Economics 103 Lecture # 11 The Competitive Firm

The last step in completing our model is to specify a type of market behavior on the part of firms. We are going to start by assuming firms are competitive. The Competitive Firm: a.Each firm takes the price as given. b.Each firm ignores the action of rival firms. c.No firm engages in strategic behavior. d.The price is set in the “market”.

Does such a firm exist? Probably true for a wheat farm. Or for your average small firm.

But these assumptions are not true for large firms: We’ll talk about these firms later.

When a firm is a price taker, they are soooo small changes in their output have no impact on the market price. They can produce as much as they want, and the price never changes. This means the demand curve they face is treated as infinitely elastic. Why does MR=AR? What is MR? AR?

A firm wants to Maximize Profit. Profit = Total Revenue – Total Costs. A necessary condition for maximizing profits is the following : Marginal Revenue = Marginal Costs. Why would the firm do better at producing 10, than some other quantity? Is the firm making a profit at 10? -the profit max. rule is P=MC

PROFIT VS RENT If there are no SUNK costs, then profit and rent are the same thing. - let’s start with this assumption. To tell if this firm is making a profit we need to measure costs on the graph. Method 1: The area under the MC curve measures VC. So if there are no sunk/fixed costs, this area would be the profit of the firm. We also call this rent, and seller’s surplus.

PROFIT VS RENT Method 2: Using the average cost curves. This shaded area should equal the other shaded area. Both areas are the total revenue minus the total costs. This method is easier because we are dealing with rectangles, and we can deal with the case of sunk costs not equaling zero.

What happens when there are fixed costs? Suppose the fixed costs equal $10. Nothing happens to the AVC. But the AC curve shift up by the AFC. Clearly the firm earns zero profit. What is the shaded area? Rent: = Total Revenue – Opportunity Costs

There seems to be no end of confusion between Rents and Profits. Why would a firm ever stay in business if it made a loss? How could a firm stay in business if it made zero profit?

Can a firm ever make an economic profit in equilibrium? The answer is NO. - entry or exit of firms will eliminate the profit or loss. -if the profit is due to a “special” factor input, then the price of this input increases until the profit is eliminated. In both cases the AC curve adjusts until profit is eliminated. Can a firm make a rent in equilibrium? Absolutely. This is the amount that could be taken away and the firm would still stay in business.

In the early 1990’s the National Institute for Health gave out fellowships for “life long support”. -after 10 years they found that only 50% of researchers were still doing research. -these 50% were clearly earning rents.

Given the structure of costs, what is the firm’s supply curve? The segment above the minimum AVC curve along the MC is the supply curve of the firm? Why? Because the firm maximizes profit when it sets P=MC.

So, if we have a competitive firm, what does the market supply look like. This turns out to depend on how the various firms differ. Case 1: All firms identical, no sunk costs. Suppose every firm was identical.

Then we would have: The market supply curve is just flat.

Suppose every firm was identical in everyway, except they had different levels of fixed/sunk costs. The marginal firm earns zero rent. The intra marginal firms earn zero profit, and positive rent. Why would a firm be intra marginal?

What does the marginal firm look like?

What happens if we combine the comparative advantage ideas from before with the diminishing marginal products of this lecture? Each individual firm would now have different shaped marginal costs. The low cost firms produce first, and as price increases higher cost firms join the market. Once again we would have extensive and intensive adjustments. The market supply curve would still be upward sloping.

The bottom line: Market supply curves are upward sloping.