Lecture Notes: Econ 203 Introductory Microeconomics Lecture/Chapter 14: Competitive Markets M. Cary Leahey Manhattan 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

3 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

4 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 $5$00  Profit = MR – MC MCMRProfitTCTRQ At any Q with MR > MC, increasing Q raises profit –$5 10 – $ $4$10 At any Q with MR < MC, reducing Q raises profit.

P1P1 MR Marginal cost and the firm’s supply decision 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 Marginal cost and the firm’s supply decision 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.

8 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).

10 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.

11 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

13 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 P2P2 Market Q P (market) One firm Q P (firm) S P3P3 Example: 1000 identical firms At each P, market Q s = 1000 x (one firm’s Q s ) AVC P2P2 P3P3 30 P1P P1P1 30,000 10,000 20,000

15 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.

16 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 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 Profit D1D1 P1P1 long-run supply D2D2 SR & LR effects of an increase in demand 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

19 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.

20 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)