Firms and Competitive Markets

Competitive Market

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

• • • • • Goal is to maximize profit – ∏ = 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

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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

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

• • 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

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

Shut down and Exit

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

Short Run Decision

• • • Focus on – 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

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

Long Run Decision

• • • Exit 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

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

• •

Profit

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

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

• • • •

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 + =

• • • • In long run # of firms not fixed – 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)

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

Some Caveats

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. P 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. Q Or some firms could just be better at it, thus having lower cost curves. But either way LR flatter than SR. Q

• • • • 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

• •

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

• • • • • • 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

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

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

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