ECON 201 Chapter 14 Notes
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This 6 page Class Notes was uploaded by Kathryn Catton on Thursday April 14, 2016. The Class Notes belongs to ECON 2010 at a university taught by Dr. Zegeye in Winter 2016. Since its upload, it has received 16 views.
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Date Created: 04/14/16
ECON 201 Chapter 14: Firms in Competitive Markets What is a Competitive Market? The Meaning of Competition: A competitive market, sometimes called a perfectly competitive market, has two MAJOR characteristics= 1) there are many buyers and many sellers in the market 2) the goods offered by the various sellers are largely the same. That means that they are perfect substitutes and there is no need for advertisements. However there are more characteristics!! 3) Free entry into and exit from the industry 4) Buyers and sellers well informed 5) each firm/buyer is a price taker 6) each firm can choose the level of output that would maximize its profit or minimize its loss 7) profit maximizing or loss minimizing output is determined at a point where MR=MC 8) MR= Change in TR/ Change in Q or Change in Q times P/ Change in Q. As a result, the actions of any single buyer or seller in the market have a negligible impact on the market price. Buyers and sellers in competitive markets must accept the price the market determines and therefore are said to be price takers. The free entry and exit in a competitive market is a powerful force shaping the long run equilibrium. The Revenue of a Competitive Firm: A firm here, like any other, tries to maximize profit (TR-TC). TR= P TIMES Q. Total revenue is proportional to the amount of output. Costs are also helpful wen figuring out revenue. The table includes Quantity, Price, Total Revenue, and Average Revenue- total revenue divided by the quantity sold. It tells the revenue a firm receives for the typical unknit sold. (P times Q)/Q. Therefore for all firms, average revenue equals the price of the good. The last column shows Marginal Revenue- which is the change in total revenue from an additional unit sold. Marginal revenue equals the price of the good. Profit Maximization and the Competitive Firm’s Supply Curve A Simple Example of Profit Maximization: The first way to find profit maximization is examining the highest profit. Where ever there is the highest profit, you find to produce at that quantity that produces the highest profit. You can also find the profit maximizing quantity by comparing the MR and MC from each unit produced. As long as MR > MC, increasing the quantity produced raises profit. At that point you can increase production because it will put more money in your pockets than it takes out. If MR < MC, you need to decrease production. If you think at the margin and make incremental adjustments to the level of production, you end up producing the profit-maximizing quantity. The Marginal-Cost Curve and the Firm’s Supply Decision: MC is upward sloping, ATC is U-Shaped, MC crosses the ATC curve at the minimum of ATC, horizontal line at the market price P. It is horizontal because a competitive firm is a price taker: the price of the firm’s output is the same regardless of the quantity that the firm decides to produce. P=AR=MR. Whether the firm begins with production at a low level or high level, the firm will eventually adjust production until the quantity produced reaches Qmax. This analysis yields 3 general rules for Pmax: 1. If MR > MC, the firm should increase its output 2. If MC > MR, the firm should decrease its output 3. At the profit-maximizing level of output, MR and MC are exactly equal 4. P = ATC, normal rate of return, P > ATC, keep producing in short run (minimize losses), P < ATC, SHUTDOWN, you can’t cover the costs. Supply curve is show above the shutdown point. These rules are key to rational decision making by any firm. Not only competitive but more you will see. In essence, because the firm’s MC curve determines the quantity of the good the firm is willing to supply at any price, the MC curve is also the competitive firm’s supply curve (below). The Firm’s Short Run Decision to Shut Down: A shutdown refers to a short run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long run decision to leave the market. A firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market does not have to pay any costs at all, fixed or variable. For example, the land is one of the farmer’s fixed costs. If the farmer decides not to produce any crops one season, the land lies fallow and he can’t recover this cost. When making a short run decision, of whether to shut down for a season, the fixed cost of the land is said to be a sunk cost. But, if he decides to leave farming altogether, he can sell the land and it is not sunk. ***Shut down if TR < VC or write as TR/Q < VC/Q. Shut down if P < AVC. The competitive firm’s short run supply curve is the proportion of its MC curve that lies above the AVC. Spilt Milk and other Sunk Costs: A sunk cost- a cost that has already been committed and cannot be recovered. In the shut-down decision, we assume that the firm can’t recover its fixed costs by temporarily stopping production. Regardless of the quantity of output supplied, even at 0, the firm still pays its fixed costs. As a result, the fixed costs are sunk in the short run and they should be ignore when deciding how much to produce. The firm’s short run supply curve is the part of the MC curve that lies above AVC and the size of the fixed cost does not matter for this supply decision. The Firm’s Long Run Decision to Exit or Enter a Market: If a firm exits, it will lose all revenue from the sale of its product, it will save not only its VC but also FC. The firm exists the market if the revenue it would get from producing is less than its total costs. Exit if TR < TC or Exit if TR/Q < TC/Q or P < ATC. You should enter if P < ATC, trying to be profitable. The competitive firm’s long run supply curve is the portion of its MC curve that lies above ATC. Measuring Profit in our Graph for the Competitive Firm: Profit= TR-TC or (TR/Q-TC/Q) times Q. Another way to write it is Profit= (P-ATC) times Q. The Supply Curve in a Competitive Market: Two cases to consider: First, we examine a market with a fixed number of firms. Second, we examine a market in which the number of firms can change as old firms exit the market and new firms enter. Both are important, for each applies to a specific time horizon. Short run- fixed number of firms is appropriate and long term the number can be adjusted to changing market conditions. Short Run: Market Supply with a Fixed Number of Firms: As long as price is above AVC, the MC is its supply curve. The quantity supplied to the market equals the sum of the quantity supplied by each firm. The market supply reflects the individual firm’s MC curves. The Long Run: Market Supply with Entry and Exit: Entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits. Exit will reduce the number of firms, decrease the quantity and drive up prices and profits. At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit. P= P-ATC times Q. The operating frim has a zero profits if and only if the price of the good equal the ATC. If price is above ATC, profit is positive, which encourages new firms to enter. If the price is less than ATC, profit is negative, which encourages some firms to exit. The process of entry and exit ends only when price and ATC are driven to equality. The level of production with the lowest average total cost is called the firm’s efficient scale. Therefore, in the long run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. In this market, there is only one prices consistent with zero profit-the minimum ATC. Why Do Competitive Firms Stay in Business If They Make Zero Profit? Economic profit is zero, but accounting profit is positive or negative. If it is positive and economic is zero, you can stay in business. Total cost includes the time and money that the firm owners devote to the business. Here the firm’s revenue must compensate the owners for these opportunity costs. Why the Long Run Supply Curve Might Slope Upward: The long run market supply curve is horizontal at the minimum of ATC. When the demand for the good increases, the long run result is an increase in the number of firms and in the total quantity supplied, without any change in the price. 2 reasons as to why the supply curve slopes upward: 1) resources used in production may be available only in limited quantities. Quantity of land is limited, more farmers= land price increases, which raises costs for farmers in the market. Thus an increase in demand for farm products can’t induce an increase in quantity supplied without also inducing a rise in farmer’s cost, which in turn means a rise in price. 2) Firms may have different costs. Some people work faster than others and some have better alternative uses of their time than others. Higher costs for firms means price must rise to make entry profitable for them. The price in the market reflects the ATC of the marginal firm- the firm that would exit the market if the price were any lower. Entry does not eliminate this profit because would-be entrants have higher costs than firms already in the market. Higher-cost firms will enter only if the price rises, making the market profitable for them. With that, a higher price may be necessary to induce a larger quantity supplied, in which case the long run supply curve is upward sloping rather than horizontal. Because firms can enter and exit more easily in the long run than in the short run, the long run supply curve is typically more elastic than the short run supply curve. Graphs below.
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