Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 14: Competitive Markets

M. Cary LeaheyManhattan College

Fall 2012

2

Goals

• Analysis of one extreme pole of corporate behavior – perfect competition; the other pole – monopoly is the subject of the next chapter

• First application of the “buzz words” developed in the prior chapter:• Production function• Price and marginal revenue (MR) and cost (MC)• Marginal costs and average total costs (ATC)• Fixed versus variable costs• Distinction between short- and long-runs

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Introduction: revenue, price and costs of a competitive firm

• Total revenue (T) TR = P X Q• Average revenue (AR) AR = TR/Q = P• Marginal revenue (MR) MR = ∆TR/ ∆Q

• Since a competitive firm can keeping changing output without changing price (a price taker), each marginal (one unit) change in revenue is equal to the product of one unit of output. So

• MR = P for competitive markets

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Profit maximization

• Profit maximization is found at the margin (the last unit produced).• So increasing Q by one unit increases costs by MC and revenue by

MR

• If MR > MC, then increase Q to raise profit.• If MR , MC, then reduce Q to raise profit.

Profit maximization

505

404

303

202

101

45

33

23

15

9

$5$00

Profit = MR – MC

MCMRProfitTCTRQAt any Q with MR > MC,

increasing Q raises profit.

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7

7

5

1

–$5

10

10

10

10

–2

0

2

4

$6

12

10

8

6

$4$10

At any Q with MR < MC,reducing Q

raises profit.

P1 MR

Marginal cost and the firm’s supply decision

At Qa, MC < MR.

So, increase Q to raise profit.

At Qb, MC > MR.

So, reduce Q to raise profit.

At Q1, MC = MR.

Changing Q would lower profit.

Q

Costs

MC

Q1Qa Qb

Rule: MR = MC at the profit-maximizing Q.

P1 MR

P2 MR2

Marginal cost and the firm’s supply decision

If price rises to P2,

then the profit-maximizing quantity rises to Q2.

The MC curve determines the firm’s Q at any price.

Hence,

Q

Costs

MC

Q1 Q2

the MC curve is the firm’s supply curve.

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Shutdown versus exit

• Shutdown refers to temporary decision not to produce output because of market condtions. (This can be a long time such a firm such as Caterpillar).

• Exit refers to the long-run decision to leave the market.• The key difference is if a firm shuts down, the firm must pay (cover)

FC. If exit in the long run, zero costs.• Costs of shutting down, loss of revenue TR• Benefit of shutting down, cost saving of variable cost (VC)• So shut down is TR < VC, or• TR/Q < VC/Q, or• P < AVC

The firm’s SR supply curve is the portion of its MC curve above AVC.

Q

Costs

A competitive firm’s SR supply curve

MC

ATC

AVC

If P > AVC, then firm produces Q where P = MC.

If P < AVC, then firm shuts down (produces Q = 0).

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The irrelevance of sunk cost

• Fixed costs are sunk costs: costs that have already been committed and cannot be recovered (water under the bridge)

• Sunk costs are irrelevant to decision-making, as they are paid regardless of your choice

• So fixed costs do not enter the decision to shut down.• Only variable costs matter for the shut down decision.

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When to exit or enter the market

• Long run decision to exit• Costs of exiting is revenue loss TR• Benefits of exiting is the cost saving TC (zero FC in long run)• Firm exits if TR < TC or• TR/Q < TC/Q or• P < ATC

• Conversely to decide to enter the market.• In the long-run, a new firm will enter if it is profitable, or TR > TC• Divide by Q, then TR/Q > TC/Q or P > ATC

The firm’s LR supply curve is the portion of its MC curve above LRATC.

Q

Costs

The competitive firm’s supply curve

MC

LRATC

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Market supply: assumptions and market supply curve

• All existing firms and possible entrants have identical costs.• Each firms costs do not change as other firms enter/leave market.• The number of firms in the market is• Fixed in short run due to fixed costs• Variable in the long run due to ‘free” entry and exit

• As long as P > AVC, each firm will produce it profit-maximizing output where MC = MR

• Market supply is the sum of the quantities supplied by all firms.

The SR market supply curve

MC

P2

Market

Q

P

(market)

One firm

Q

P

(firm)

SP3

Example: 1000 identical firmsAt each P, market Qs = 1000 x (one firm’s Qs)

AVCP2

P3

30

P1

2010

P1

30,00010,000 20,000

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Entry and exit in the long run

• In the long run, the number of firms can change due to entry/exit.• If existing firms earn profits, then new firms enter, SR supply curve

shifts to the right. P falls, reducing profits and slowing entry.• If existing firms suffer losses, some firms exit, SR supply curve

shifts left, P rises , reducing remaining firms losses.• All existing firms and possible entrants have identical costs.

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Zero profit condition in the long run

• In the long-run equilibrium is obtained when the entry/exit process is complete and the remaining firms earn economic profit.

• Zero economic profit occurs when P = ATC• Since production occurs where P = MR = MC = ATC in long run,• since MC equals ATC at minimum ATC• So in long run P = minimum ATC• Firms stay in business with zero profit, since it includes all costs

including the opportunity cost of the owners time and money.• So economic profit = zero; accounting profit > zero

The LR market supply curve

MCMarket

Q

P

(market)

One firm

Q

P

(firm)

In the long run, the typical firm earns zero profit.

LRATClong-runsupply

P = min. ATC

The LR market supply curve is horizontal at P = minimum ATC.

S1

Profit

D1

P1long-runsupply

D2

SR & LR effects of an increase in demand

MC

ATC

P1

Market

Q

P

(market)

One firm

Q

P

(firm)

P2P2

Q1 Q2

S2

Q3

A firm begins in long-run eq’m…

…but then an increase in demand raises P,…

…leading to SR profits for the firm.

Over time, profits induce entry, shifting S to the right, reducing P…

…driving profits to zero and restoring long-run eq’m.

AB

C

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Why is the long run supply curve positively sloped?

• The long run supply could be horizontal like the short run curve if: Costs do not change in response to entry/exit

• Otherwise the supply curve is the “normal” positive slope

• If firms have different costs, lower cost firms enter before those with higher costs, Further changes in P make it worthwhile for less efficient firms to enter the market increasing quantity supplied. So for the marginal firm, P = minimum ATC and profit = 0. For lower cost firms, profit > 0

• If costs change as firms enter the market (as more farmers till a fixed number of acres), costs rise and prices rise. The cost for all firms rise, giving a positively sloped curve, as prices have to rise to increase aggregate supply.

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Summary and conclusion

• Competitive market is efficient• Profit maximization MC = MR• Perfect competition P = MR• With competitive equilibrium P = MC• Since MC is the cost of the last extra unit equal to the value to

buyers of that marginal unit, then the competitive equilibrium maximizes total (consumer and producer) surplus

• Shutdown; a will shut down is P < AVC• Exit, a firm will exit if P < ATC• With free entry and exit profits are zero in the long-run, where• P = minimum ATC (= MC)