1. Competitive firms and markets

2. 2 Introduction Profit maximization Behavior of a firm in a competitive market: In the short run (SR) In the long run (LR)

3. 3 Profit maximization π(q) = R(q) – C(q) 2 steps: What is the output level, q*, which maximizes profits (minimises losses) ? Is the firm better off producing q* or shutting down?

4. 4 Output decision What do you think is the typical shape of a profit curve? At q*, what is the slope of this curve? Conclusions? π q q*

5. 5 A firm maximizes profits when: MC = MR If MC < MR, how can the firm increase its profits? What if MC > MR? The single MOST important thing

6. 6 Perfect competition A competitive firm is said to be a « price taker » Explain. A competitive firm faces a demand curve which is perfectly elastic.

7. 7 Conditions for perfect competition Five conditions: Large number of firms and consumers Identical product sold across firms Free entry and exit in the market Perfect information No transaction costs

8. 8 Competition in the short run MC = MR Yet, R = p x q and « price taker » Hence, profit is max if: MC = _____ firm’s internal structure market structure  MR = ____

9. Profit maximization (graph.)  Shade the area corresponding to the firm’s maximum profit. Compute the value of this maximum profit? q $/q MR=P MC q*=280 P=8 AC 0 6.5 6 q $ R q* C π

10. Firm behavior in a competitive market 1. Short-run behavior

11. 11 Shutdown decision Should a firm shut down if π(q*) < 0 ? Ex1: At q*, R = $2,000, VC = $1,000 and F = $3,000 Ex2: At q*, R = $500, VC = $1,000 and F = $3,000 Conclusion ?

12. 12 Output decision (cont.) A firm should continue to operate in the short run if its revenue covers its variable cost. Shutdown if:R < VC

13. 13 Shutdown if R < VC  P x q < VC  P < VC / q Therefore: Shutdown if P < AVC Shutdown decision

14. 14 Shutdown decision (graph.) If the firm produces q* units, what will be its profit (or its loss)? If the firm shuts down, what will it lose? q $/q MC q* P AC 0 AVC A B

15. 15 Three regions q pMC AC 0 AVC π > 0 π < 0 operate shutdown break-even point shutdown point

16. 16 Firm’s supply curve Draw the firm’s supply curve. Explain q $/q MC AC AVC

17. 17 Market supply curve Horizontal sum of individual firms’ supply curves (like D) Ex: 2 firms, Q = q 1 + q 2. q1q1 s1s1 q2q2 s2s2 Q S = s 1 + s 2 100 200 400300 700 p p p

18. 18 Price-elasticity of supply Similar to the price elasticity of demand: Interpretation: The price elasticity of supply represents the percentage change in Q s when P changes by 1%. % change in Q s ∆Q s /Q s E s p = --------------------------- = ---------------- % change in P∆P/P

19. Firm behavior in a competitive market 2. Long-run behavior

20. 20 Competition in the long run Recall: all costs are variable Profit maximization: MC = MR  MC = P Shutdown decision: R < C, (selling below cost is not sustainable in the long-run). Hence, shutdown if R < C  π < 0. In the LR, a firm only produces if it does not incur any losses

21. 21 LR firm supply curve Draw. q $/q MC LR AC LR AVC LR

22. 22 LR market supply curve As before: horizontal sum of individual curves… BUT… how many firms are there? If the market is profitable (π > 0  p > AC), what will happen? Else, if π < 0 (LR loss), describe the sequence of events.

23. 23 Graphically q $/q MC LR AC LR p Q S LR p = min AC LR

24. 24 Zero profits in the long run ??? Recall: We’re talking about economic profit (π = π accounting – C opportunity ) π < 0  I could earn more money elsewhere Hence, when π = 0, the firm « makes money » (π accounting > 0), but no more than it would if it utilized its resources differently: it is making normal profits.

25. 25 Conclusion Behavior of a competitive firm MC = MR : Reconciling the internal structure of the firm with current market conditions Next: Supply and demand, a cooperative process

26. Example (1) A pizza shop in a perfectly competitive environment with the following total costs produces six pizzas. Quantity Total Costs ($) 010 115 225 340 460 585 6115 7150 What is the price of a a pizza in this industry?

27. Example (1) Perfect competition  Firm is a price taker so it sets q such that MC=P QuantityTotal Costs ($)MC 010--- 1155 22510 34015 46020 58525 611530 715035 At q=6, MC=30, the price is 30$

28. Example (2) You operate Econsultants. One of your clients, Handspring, has recently decided to start a cell phone division in addition to producing handheld personal organizers. Unfortunately, this division of the company is not doing as well as they had hoped and has asked you to assess whether or not they should continue to operate in the short run. The current market price for a cell phone is $100/phone and at this price, Handspring would like to supply 100 phones. However, at a quantity of 100 phones, Handspring has an ATC of $110/phone and an AVC of $75/phone. Starting a cell phone division involved many one-time costs (i.e. the building of factories). In the short run, would you suggest that Handspring continue to operate this division of the company? Explain your answer.

29. Example (2) Operate in SR or not? Represent graphically. P=100$q=100ATC=110$AVC=75$ The question assumes that q is such that P=MC, the firm is optimizeing. SR decision  is P > than AVC? Yes  Operate in the short run to eat some of the fixed costs.

30. Example (3) The owner of a firm wants to know if it should change the level of output and/or if it should stay in the business in the short and long run. You are given the following information. Rev=3,000$AVC is @ min FC=500$TC=3125$P=40$

31. Example (3) 1. Is P=MC? MC=AVC because it is @ min. We needAVC. VC=TC-FC  3125$-500$=2625$. AVC=VC/Q, We need Q. Rev=P*Q  3,000$=Q*40$  Q=3,000$/40$=75 AVC=2625$/75$=35$  P (40$) > AVC (35$)!!!!! This means that the level of output is not chosen optimally. Output needs to be raised before decisions about SR and LR are to be taken.