Firms in Competitive Markets

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1 1 Basic Economics Chapter 14 Firms in Competitive Markets Competitive markets (1) Market with many buyers and sellers (e.g., ) (2) Trading identical products (e.g., ) (3) Each buyer and seller is a price taker (no price influence) (4) Firms can freely enter or exit the market (e.g., ) The revenue of a competitive firm - Maximize profit (= total revenue total cost) Total revenue = price times quantity = P Q - Proportional to the amount of output What is a Competitive Market Average revenue (AR) = total revenue (TR) divided by the quantity/units sold (Q) Marginal revenue (MR) = change in total revenue ( TR) from an additional unit sold ( Q) For competitive firms, average revenue (AR) = P marginal revenue (MR) = P In perfectly competitive industries, price is a given for the typical firm (company) because the firm has no influence on the price (it s a price taker). The Firm s Goal of Profit Maximization: Maximize profit: produce quantity (Q) where profit (total revenue total cost) is greatest - Compare marginal revenue (MR) with marginal cost (MC): i.e.,

2 2 if MR > MC, then increase production (Q); if MR < MC, then decrease production (Q); maximize profit where MR = MC Table 1 Total, Average, and Marginal Revenue for a Competitive Firm Table 2 Profit Maximization: A Numerical Example

3 Profit Maximization The marginal-cost curve and the firm s supply decision: MC curve is upward sloping - ATC curve is U-shaped; MC curve crosses the ATC curve at the minimum of ATC curve P = AR = MR Rules for profit maximization: - If MR > MC, then firm should increase output - If MR < MC, then firm should decrease output - If MR = MC, then this is the profit-maximizing level of output Marginal-cost curve - Determines the quantity of the good the firm is willing to supply at any price; it is also the firm s supply curve Fig. 1 Profit Maximization for a Competitive Firm 3 This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-variable-cost curve (AVC). It also shows the market price (P), which equals marginal revenue (MR) and average revenue (AR). At the quantity Q 1, marginal revenue MR 1 exceeds marginal cost MC 1, so raising production increases profit. At the quantity Q 2, marginal cost MC 2 is above marginal revenue MR 2, so reducing production increases profit. The profitmaximizing quantity Q MAX is found where the horizontal price line intersects the marginal-cost curve.

4 Fig. 2 Marginal Cost as the Competitive Firm s Supply Curve 4 An increase in the price from P 1 to P 2 leads to an increase in the firm s profit-maximizing quantity from Q 1 to Q 2. Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it is the firm s supply curve. Shutdown - Short-run decision not to produce anything is made for a specified period of time (say, for a month only) due to current market conditions (say, the firm wants to ride out a weak market). - Even if it shuts down, the firm still has to pay fixed costs Exit: the long-run decision to leave the market (e.g. ) - Firm doesn t have to pay any costs The firm s short-run decision to shut down depends on TR (total revenue) and VC (variable costs) or, on P and AVC. Firm s decision: shut down if TR<VC (or, P < AVC) The competitive firm s short-run supply curve: it is the portion of its MC curve that lies above AVC

5 Fig. 3 The Competitive Firm s Short-Run Supply Curve 5 In the short run, the competitive firm s supply curve is its marginal-cost curve (MC) above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down. Sunk cost - Cost that has already been committed (e.g., ) - It cannot be recovered - Ignore them when making decisions Example: Near-empty restaurants The near-empty restaurant: Should it stay open for lunch? - Fixed costs Not relevant in decision to shut down Fixed costs are sunk costs in short run - Variable costs (VC) are relevant - Shut down if revenue from lunch < variable costs - Stay open if revenue from lunch > variable costs Firm s long-run decision - Exit the market if TR < TC (or if P < ATC) - Enter the market if TR > TC (or if P > ATC) The competitive firm s long-run supply curve - The portion of its marginal-cost curve that lies above ATC

6 6 Measuring profit: - If P > ATC (we have positive profit) Profit, = TR TC = (P ATC) Q - If P < ATC (we have a loss or negative profit) Loss = TR TC = (P ATC) Q (i.e., minus) Fig. 4 The Competitive Firm s Long-Run Supply Curve In the long run, the competitive firm s supply curve is its marginal-cost curve (MC) above average total cost (ATC). If the price falls below average total cost, the firm is better off exiting the market. Fig. 5 Profit as the Area between Price and Average Total Cost (a) A firm with profits 1 2 The area of the shaded box between price and average total cost represents the typical firm s profit. The height of this box is price minus average total cost (P ATC), and the

7 7 width of the box is the quantity of output (Q). In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm suffers a loss. Supply Curve Short run: market supply with a fixed number of firms - In the short run, the number of firms is fixed - Each firm supplies quantity where P = MC - For P > AVC: supply curve is the MC curve - To get the market supply curve, add up quantity supplied by each firm Long run: Firms can enter and exit the market - If P > ATC, firms make positive profit so then new firms enter the market because they are attracted. - If P < ATC, firms make negative profit so then existing firms exit the market because they re suffering losses. Fig. 6 Short Run Market Supply In the short run, the number of firms in the market is fixed. As a result, the market supply curve, shown in panel (b), reflects the individual firms marginal-cost curves, shown in

8 8 panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the quantity supplied by each firm. Long run - Process of entry and exit ends when: (i) Firms still in market (existing firms) make zero economic profit (P = ATC): remember: = (P ATC) Q = (0) Q = 0 so that if P = ATC, then (ii) Because MC = ATC, then firms are producing at an efficient scale (min. pt. of the ATC curve) Long run supply curve for the industry is perfectly elastic, i.e., it is horizontal at the minimum pt. of the ATC curve Why do competitive firms stay in business even if they make zero profit? - Remember? It is also the case that profit, = TR TC - Remember? Total cost includes all opportunity costs Thus, zero-profit equilibrium means: - Economic profit is zero - Accounting profit is positive

9 Fig. 7 Long Run Market Supply 9 In the long run, firms will enter or exit the market until profit is driven to zero. As a result, price equals the minimum of average total cost, as shown in panel (a). The number of firms adjusts to ensure that all demand is satisfied at this price. The long-run market supply curve is horizontal at this price, as shown in panel (b). The market in long run equilibrium: (1) P = minimum ATC (2) Zero economic profit Increase in demand: the demand curve shifts right Short run results in: - Higher equilibrium quantity (Q), and - Higher price: P > ATC, i.e., positive economic profit Positive economic profit in the short run Long run (over time), firms enter the market, and so, the short run supply curve shifts right, and so price decreases back to minimum ATC. But equilibrium quantity increases because there are more firms in the market. Efficient scale is achieved.

10 Fig. 7 An Increase in Demand in the Short and Long Run (a) 10 The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost (ATC). Panel (b) shows what happens in the short run when demand rises from D 1 to D 2. The equilibrium goes from point A to point B, price rises from P 1 to P 2, and the quantity sold in

11 11 the market rises from Q 1 to Q 2. Because price now exceeds average total cost, firms make profits, which over time encourage new firms to enter the market. Fig. 7 An Increase in Demand in the Short and Long Run (a) This entry shifts the short-run supply curve to the right from S 1 to S 2, as shown in panel (c). In the new long-run equilibrium, point C, price has returned to P 1 but the quantity sold has increased to Q 3. Profits are again zero, price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand.