What is a Competitive Market?

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1 Firms in Competitive Markets Competitive market (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 ˣ Q Proportional to the amount of output PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 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 (): i.e., if MR >, then increase production (Q); if MR <, then decrease production (Q); maximize profit where MR = 2 1

2 Table 1 Total, Average, and Marginal Revenue for a Competitive Firm 3 Table 2 Profit Maximization: A Numerical Example 4 2

3 Profit Maximization The marginal-cost curve and the firm s supply decision: curve is upward sloping curve is U-shaped; curve crosses the curve at the minimum of curve P = AR = MR Rules for profit maximization: If MR >, then firm should increase output If MR <, then firm should decrease output If MR =, 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 5 Figure 1 Profit Maximization for a Competitive Firm Costs and Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. 2 P=MR 1 =MR 2 AVC P=AR=MR 1 Q 1 Q MAX This figure shows the marginal-cost curve (), the average-total-cost curve (), 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 1, so raising production increases profit. At the quantity Q 2, marginal cost 2 is above marginal revenue MR 2, so reducing production increases profit. The profit-maximizing quantity Q MAX is found where the horizontal price line intersects the marginal-cost curve. Q 2 6 3

4 Figure 2 Marginal Cost as the Competitive Firm s Supply Curve P 2 AVC Q 1 Q 2 An increase in the price from to P 2 leads to an increase in the firm s profitmaximizing 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. 7 Profit Maximization 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 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 curve that lies above AVC 8 4

5 Figure 3 The Competitive Firm s Short-Run Supply Curve Costs 1. In the short run, the firm produces on the curve if P>AVC, but shuts down if P<AVC. AVC In the short run, the competitive firm s supply curve is its marginal-cost curve () above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down. 9 Profit Maximization 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 1 5

6 Profit Maximization Firm s long-run decision Exit the market if TR < TC (or if P < ) Enter the market if TR > TC (or if P > ) Competitive firm s long-run supply curve The portion of its marginal-cost curve that lies above Measuring profit: If P > (we have positive profit) Profit, = TR TC = (P ) ˣ Q If P < (we have a loss or negative profit) Loss = TR - TC = (P ) ˣ Q (i.e., minus) 11 Figure 4 The Competitive Firm s Long-Run Supply Curve Costs 1. In the long run, the firm produces on the curve if P>, but exits if P< In the long run, the competitive firm s supply curve is its marginal-cost curve () above average total cost (). If the price falls below average total cost, the firm is better off exiting the market. 12 6

7 Figure 5 Profit as the Area between and Average Total Cost (a) A firm with profits (b) A firm with losses P Profit P=AR=MR Loss P P=AR=MR Q (profit-maximizing quantity) Q (loss-minimizing quantity) 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 ), and the 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 has losses. 13 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 = For P > AVC: supply curve is 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 > firms make positive profit so then new firms enter the market If P < firms make negative profit so then existing firms exit the market 14 7

8 Figure 6 Short-Run Market Supply (a) Individual firm supply (b) Market supply Supply $2. $ (firm) 1, 2, (market) 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 panel (a). Here, in a market of 1, firms, the quantity of output supplied to the market is 1, times the quantity supplied by each firm. 15 Supply Curve Long run Process of entry and exit ends when Firms still in market (existing firms) make zero economic profit (P = ) Because = then, it is efficient scale Long run supply curve perfectly elastic Horizontal at minimum Why do competitive firms stay in business if they make zero profit? Remember? Profit, = TR TC Total cost includes all opportunity costs Zero-profit equilibrium Economic profit ( ) is zero Accounting profit is positive 16 8

9 Figure 7 Long-Run Market Supply (a) Firm s Zero-Profit Condition (b) Market supply P= minimum Supply (firm) (market) 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 longrun market supply curve is horizontal at this price, as shown in panel (b). 17 Supply Curve Market in long run equilibrium (1) P = minimum (2) Zero economic profit Increase in demand: the demand curve shifts right Short run results in: Higher equilibrium quantity (Q), and Higher price: P >, i.e., positive eco. 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 But equilibrium quantity increases because there are more firms in the market Efficient scale is achieved 18 9

10 Figure 8 An Increase in Demand in the Short Run and Long Run (a) Market 1. A market begins in long-run equilibrium Short-run supply, S 1 (a) Initial Condition Firm 2. with the firm earning zero profit. A Long-run supply Demand, D 1 Q 1 (market) 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. (firm) 19 Figure 8 An Increase in Demand in the Short Run and Long Run (b) (b) Short-Run Response Market Firm 3. But then an increase in 4. leading to demand raises the price short-run profits. S 1 (short run) B P 2 P A Long-run 2 supply D 1 D 2 Q 1 Q 2 (market) (firm) 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 to P 2, and the quantity sold in 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. 2 1

11 Figure 8 An Increase in Demand in the Short Run and Long Run (c) (c) Long-Run Response Market Firm 5. When profits induce entry, supply 6. restoring long-run increases and the price falls, equilibrium. P 2 A B C S 1 S 2 Long-run supply D 1 D 2 Q 1 Q 2 Q 3 (market) (firm) 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 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

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