F IRMS IN A C OMPETITIVE M ARKET Mr. Barnett University High School

I NTRODUCTION : A S CENARIO Three years after graduating, you run your own business. You must decide how much to produce, what price to charge, how many workers to hire, etc. What factors should affect these decisions? Your costs (studied in preceding chapter) How much competition you face We begin by studying the behavior of firms in perfectly competitive markets.

C HARACTERISTICS OF P ERFECT C OMPETITION 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market.  Because of 1 & 2, each buyer and seller is a “ price taker ” – takes the price as given.

Advertising Free Riders?

D ECISIONS OF A C OMPETITIVE F IRM Price….no, all firms are price takers To produce the good…yes or no How much to produce

Q UICK R EVIEW Marginal product (MP) is the additional product generated from using one more unit of input (usually labor). Marginal cost (MC) is the additional cost generated from selling one more unit of output Marginal revenue is the additional revenue generated from selling one more unit of output ∆ TR ∆Q∆Q MR = ∆ TC ∆Q∆Q MC = ∆ TP ∆Q∆Q MP =

T HE R EVENUE OF A C OMPETITIVE F IRM Total revenue ( TR ) Average revenue ( AR ) Marginal revenue ( MR ) : The change in TR from selling one more unit. ∆ TR ∆Q∆Q MR = TR = P x Q TR Q AR = = P

ACTIVE LEARNING C ALCULATING TR, AR, MR ACTIVE LEARNING 1 C ALCULATING TR, AR, MR © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fill in the empty spaces of the table. $50$105 $40$ n/a$100 TR PQ MRAR $10

ACTIVE LEARNING A NSWERS ACTIVE LEARNING 1 A NSWERS © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Fill in the empty spaces of the table. $50$105 $40$ n/a $30 $20 $10 $0$100 TR = P x QPQ ∆ TR ∆Q∆Q MR = TR Q AR = $10 Notice that MR = P

MR = P FOR A C OMPETITIVE F IRM A competitive firm can keep increasing its output without affecting the market price. MR = P is only true for firms in competitive markets.

P ROFIT M AXIMIZATION What Q maximizes the firm’s profit? To find the answer, “ think at the margin.” If increase Q by one unit, revenue rises by MR, cost rises by MC. If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit.

P ROFIT M AXIMIZATION $5$00  Profit = MR – MC MCMC MR Profi t TCTR Q At any Q with MR > MC, increasing Q raises profit –$5 10 – $ $4$10 (continued from earlier exercise) At any Q with MR < MC, reducing Q raises profit.

P1P1 MR MC AND THE F IRM ’ S S UPPLY D ECISION At Q a, MC < MR. So, increase Q to raise profit. At Q b, MC > MR. So, reduce Q to raise profit. At Q 1, MC = MR. Changing Q would lower profit. Q Costs MC Q1Q1 QaQa QbQb Rule: MR = MC at the profit-maximizing Q.

P1P1 MR P2P2 MR 2 MC AND THE F IRM ’ S S UPPLY D ECISION If price rises to P 2, then the profit- maximizing quantity rises to Q 2. The MC curve determines the firm’s Q at any price. Hence, Q Costs MC Q1Q1 Q2Q2 the MC curve is the firm’s supply curve.

Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. Q Costs, P MC ATC P = $10 MR 50 $6 A competitive firm ACTIVE LEARNING I DENTIFYING A FIRM ’ S PROFIT ACTIVE LEARNING 2 I DENTIFYING A FIRM ’ S PROFIT © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

profit Q Costs, P MC ATC P = $10 MR 50 $6 A competitive firm Profit per unit = P – ATC = $10 – 6 = $4 Total profit = ( P – ATC ) x Q = $4 x 50 = $200 ACTIVE LEARNING A NSWERS ACTIVE LEARNING 2 A NSWERS © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Determine this firm’s total loss, assuming AVC < $3. Identify the area on the graph that represents the firm’s loss. Q Costs, P MC ATC A competitive firm $5 P = $3 MR 30 ACTIVE LEARNING I DENTIFYING A FIRM ’ S LOSS ACTIVE LEARNING 3 I DENTIFYING A FIRM ’ S LOSS © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

loss MR P = $3 Q Costs, P MC ATC A competitive firm loss per unit = $2 Total loss = ( ATC – P ) x Q = $2 x 30 = $60 $5 30 ACTIVE LEARNING A NSWERS ACTIVE LEARNING 3 A NSWERS © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

S HUTDOWN VS. E XIT Shutdown : A short-run decision not to produce anything because of market conditions. Exit : A long-run decision to leave the market. A key difference: If shut down in SR, must still pay FC. If exit in LR, zero costs.

A F IRM ’ S S HORT - RUN D ECISION TO S HUT D OWN Cost of shutting down: revenue loss = TR Benefit of shutting down: cost savings = VC (firm must still pay FC ) So, shut down if TR < VC Divide both sides by Q : TR / Q < VC / Q So, firm’s decision rule is: Shut down if P < AVC

T HE I RRELEVANCE OF S UNK C OSTS Sunk cost : a cost that has already been committed and cannot be recovered Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. So, FC should not matter in the decision to shut down.

The firm’s SR supply curve is the portion of its MC curve above AVC. Q Costs A C OMPETITIVE F IRM ’ S SR S UPPLY C URVE MC ATC AVC If P > AVC, then firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0).

A F IRM ’ S L ONG -R UN D ECISION TO E XIT Cost of exiting the market: revenue loss = TR Benefit of exiting the market: cost savings = TC (zero FC in the long run) So, firm exits if TR < TC Divide both sides by Q to write the firm’s decision rule as: Exit if P < ATC

A N EW F IRM ’ S D ECISION TO E NTER M ARKET In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. Divide both sides by Q to express the firm’s entry decision as: Enter if P > ATC

L ONG R UN Long run All costs are variable Firms can enter and exit the market If P > ATC – firms make positive profit New firms enter the market If P < ATC – firms make negative profit Firms exit the market

The Firm’s Short-Run Supply Curve  FIGURE 24.5 Short-Run Supply Curves SHORT-RUN SUPPLY CURVES 24.4 In Panel A, the firm’s short-run supply curve is the part of the marginal-cost curve above the shut-down price. In Panel B, there are 100 firms in the market, so the market supply at a given price is 100 times the quantity supplied by the typical firm. At a price of $7, each firm supplies 6 shirts per minute (point b ), so the market supply is 600 shirts per minute (point f )

Market Equilibrium  FIGURE 24.6 Market Equilibrium In Panel A, the market demand curve intersects the short-run market supply curve at a price of $7. In Panel B, given the market price of $7, the typical firm satisfies the marginal principle at point b, producing six shirts per minute. The $7 price equals the average cost at the equilibrium quantity, so economic profit is zero, and no other firms will enter the market. SHORT-RUN SUPPLY CURVES 24.4

long-run market supply curve A curve showing the relationship between the market price and quantity supplied in the long run. increasing-cost industry An industry in which the average cost of production increases as the total output of the industry increases; the long-run supply curve is positively sloped. THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY 24.5

The average cost of production increases as the total output increases, for two reasons: Increasing input price. As an industry grows, it competes with other industries for limited amounts of various inputs, and this competition drives up the prices of these inputs. Less productive inputs. A small industry will use only the most productive inputs, but as the industry grows, firms may be forced to use less productive inputs. THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY 24.5

Drawing the Long-Run Market Supply Curve  FIGURE 24.7 Long-Run Market Supply Curve The long-run market supply curve shows the relationship between the price and quantity supplied in the long run, when firms can enter or leave the industry. At each point on the supply curve, the market price equals the long-run average cost of production. Because this is an increasing-cost industry, the long-run market supply curve is positively sloped. THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY 24.5

The Short-Run Response to an Increase in Demand  FIGURE 24.8 Short-Run Effects of an Increase in Demand An increase in demand for shirts increases the market price to $12, causing the typical firm to produce eight shirts instead of six. Price exceeds the average total cost at the eight-shirt quantity, so economic profit is positive. Firms will enter the profitable market. SHORT-RUN AND LONG-RUN EFFECTS OF CHANGES IN DEMAND 24.6

The Long-Run Response to an Increase in Demand  FIGURE 24.9 Short-Run and Long-Run Effects of an Increase in Demand The short-run supply curve is steeper than the long-run supply curve because of diminishing returns in the short run. In the short run, an increase in demand increases the price from $7 (point a ) to $12 (point b ). But in the long run, firms can enter the industry and build more production facilities, so the price eventually drops to $10 (point c ). The large upward jump in price after the increase in demand is followed by a downward slide to the new long-run equilibrium price. SHORT-RUN AND LONG-RUN EFFECTS OF CHANGES IN DEMAND 24.6

constant-cost industry An industry in which the average cost of production is constant; the long- run supply curve is horizontal. decreasing-cost industry An industry in which the average cost of production decreases and output increases; the long-run supply curve is downward sloping. LONG-RUN SUPPLY FOR A CONSTANT-COST INDUSTRY 24.7

Long-Run Supply Curve for a Constant-Cost Industry  FIGURE Long-Run Supply Curve for a Constant- Cost Industry In a constant-cost industry, input prices do not change as the industry grows. Therefore, the average production cost is constant and the long-run supply curve is horizontal. For the candle industry, the cost per candle is constant at $0.05, so the supply curve is horizontal at $0.05 per candle. LONG-RUN SUPPLY FOR A CONSTANT-COST INDUSTRY 24.7

Hurricane Andrew and the Price of Ice ► FIGURE Hurricane Andrew and the Price of Ice A hurricane increases the demand for ice, shifting the demand curve to the right. In the short run, the supply curve is relatively steep, so the price rises by a large amount—from $1 to $5. In the long run, firms enter the industry, pulling the price back down. Because ice production is a constant- cost industry, the supply is horizontal, and the large upward jump in price is followed by a downward slide back to the original price. LONG-RUN SUPPLY FOR A CONSTANT-COST INDUSTRY 24.7

L ONG RUN – A LL COSTS VARIABLE

S UPPLY C URVE Long run Process of entry and exit ends when… Firms still in market make zero economic profit (P = ATC) Because MC = ATC: Efficient scale Long run supply curve – perfectly elastic Horizontal at minimum ATC 50

T HE LR M ARKET S UPPLY C URVE MC Market Q P (market ) One firm Q P (firm ) In the long run, the typical firm earns zero profit. LRATC long- run supply P = min. ATC The LR market supply curve is horizontal at P = minimum ATC.

S1S1 Profi t D1D1 P1P1 long- run supply D2D2 SR & LR E FFECTS OF AN I NCREASE IN D EMAND MC ATC P1P1 Market Q P (market) One firm Q P (firm) P2P2 P2P2 Q1Q1 Q2Q2 S2S2 Q3Q3 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. A B C

W HY D O F IRMS S TAY IN B USINESS IF P ROFIT = 0 IN L ONG RUN Recall, economic profit is revenue minus all costs, including implicit costs like the opportunity cost of the owner’s time and money. This is called “normal profit” All resources available to the firm are being efficiently used and could not be put to better use elsewhere. It is important to note that zero economic profit does not mean that the company is not earning any money (accounting profit) Competitive Market – Productively (Least Cost) and Allocatively Efficient (Max surplus)

L ONG RUN – A LL COSTS VARIABLE

The firm’s LR supply curve is the portion of its MC curve above LRATC. Q Costs T HE C OMPETITIVE F IRM ’ S S UPPLY C URVE MC LRATC

W HY THE LR S UPPLY C URVE M IGHT S LOPE U PWARD The LR market supply curve is horizontal if 1) all firms have identical costs, and 2) costs do not change as other firms enter or exit the market. If either of these assumptions is not true, then LR supply curve slopes upward.

1) F IRMS H AVE D IFFERENT C OSTS As P rises, firms with lower costs enter the market before those with higher costs Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied Hence, LR market supply curve slopes upward

2) C OSTS R ISE AS F IRMS E NTER THE M ARKET In some industries, the supply of a key input is limited (e.g., amount of land suitable for farming is fixed). The entry of new firms increases demand for this input, causing its price to rise. This increases all firms’ costs. Example: There’s a limited amount of beachfront property. An expansion of the beach resort industry will bid up the price of such property, and raises costs in the industry.

CONCLUSION: T HE E FFICIENCY OF A C OMPETITIVE M ARKET Profit-maximization: MC = MR Perfect competition: P = MR So, in the competitive eq’m: P = MC Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. So, the competitive eq’m is efficient and maximizes total surplus.

SUMMARY For a firm in a perfectly competitive market, price = marginal revenue = average revenue. If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run. If P < ATC, a firm will exit in the long run. In the short run, entry is not possible, and an increase in demand increases firms’ profits. With free entry and exit, profits = 0 in the long run, and P = minimum ATC.