Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading...

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

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

Quantity

MC

ATC

AVCP = MR

= AR

Q*

Profit Max Decision

Producing here MC > MR so don’t

Producing here MC < MR so produce more

MC = MR so profit maxed

• 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

Quantity

MC

ATC

AVC

P1

Q1 Q2

P2

MC Curve as Supply Curve

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

MCATC

AVC

Costs

Quantity

In short run firms produce on the MC curve if P > AVC

In short run firms shut down if P < AVC

Short Run Supply Curve

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

MCATCCosts

Quantity

In long run firms produce on MC curve if P > ATC

Firms exit market if P<ATC

Long Run Supply Curve

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

P

AVC

Q*

Profit

Profit Maximizing QQ*

Loss

Cost Minimizing Q

MCMC

AVC AVC

P

AVC

Firm with Profits Firm with Losses

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)

P = Min ATC

MCATC

Supply

PricePrice

Quantity Quantity

Multiple Firms with identical cost curves

Add up supply at MC = ATC level for each to get Market Supply

Long Run Market Supply

Some Caveats

P

Q

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.

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.

P

Q

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

• 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

Market Firm

D SR Supply

LR Supply

MCATC

P P

Q Q

Initial State of Equilibrium

P’

Q’

Market Firm

D SR Supply

LR Supply

MCATC

P P

Q Q

Demand Shifts, + Profits

P’’

Price increases

Which leads to + profits

Market Firm

DSR Supply MCATC

P P

Q Q

Supply Shifts, 0 Profits

P’’’

Profits induce firms to enter market

Restoring Long Run Equilibrium, but with more firms

Price falls back