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Firms and Competitive Markets

Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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Page 1: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

Firms and Competitive Markets

Page 2: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

Competitive Market• Properties– Many buyers and sellers– Trading identical products– Each buyer and seller a price taker– Free entry/exit of the market

Page 3: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

• 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

Page 4: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 5: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 6: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

• 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

Page 7: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

Costs and Revenue

Quantity

MC

ATC

AVC

P1

Q1 Q2

P2

MC Curve as Supply Curve

Page 8: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 9: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 10: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 11: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 12: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

MCATCCosts

Quantity

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

Firms exit market if P<ATC

Long Run Supply Curve

Page 13: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 14: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

P

AVC

Q*

Profit

Profit Maximizing QQ*

Loss

Cost Minimizing Q

MCMC

AVC AVC

P

AVC

Firm with Profits Firm with Losses

Page 15: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 16: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

• 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)

Page 17: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 18: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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.

Page 19: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

• 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

Page 20: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 21: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

• 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

Page 22: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

Market Firm

D SR Supply

LR Supply

MCATC

P P

Q Q

Initial State of Equilibrium

P’

Q’

Page 23: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

Market Firm

D SR Supply

LR Supply

MCATC

P P

Q Q

Demand Shifts, + Profits

P’’

Price increases

Which leads to + profits

Page 24: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker

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

Page 25: Firms and Competitive Markets. Competitive Market Properties – Many buyers and sellers – Trading identical products – Each buyer and seller a price taker