exit the market until profit is driven to zero. u In the long run, price equals the minimum of average total cost. u The long-run market supply curve is horizontal at this price.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit... (a) Firm’s Zero-Profit Condition Quantity (firm) 0 Price P = minimum ATC (b) Market Supply Quantity (market) Price 0 Supply MC ATC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit u After all entry & exit, firms that remain must be making zero economic profit. u Entry & exit ends only when price and average total cost are driven to equality. u Long-run equilibrium must have firms operating at their efficient scale – their minimum long run average total cost.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u In a market with free entry and exit, economic profits are driven to zero in the long run and the firms that remain produce at efficient scale.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increase in Demand in the Short Run u An increase in demand raises price and quantity in the short run. u Firms earn profits because price now exceeds average total cost.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increase in Demand in the Short Run... Market Firm Quantity (firm) 0 Price MC ATC P1P1 Quantity (market) Price 0 D1D1 P1P1 Q1Q1 A S 1 Long-run supply (a) Initial Condition P

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. D2D2 Increase in Demand in the Short Run... Market Firm Quantity (firm) 0 Price MCATC P1P1 Quantity (market) Price 0 D1D1 P1P1 Q1Q1 A S1S1 Long-run supply (b) Short-Run Response Q2Q2 B P2P2 P2P2 Profit

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increase in Demand in the Long Run... Market Firm Quantity (firm) 0 Price MCATC P1P1 Quantity (market) Price 0 D1D1 P1P1 Q1Q1 A S1S1 Long-run supply (c) Long-Run Response D2D2 B Q2Q2 P2P2 S2S2 C Q3Q3

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Why the Long-Run Supply Curve Might Slope Upward u Some resources used in production may be available only in limited quantities. u Firms may have different costs, e.g., owing to location.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Marginal Firm The marginal firm is the firm that would exit the market if the price were any lower.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. u The price of the good equals both the competitive firm’s average revenue and its marginal revenue.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u To maximize profit a firm chooses the quantity of output such that marginal revenue equals marginal cost. u This is also the quantity at which price equals marginal cost. u Therefore, the firm’s marginal cost curve is its supply curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. u In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Summary u In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale. u Changes in demand have different effects over different time horizons.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Graphical Review

Profit Maximization for the Competitive Firm... P = AR = MR P=MR 1 MC Quantity 0 Costs and Revenue ATC AVC Q MAX The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC 1 Q1Q1 MC 2 Q2Q2 Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Marginal-Cost Curve and the Firm’s Supply Decision... Quantity 0 Costs and Revenue MC ATC AVC Q1Q1 P 1 P 2 Q2Q2 This section of the firm’s MC curve is also the firm’s supply curve. Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

The Firm’s Short-Run Decision to Shut Down... Quantity ATC AVC 0 Costs MC If P < AVC, shut down. If P > AVC, keep producing in the short run. If P > ATC, keep producing at a profit. Firm’s short-run supply curve.

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC = Long-run S ATC AVC 0 Costs Firm enters if P > ATC Firm exits if P < ATC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Competitive Firm’s Long- Run Supply Curve... Quantity MC ATC AVC 0 Costs Firm’s long-run supply curve

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Profit in the Graph for the Competitive Firm... Profit QQuantity 0 Price P = AR = MR ATCMC P ATC Profit-maximizing quantity a. A Firm with Profits

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Measuring Profit in the Graph for the Competitive Firm... Loss Quantity 0 Price P = AR = MR ATCMC P Q Loss-minimizing quantity ATC b. A Firm with Losses

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Short Run: Market Supply with a Fixed Number of Firms... (a) Individual Firm Supply Quantity (firm) 0 Price (b) Market Supply Quantity (market) Price 0 Supply MC 1.00 $ $ ,000200,000

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. The Long Run: Market Supply with Entry and Exit... (a) Firm’s Zero-Profit Condition Quantity (firm) 0 Price P = minimum ATC (b) Market Supply Quantity (market) Price 0 Supply MC ATC

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increase in Demand in the Short Run... Market Firm Quantity (firm) 0 Price MC ATC P1P1 Quantity (market) Price 0 D1D1 P1P1 Q1Q1 A S 1 Long-run supply (a) Initial Condition P

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increase in Demand in the Short Run... D2D2 Market Firm Quantity (firm) 0 Price MCATC P1P1 Quantity (market) Price 0 D1D1 P1P1 Q1Q1 A S1S1 Long-run supply (b) Short-Run Response Q2Q2 B P2P2 P2P2 Profit

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc. Increase in Demand in the Short Run... Market Firm Quantity (firm) 0 Price MCATC P1P1 Quantity (market) Price 0 D1D1 P1P1 Q1Q1 A S1S1 Long-run supply (c) Long-Run Response D2D2 B Q2Q2 P2P2 S2S2 C Q3Q3