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Firms and Competitive Markets

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Presentation on theme: "Firms and Competitive Markets"— Presentation transcript:

1 Firms and Competitive Markets

2 Competitive Market Properties Many buyers and sellers
Trading identical products Each buyer and seller a price taker Free entry/exit of the market

3 Goal is to maximize profit Total Revenue Average Revenue
∏ = TR - TC Total Revenue Price time quantity: TR = P x Q Average Revenue Total Revenue divided by quantity sold Marginal Revenue Change in revenue from additional unit sold For competitive firms Average Revenue = P Marginal Revenue = P

4 Profit Max Profit Maximization
Produce at the quantity that maximizes the difference between TR and TC Compare marginal revenue with marginal cost If MR > MC increase production If MR < MC decrease production If MR = MC profit maximized

5 Profit Max Decision Costs and Revenue MC
Producing here MC > MR so don’t ATC MC = MR so profit maxed AVC P = MR = AR Producing here MC < MR so produce more Q* Quantity

6 Marginal Cost Curve (MC) determines the quantity a firm would be willing to supply at a given price
Therefore it is the firms supply curve

7 MC Curve as Supply Curve
Costs and Revenue MC ATC P2 AVC P1 Q1 Q2 Quantity

8 Shut down and Exit Shut Down Exit (don’t Enter)
Short Run decision not to produce Still have to pay fixed costs though Exit (don’t Enter) Long Run decision No costs

9 Short Run Decision Focus on Decision
Total Revenue Variable costs (fixed costs are fixed, so ignore) Decision Shut down if TR < VC ( or MR/AR < AVC ) Competitive Firms Short Run Supply Curve MC curve above the AVC curve

10 Short Run Supply Curve Costs ATC MC
In short run firms produce on the MC curve if P > AVC AVC Quantity In short run firms shut down if P < AVC

11 Long Run Decision Exit Market if: Enter Market if:
TR < TC Or P < ATC Enter Market if: TR > TC Or P > ATC Competitive Firms Long Run Supply Curve Portion of the MC curve above the ATC curve

12 Long Run Supply Curve Costs ATC MC
In long run firms produce on MC curve if P > ATC Firms exit market if P<ATC Quantity

13 Profit If P > ATC If P < ATC Positive profits
∏ = TR – TC = (P – ATC) x Q If P < ATC Negative profits (losses) Loss = TC – TR = (ATC – P) x Q

14 Firm with Profits Firm with Losses AVC AVC MC MC Profit P Loss AVC AVC P Q* Q* Profit Maximizing Q Cost Minimizing Q

15 Market Supply Curve In short run # of firms fixed
Each firm supplies where P = MC Each firms supply curve is the MC curve above their AVC curve (otherwise 0) For market supply just add up horizontally S1 S2 S - Market + =

16 In long run # of firms not fixed If P > ATC
Free entry/exit If P > ATC Profits are positive Firms enter market If P < ATC Firms taking losses Firms exit the market This means all firms (assuming identical cost curves) will produce at MC = ATC (efficient pt) So MKT supply curve will be horizontal at that point (perfectly elastic)

17 Long Run Market Supply Multiple Firms with identical cost curves
Add up supply at MC = ATC level for each to get Market Supply Price Price MC ATC P = Min ATC Supply Quantity Quantity

18 Some Caveats And perhaps it could still slope up if by increasing market size they bid up the cost of inputs. This would cause latte entering firms to have higher cost curves. P P Actual Supply would be more like this, with holes and dots denoting when different firms enter. That is it would not be a smooth line. Or some firms could just be better at it, thus having lower cost curves. But either way LR flatter than SR. Q Q

19 So why stay in business if making zero profit?
Profit = Total Revenue – Total Costs Total Costs include opportunity costs Zero Profit Equilibrium Zero economic profit Positive accounting profit

20 Shift in Demand and LR and SR supply response
Market in long run eq. P = ATC Zero economic profit Increase in demand Demand shifts out Short Run Higher quantity, higher price P > ATC Positive economic profit

21 Because of positive profits
Firms enter in the long run SR supply curve shifts right Price falls back to low point on ATC Quantity increases (because of more firms) Back to efficient scale

22 Initial State of Equilibrium
Market Firm P P MC ATC D SR Supply P’ LR Supply Q’ Q Q

23 Demand Shifts, + Profits
Market Firm P P Price increases MC ATC D SR Supply Which leads to + profits P’’ LR Supply Q Q

24 Supply Shifts, 0 Profits Market Firm P P SR Supply MC ATC D
Profits induce firms to enter market P’’’ Restoring Long Run Equilibrium, but with more firms Price falls back Q Q


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