Econ.14 Tuesday, November 15, 2016 11:08 AMChapter 14: Firms in competitive markets Chapter Overview: • What is a perfectly competitive market? • What is marginal revenue? How is it related to total and averagrevenue? • How does a firm in a competitive market determine the quantity that maximizes profits? • When might a competitive firm shut dowDon't forget about the age old question of greco roman household codes
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n in the short run? • When might a competitive firm shut down in the long run? • What does the market supply curve look like in the short run? Inthe long run? Scenario: starting your own business: • Three years after graduating, you are running your own business • You must decide how much to produce, what price to charge, how many workers to hire, etc. • What factors should affect these decisions? ○ Your costs (covered in Chapter 13) ○ How much competition you face • Look at how firms behave in perfectly competitive markets Charcteristics of Perfect Competition: Many buyers and sellers The goods offered for sale are largely the same Firms can freely enter or exit the market • Because of 1 & 2, each buyer and seller is a “price taker” • These firms do not set their price; they take the price as given • Example – a farmer does not set the price for the commodity cornthat is sold e • Because of 1 & 2, each buyer and seller is a “price taker” • These firms do not set their price; they take the price as given • Example – a farmer does not set the price for the commodity cornthat is sold Revenue of a competitive Firm Total revenue (TR) = price x quantity Average revenue (AR) = total revenue/ quantity = price Marginal revenue (MR) = change in total revenue/ change in quantity = price MR = price for a competitive firm • A competitive firm can keep increasing its output without affecting the market price ○ It doesn’t matter how many bushels of corn that a farmer sells, the market price for corn will not change • So, each one-unit increase in Quantity causes revenue to rise byP (MR = P) • MR = P is only true for firms in competitive markets Profit Maximization • What Q maximizes the firm’s profits? • To determine the answer, “think at the margin” If Q increases by one unit revenue rises by MR cost rises by MC • To determine the answer, “think at the margin” If Q increases by one unit revenue rises by MR cost rises by MC • If MR > MC, then increase Q to raise profit • If MR < MC, then reduce Q to raise profit Marginal Cost and the firm's supply decision •If the price rises to P2, then the profit maximizing quantity rises to Q2. Marginal Cost and the firm's supply decision • If the price rises to P2, then the profit maximizing quantity rises to Q2. • The MC curve determines the firm’s Q at any price. • Hence, the MC curve is the firm’s supply curve. Shutdown versus Exit • Shutdown • ○ Exit A short-run decision not to produce anything because of market conditions. ○ A long-run decision to leave the market •Long run phenA key difference ○ If the firm is shutdown in the short run, the firm must stilpay Fixed Costs ○ If the firm exits in the long run, there are zero costs Short run phenomenon menonl The irrelevance of sunk costs • Sunk cost: accost that has already been committed and cannot be recovered • Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice • Fixed Costs are sunk costs. The firm must pay its Fixed Costs whether it produces or shuts down. •So, Fixed Costs should not matter in the decision of whether to shut down. . • So, Fixed Costs should not matter in the decision of whether to shut down. A competitive Firm's Supply Curve • Determine this firm’s total profit • Identify the area on the graph that represents the firm’s profit. • Determine this firm’s total loss, assuming AVC < $3 • Identify the area on the graph that represents the firm’s loss. .Market Supply: Assumptions 1. All existing firms and potential entrants have identical costs a. This is a simplistic assumption; in the real world, thiassumption does not strictly hold 2. Each firm’s costs do not change as other firms enter or exitthe market a. This is a simplistic assumption; in the real world, thiassumption does not strictly hold 3.The number of firms in the market is a. Fixed in the short run due to fixed costs b. Variable in the long run due to free entry and exit assumption does not strictly hold 3. The number of firms in the market is a. Fixed in the short run due to fixed costs b. Variable in the long run due to free entry and exit The short run market supply curve • As long as P ≥ AVC, each firm will produce its profit-maximizinquantity, where MR = MC • Recall from Chapter 4: At each price, the market quantity supplied is the sum of quantities supplied by all firms Entry and exit in the long run • In the Long Run, the number of firms can change due to entry & exit • If existing firms earn positive economic profit, ○ New firms enter, Short Run market supply shifts right ○ P falls, reducing profits and slowing entry • If existing firms incur losses ○ Some firms exit, Short Run market supply shifts left ○ P rises, reducing remaining firms’ losses The zero-profit condition • Long run equilibrium – ○ ome rms ex, or un mare suppy ss e ○ P rises, reducing remaining firms’ losses The zero-profit condition • Long run equilibrium The process of entry or exit is complete – remaining firms earn zero economic profit • Zero economic profit occurs when P = ATC • Since firms produce where P = MR = MC, the zero economic profit condition is P = MC = ATC • Recall that MC intersects ATC at minimum ATC • Hence, in the long run, P = minimum ATC Why do firms stay in business in profit = 0? • •Recall that economic profit is revenue minus all costs (explicitcosts plus implicit costs). Implicit costs include the opportunity cost of the owner’s time and money. In the zero economic profit equilibrium, ○ Firms earn enough revenue to cover these costs ○ Accounting profit is positive WONT HAVE TO DRAW JUST EXPLAINWhy the LR supply curve might slope upward •Why the LR supply curve might slope upward • The long run market supply curve is horizontal if: ○ All firms have identical costs and ○ Costs do not change as other firms enter or exit the market • If either of these assumptions is not true, then the long run supply curve slopes upward Why the LR Supply Curve Might Slope Upward Firms have different costs NOT TESTING ON TH• As P rises, firms with lower costs enter the market before thosewith higher costs • Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases the quantity supplied • Therefore, the LR market supply curve will slope upward • At any P, ○ For the marginal firm, P = minimum ATC and profit = 0 ○ For lower-cost firms, profit > 0 Why the LR Supply Curve Might Slope Upward Costs rise as firms enter the market NOT TESTING ON TH• In some industries, the supply of a key input is limited (e.g., the amount of land suitable for farming is fixed) • The entry of new firms increases demand for this input, causing its price to rise • This increases the cost for all firms • Therefore, an increase in P is required to increase the market quantity supplied, so the supply curve is upward sloping Conclusion The efficiency of a competitive market • Recall that MC is the cost of producing the marginal unit. • P is the value to the buyers of the marginal unit • IS IS . • P is the value to the buyers of the marginal unit •