1. Firms in a Competitive Market14
Firms in a Competitive Market

2. Overview
market structure describes the state (type) of a market with respect to competition.
The major market forms are:
Perfect competition, in which the market consists of a very large number of firms producing a homogeneous product.
Monopolistic competition, also called competitive market, where there are a large number of independent firms which have a very small proportion of the market share.
Oligopoly, in which a market is dominated by a small number of firms which own more than 40% of the market share.
Monopoly, where there is only one provider of a product or service.
Natural monopoly, a monopoly in which economies of scale cause efficiency to increase continuously with the size of the firm.

3. What is a Competitive Market?
Market with many buyers and sellers
Trading identical products
Each buyer and seller is a price taker
Firms can freely enter or exit the market
Implying
No firm or individual has any “market power”
No ability to set or effect market equilibrium price

4. Profit Maximizing Rule
Change in Profit
ΔProfit = MR – MC
Profit maximizing rule:
To maximize profits, the firm should use a marginal analysis
Profit is maximized by choosing the level of output such that
MR = MC

5. Profit Maximization Image: Animated Figure 9.1 Lecture notes:
We can use the profit maximizing rule, MR = MC, to identify the most profitable output in a three-step process:
1.Locate the point at which the firm will maximize its profits: MR = MC
2.Look for the profit maximizing output: move down the vertical dashed line to x axis at point Q. Any quantity greater than, or less than, Q would result in lower profits.
3. Determine the average cost of producing Q units. From Q move up along the dashed line until it intersects with the ATC curve. From that point move horizontally until you come to the y axis. This tells us the average cost, C, of making Q units.
Since the MR is the price, and the price is higher than the average cost, the firm makes the profit shown in the green rectangle, which is the visual representation of the profit the firm earns.

6. Profit Maximizing Rule
Profit is maximized by choosing the level of output such that
MR = MC
If MR > MC
The firm can increase profits by producing more Q
If MR < MC
The firm has produced “too much” Q, and profits are not maximized
Lecture notes:
Where does MR = MC come from? Think about the intuition of cleaning an additional driveway.
If the MR >MC for clearing another driveway, clearing that additional driveway will increase profits!
However, if the MC > MR for clearing that driveway, then doing so will decrease profits and this action should not be taken.

7. When to Operate or Shut Down (Short Run)
Image: Animated Figure 9.2
Lecture notes:
Green = go. Yellow = caution. Red = stop.
If the MR curve is above the minimum point on the ATC curve, the firm will make a profit (shown in green).
If the MR curve is below the minimum point on the ATC curve but above the minimum point on the AVC curve, the firm will operate at a loss (shown in yellow).
If the MR curve is below the minimum point on the AVC curve, the firm will temporarily shut down (shown in red).

8. Profit and Loss in the Short Run
Condition
Outcome
P > ATC
The firm makes a profit
ATC > P > AVC
The firm will operate to minimize loss
AVC > P
The firm will temporarily shut down
Lecture notes:
Yellow area detail:
In this area, you are covering all of your VC (variable costs) and at least SOME of your FC (fixed costs). You are operating at a loss because you can’t cover ALL of your expenses. So why are we still producing?
Think about this: Suppose I have FC = $1,000. If I produce Q = 0, I have no revenues, but I also have no VC. Thus, I will lose $1,000 if I shut down and produce Q = 0. However, what if I can cover all of my VC and SOME of my FC? What if I am able to pay $400 of my $1,000 FC? Then, I will ONLY lose $600 for the time period. It’s better to lose $600 than to lose $1,000.
I’m still maximizing my profit, it’s just that my profit is negative!

9. Short Run Supply Curve Image: Animated Figure 9.3 From the text:
In the short run diminishing marginal product causes the firm’s costs to rise as the quantity produced increases. This is reflected in the shape of the firm’s supply curve, shown in yellow. The supply curve is upward-sloping above the minimum point on the AVC curve. Below the minimum point on the AVC curve—denoted by V on the y axis—the supply curve becomes vertical at a quantity of 0, indicating that a willingness to supply the good does not exist below a price of V. At prices above V, the firm will offer more for sale as the price increases.

10. Long Run Supply Curve Kapital – Not Changed
Image: Animated Figure 9.4
From the text:
Any point below the minimum point on the ATC curve, denoted by C on the y axis, the firm will experience a loss. Since, in the long run, firms are free to enter or exit the market, no firm will willingly produce in the market if the price is less than cost (P < C). As a result, no supply exists below C. However, if price is greater than cost (P > C), the Float expects to make a profit and so it will continue to produce. Therefore, profits and losses act as signals for resources to enter or leave an industry.
The firm’s long-run supply curve, shown in yellow, is upward-sloping above the minimum point on the ATC curve, which is denoted by denoted by C on the y-axis. The supply curve becomes vertical at a quantity of 0, indicating that a willingness to supply the good does not exist below a price of C. In the long run, a firm that expects price to exceed ATC will continue to operate, since the conditions for making a profit seem favorable. On the other hand, a firm that does not expect price to exceed ATC should cut its losses and exit the industry.

11. Long Run Shut Down Criteria
Condition
Outcome
P > ATC
The firm makes a profit
P < ATC
The firm should shut down
Lecture notes:
Notice now that there is just one cost curve, the ATC. In the long run, all inputs (capital and labor) are variable so we don’t distinguish between fixed and variable costs.
Also, note that there is no yellow area here. In the short run case, we said a firm may temporarily experience a loss. However, realize that no firm can indefinitely sustain losses before shutting down or going out of business. If conditions are bad (low prices) for long enough, the firm will have to shut down or exit the industry in the long run.

12. Overview of Market Structures
Quick Reference to Basic Market Structures
Market Structure
Seller Entry Barriers
# of Sellers
Buyer Entry Barriers
# Buyers
Perfect Competition No
Many
Monopolistic competition
Oligopoly (few firms)
Yes
Few
Oligopsony (few buyers)
Monopoly (one firm)
One
Monopsony (one buyer)

13. Basic Assumptions: Perfect Competition
Atomicity
There is a large number of small producers and consumers on a given market,
each so small that its actions have no significant impact on others.
Firms are price takers, meaning that the market sets the price that they must choose.
Homogeneity
Goods and services are perfect substitutes; that is, there is no product differentiation. (All firms sell an identical product)
Perfect and complete information
All firms and consumers know the prices set by all firms
Equal access
All firms have access to production technologies, and resources are perfectly mobile.
Free entry
Any firm may enter or exit the market as it wishes (no barriers to entry).
Individual buyers and sellers act independently
The market is such that there is no scope for groups of buyers and/or sellers to come together to change the market price (collusion and cartels are not possible under this market structure)
Behavioral assumptions of perfect competition are that:
Consumers aim to maximize utility/well-being
Producers aim to maximize profits.