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Basic Economics Chapter 14
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
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
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.,
Firms in Competitive Markets
What is a Competitive Market
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).
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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
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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
Profit Maximization
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 Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising
production increases profit. At the quantity Q2, marginal cost MC2 is above
marginal revenue MR2, so reducing production increases profit. The profit-
maximizing quantity QMAX is found where the horizontal price line intersects
the marginal-cost curve.
Fig. 1 Profit Maximization for a Competitive Firm
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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
Fig. 2 Marginal Cost as the Competitive Firm’s Supply Curve
An increase in the price
from P1 to P2 leads to an
increase in the firm’s
profit-maximizing
quantity from Q1 to Q2.
Because the marginal-cost
curve shows the quantity
supplied by the firm at
any given price, it is the
firm’s supply curve.
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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
Fig. 3 The Competitive Firm’s Short-Run Supply Curve
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.
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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)
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
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
1
2
(a) A firm with profits
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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.
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.
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
Supply Curve
Fig. 6 Short Run Market Supply
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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 so that if P = ATC, then
= (0) × Q
= 0
(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
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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.
Fig. 7 Long Run Market Supply
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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 D1 to D2. The equilibrium goes from point A to
point B, price rises from P1 to P2, and the quantity sold in
Fig. 7 An Increase in Demand in the Short and Long Run (a)
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the market rises from Q1 to Q2. Because price now exceeds
average total cost, firms make profits, which over time
encourage new firms to enter the market.
This entry shifts the short-run supply curve to the right from
S1 to S2, as shown in panel (c). In the new long-run
equilibrium, point C, price has returned to P1 but the
quantity sold has increased to Q3. 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.
Fig. 7 An Increase in Demand in the Short and Long Run (a)
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