Firms in Perfectly Competitive Markets

A. Many buyers and sellers B. The goods are the same C. Buyers and sellers have a negligible impact on the market D. All participants are price makers E. Free entry and exit

1. D 2. Maximize profits 3. Marginal Revenue 4. MR and AR 5. Decrease 6. MR = MC 7. MR and MC

 When a gas station increases its prices, consumers may buy elsewhere  When a water co. increases its prices, consumers may decrease consumption, but have little or no choice on their supplier  ……..these firms have…………  Market power (price makers)

 Different market structures shape a firm’s pricing and production decisions Perfectly Comp Monop Compet OligopolyMonopoly

 Goal:  Analyze competitive firms and S curves w/ relation to its costs of production

 Many buyers/sellers  Each has negligible impact  No market power  Price taker  Identical (same) goods  Free entry/exit  = access to info./technology

 Goal :  Maximize profit  TR – TC  *can only change TR if change Q; can not change Price (TR = P x Q)

 Average Revenue – how much a firm receives for a “typical” unit sold (see table 14-1) TR/Q  For all firms: AR = P If TR = P x Q [ 10 = 5 x 2 ] And AR = TR / Q [5 x 2 / 2 ] …AR = 5 and P = 5  AR = P : true for all firms

 Marginal Rev  Change in TR from sale of each additional unit of output  Change TR / Change in Q  TR = P x Q and P is fixed …so if Q increases by 1 unit, then TR increase by (P) dollars  1 unit x $5 = TR = $5  2 units x $5 = TR = $10  MR = Change TR / Change Q  MR = $5 / 1 = $5  MR = $5  MR = P  MR = P for competitive firm only (*b/c P is fixed)

 When a competitive firm doubles the amount it sells, what happens to the P and its TR?

QTRTCProfitMRMC How much to supply? What’s your goal? Profit Max level of output? MR > MC ….so…. increase Q MR < MC ….so…. decrease Q

Marginal Cost Curve and Firm’s Supply Decision P = horizontal in perfect competition P=AR=MR What Q maximizes profits? MR = MC This is the profit max. level of Q for ALL FIRMS At any P, a firm will max profits where P intersects MC MR = MC is same as P = MC ATC AVC

 The MC curve determines the Q the firm is willing to supply at any P…….  The MC curve is the Supply Curve for the firm  P = MR = AR = D …..back to fig 14-1 Where S (MC) and D (P,MR,AR) meet is equilibrium and profit max.

 Draw a firm’s S and D (MC and MR)  Identify profit max output  Identify output where MR>MC; label it Q1  Identify output where MR<MC; label it Q2  Identify the Efficient Scale

 Airline example 1990’s  Losing money but continue to operate  Why?  Cant recover “sunk” costs of airplanes  As long as MR from each flight covers variable costs – continue to operate

 “shut down” – temporary, short run decision to halt production  When? Why?  If can not cover variable costs of production  Shut down and lose all revenue….  …will still pay fixed costs  ….but will save on variable costs  Ex: a restaurant decides to close for lunch  (its revenue was not covering variable costs of servers, cooks, etc…)

Shut down if TR < VC Or TR / Q < VC / Q [AR < AVC] Since AR = P…… …..shut down if P < AVC “Short Run shut down decision = P < AVC” Draw it

 See figure 14-3  Portion of the MC that is above AVC

 You bought a ticket to the playoff game for $7. You told your friend you would be willing to pay $10.  When you arrive, you realize you lost your ticket.  Should you buy another ticket or just go home?  As long as MB > or = MC ; buy another ticket

 Exit decision : TR < TC or if P < ATC  Long Run decision – going out of business  Firm’s long-run supply curve is the portion of its MC curve that lies above ATC  Calculate Profit : (P-ATC) x Q  Graphing Profit and Loss

 Profit = TR – TC  or (P – ATC) x Q P>ATC = Profit = Entry P < ATC = Loss = Exit

 As long as P > AVC, each firm’s MC curve is its supply curve  Market is just a sum of the Q for each indiv. firm

 Firms will enter or exit based on incentives (are existing firms profitable?)  At the end of the process, firms that remain in the market must be making zero economic profit  This happens when P = ATC or TR = TC SO…

 If firms maximize profit at P = MC and P = ATC to make economic profits equal zero then… The level of production will be at the efficient scale where MC = ATC TR – TC = 0 P-ATC = 0

 Zero profit includes opportunity costs, so to stay in business, firm’s revenues must be compensating owner for opp. costs

 Side by Side Analysis  If market is in long-run equilibrium, firms earn zero profit and P = min. of ATC  If demand increases, price increases and firms will produce more in short run… so, P is now greater than ATC and firms are earning profit  Profit attracts new firms and supply curve shifts to right, lowering price and returning us to zero economic profit

 Normally, we assume all entrants to market face same costs and ATC was unaffected by entry of others, so long-run Supply curve of industry is horizontal line at minimum of ATC

 2 possible reasons why this might not be the case: 1. If a resource is limited in quantity, entry will increase price of resource and raise ATC 2. If firms have different costs, it’s likely those with lowest costs enter industry first. If demand then increases, firms that would enter will likely have higher costs