Firms in Competitive Markets Chapter 14 Firms in Competitive Markets 1

Objectives 1.) Know the characteristics of a competitive market 2.) Understand how competitive firms decide how much to produce 3.) Know when competitive firms shut down temporarily 4.) Learn what causes competitive firms to enter and leave a market 5.) Understand the determination of the market’s short-run and long-run supply curves 1

PREFECT COMPETITIVE Market structure is a market characterize by Many, many firms Homogenous product No control over price(price taker) Easy entrance and exit to and from the market

A Perfectly Competitive Market (Chapter 4) A Market in which: -There are a large number of buyers and sellers -The goods offered are functionally identical products. -There is freedom of market entry & exit. 2

A Perfectly Competitive Market (Chapter 4) Results in a Market: -not controlled by any one person or firm. -with a narrow “range of prices.” where Buyers and Sellers are Price Takers. 3

Perfect Competition - Price Takers The individual firm produces such a small portion of the total market output that it cannot influence the price it charges for the product it sells. The firm is a Price Taker in that it takes the market determined price as the price it will receive for its output. 4

The Revenue of a Competitive Firm Total Revenue for a firm is the market selling price times the quantity sold. TR = (P x Q) Total revenue is proportional to the amount of output. (Table 14-1) Graphically: Total revenue increases at a constant rate, as each unit sold sells for a constant price. 5

Total Revenue Firm In Perfect Competition $ Total Revenue $25 $20 $15 $10 $ 5 Quantity 1 2 3 4 5 6

Total Revenue Firm In Perfect Competition $ Total Revenue $25 $20 At a market price of $5, total revenue is ($5x1) = $5! $15 $10 $ 5 Quantity 1 2 3 4 5 7

Alternative Measurements of Revenue Average Revenue: Tells us how much revenue a firm receives for the typical unit sold. AR = TR ÷ Q Average Revenue equals the price of the good, in perfect competition. 8

Alternative Measurements of Revenue Marginal Revenue: Tells us how much revenue a firm receives for one additional unit of output. MR = TR ÷ Q Marginal Revenue equals the price of the good, in perfect competition. Graphically: Each unit sold will add the same amount to total revenue, $5! 9

Total, Average, and Marginal Revenue for a Competitive Firm Quality Price Total Revenue Average Revenue Marginal Revenue Q P (TR=P*Q) (AR=TR/Q) (MR= TR / Q) 1 2 3 4 5 6 7 8 gallon $6 6 $6 12 18 24 30 36 42 48 $6 6 $6 6 12

Quality Total Revenue Total Cost Profit Marginal Revenue Marginal cost (Q) (TR) (TC) (TR - TC) (MR = TR / Q) (MC = TC / Q) 1 2 3 4 5 6 7 8 $ 0 6 12 18 24 30 36 42 48 $ 3 5 8 12 17 23 30 38 47 -$3 1 4 6 7 $ 6 6 $2 3 4 5 6 7 8 9 9

Profit Maximization for the Competitive Firm The goal of a competitive firm is to maximize profit. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

Total Revenue Firm In Perfect Competition $ Total Revenue $25 $20 $15 $10 Marginal Revenue $ 5 Quantity 1 2 3 4 5 10

Quick Quiz! When a competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue? 11

Profit Maximization Profit = TR -TC The goal of a competitive firm is to maximize profit. Profit = TR -TC Graphically: Combine graphs from Chapter 13 with Chapter 14 12

Profit Maximization Total $ Cost Quantity $25 $20 $15 $10 $ 5 1 2 3 4 13

Profit Maximization Total $ Cost Total Revenue Quantity $25 $20 $15 $10 $ 5 Quantity 1 2 3 4 5 14

Profit Maximization Total $ Cost Total Revenue Quantity $25 $20 $15 $10 $ 5 Quantity 1 2 3 4 5 15

Profit Maximization Total $ Cost Total Revenue Profit Maximization $25 $20 Profit Maximization at Q = 3 units! $15 $10 $ 5 Quantity 1 2 3 4 5 16

} Profit Maximization Total $ Cost Total Revenue Profit Maximization $25 $20 Profit Maximization at Q = 3 units! } $15 $10 $ 5 Quantity 1 2 3 4 5 17

Profit Maximization Maximum profits occur at a quantity that maximizes the difference (distance) between revenue and costs. 18

The Competitive Firm’s Cost Curves Chapter 13 revisit of average cost curves: The marginal-cost curve (MC) is upward sloping. The average-total-cost curve (ATC) is U- shaped. Marginal Cost crosses the Average-Total- Cost at the minimum ATC. Graphically. . . (Figure 14.1) 19

The Shape of Typical Cost Curves MC ATC AVC Cost ($’s) Quantity 20

The Competitive Firm’s Profit Maximizing Output Adding a line for the market price which is the same as the firm’s average revenue (AR) and its marginal revenue (MR). Identify the level of output that maximizes profit. 21

The Competitive Firm’s Profit Maximizing Output Price MC ATC P=MR=AR AVC Quantity 22

The Competitive Firm’s Profit Maximizing Output Price MC ATC P=MR=AR AVC Quantity 23

The Competitive Firm’s Profit Maximizing Output Price MC ATC P=MR=AR AVC Quantity QMax 24

The Competitive Firm’s Profit Maximizing Output Price MC ATC P=MR=AR AVC Quantity QMax 25

The Competitive Firm’s Profit Maximizing Output Price MC ATC P=MR=AR AVC Maximum Profits! Quantity QMax 26

The Competitive Firm’s Profit Maximizing Output Profit is maximized when MR = MC A competitive firm will adjust its level of production until the quantity reaches QMax where profit is maximized. 27

The Marginal-Cost Curve and the Firm’s Supply Decision... Copyright © 2001 by Harcourt, Inc. All rights reserved The Marginal-Cost Curve and the Firm’s Supply Decision... This section of the firm’s MC curve is also the firm’s supply curve. Costs and Revenue MC P2 Q2 P1 ATC Q1 AVC Quantity

The Competitive Firm’s Shut-Down Decision Alternative levels of output produced because the firm is a price taker. If the selling price is below the minimum average variable cost, the firm should shut down! 28

Shut Down! Costs are greater than market price MC ATC AVC P=MR=AR Quantity Q Don’t Produce! 29

Shut Down! Costs are greater than market price MC ATC AVC Q Don’t Produce! Loss! P=MR=AR Quantity 30

The Competitive Firm’s Shut Down Decision Alternative levels of output produced because the firm is a price taker. If the selling price is above the minimum average variable cost but below average total cost, the firm should produce in the short-run a quantity that corresponds with MR = MC. Incurs economic losses, but minimized. 31

Short-Run Production Minimize Losses when MR = MC Price MC ATC AVC P=MR=AR Quantity Qshort-run 32

The Competitive Firm’s Output Decision Alternative levels of output produced because the firm is a price taker. If the selling price is above the minimum average total cost the firm should produce a quantity that corresponds with MR = MC. Incurs economic profits 33

The Competitive Firm’s Output Decision Price MC ATC P=MR=AR AVC Quantity QMax 34

The Competitive Firm’s Supply Curve Short-Run Supply: Is the portion of its marginal cost curve that lies above average variable cost. Long-Run Supply: Is the marginal cost curve above the minimum point of its average total cost curve. 35

The Competitive Firm’s Supply Curve Price MC ATC P=MR=AR AVC P1 Quantity Q1 36

The Competitive Firm’s Supply Curve Price MC ATC P=MR=AR AVC P2 P1 Quantity Q1 Q2 37

The Competitive Firm’s Supply Curve Price MC ATC P3 P=MR=AR AVC P2 P1 Quantity Q1 Q2 Q3 38

The Competitive Firm’s Supply Curve Price P3 } P2 Firms Short Run Supply Curve P1 Quantity Q1 Q2 Q3 39

The Firm’s Profit Profit equals total revenue (TR) minus total costs (TC) Profit = TR - TC Profit = ([TR ÷ Q] - [TC ÷ Q]) x Q Profit = (P - ATC) x Q 40

The Competitive Firm’s Decision To Produce, Shut Down or Exit In the short-run, a firm will choose to shut down temporarily if the price of the good is less than the average variable cost. In the long-run when the firm can recover both fixed and variable costs, the firm will choose to remain in business. 41

The Firm’s Short-Run Decision to Shut Down A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market. 28

The Firm’s Short-Run Decision to Shut Down The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down. Sunk costs are costs that have already been committed and cannot be recovered.

Quick Quiz! How does the price faced by a profit- maximizing competitive firm compare to its marginal cost? When will a profit- maximizing firm decide to shut down? 42

The Market Supply Curve For any give price, each firm supplies a quantity of output so that price equals its marginal cost. The quantity of output supplied to the market equals the sum of the quantities supplied by the individual firms. 43

The Market Supply Curve Firms will enter or exit the market until profit is driven to zero. In the long-run, price equals the minimum of average total cost. (Figure 14-7) Because firms can enter and exit more easily in the long run than in the short-run, the long-run supply curve is more elastic than the short-run supply curve. 44

Market Supply with Entry and Exit (Figure 14-7) (a) Firm’s Zero-Profit Condition (b) Market Supply Price Price MC ATC P=minimum ATC Supply Quantity (firm) Quantity (market)

Summary/Conclusion If business firms are competitive and profit-maximizing, the price of a good equals the marginal cost of making that good. If firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production. 45