Firms in Competitive Markets Chapter 14

Competitive Market Lots of buyers and sellers dealing in identical goods. Sellers can freely enter or leave.

Firms in a competitive market … … are price takers. They take the price as given because nothing they do can affect it. For a firm in a competitive market, the price is the marginal revenue.

Profit maximization assumption Firms act to maximize profit (Π ). Profit = total revenue – total cost = PQ – FC – VC

Profit maximization example Q TR TC Π MR MC ΔΠ 3 (3) 6 1 5 2 4 12 8 18 24 17 7 30 23 36 (1) 42 38 (2) 48 47 9

Rule for profit maximization If MC is rising, produce up to the point at which MC = MR.

Figure 1 Profit Maximization for a Competitive Firm Costs The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. and Revenue MC MC 2 Q ATC P = MR 1 2 AR Q MAX AVC MC 1 Q Quantity Copyright © 2004 South-Western

Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve Price This section of the firm’s MC curve is also the firm’s supply curve. MC P 2 Q ATC P 1 Q AVC Quantity Copyright © 2004 South-Western

Figure 3 The Competitive Firm’s Short Run Supply Curve Costs Firm ’ s short-run supply curve If P > ATC, the firm will continue to produce at a profit. MC ATC If P > AVC, firm will continue to produce in the short run. AVC Firm shuts down if P < AVC Quantity Copyright © 2004 South-Western

Shutdown vs. Exit A shutdown refers to a short-run decision not to produce anything during a specific period of time. Exit refers to a long-run decision to leave the market.

Figure 4 The Competitive Firm’s Long-Run Supply Curve Costs Firm ’ s long-run supply curve MC = long-run S Firm enters if P > ATC ATC Firm exits if P < ATC Quantity Copyright © 2004 South-Western

Figure 5 Profit as the Area between Price and Average Total Cost (a) A Firm with Profits Price ATC MC Profit ATC Q P P = AR MR Quantity (profit-maximizing quantity) Copyright © 2004 South-Western

Figure 5 Profit as the Area between Price and Average Total Cost (b) A Firm with Losses Price MC ATC ATC Q Loss P = AR MR Quantity (loss-minimizing quantity) Copyright © 2004 South-Western

Figure 6 Market Supply with a Fixed Number of Firms (a) Individual Firm Supply (b) Market Supply Price Price MC Supply $2.00 200 $2.00 200,000 1.00 100 1.00 100,000 Quantity (firm) Quantity (market) Copyright © 2004 South-Western

Figure 7 Market Supply with Entry and Exit (a) Firm ’ s Zero-Profit Condition (b) Market Supply Price Price MC ATC P = minimum ATC Supply Quantity (firm) Quantity (market) Copyright © 2004 South-Western

Figure 8 An Increase in Demand in the Short Run and Long Run (a) Initial Condition Firm Market Price Price ATC MC S Short-run supply, 1 D Demand, 1 1 Q A P 1 Long-run supply P 1 Quantity (firm) Quantity (market)

Figure 8 An Increase in Demand in the Short Run and Long Run (b) Short-Run Response Firm Market Price Price D 2 ATC MC Profit S 1 Q 2 P B P 2 D 1 Q 1 A P 1 P Long-run 1 supply Quantity (firm) Quantity (market) Copyright © 2004 South-Western

Figure 8 An Increase in Demand in the Short Run and Long Run (c) Long-Run Response Firm Market Price Price D 2 S MC ATC 1 S 2 B P 2 A Q 3 C P 1 P Long-run 1 supply D 1 Quantity (firm) Q Q Quantity (market) 1 2 Copyright © 2004 South-Western