1. Background to Supply: Firms in Competitive Markets6
Background to Supply: Firms in Competitive Markets
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2. What Is A Competitive Market?
A perfectly competitive market has the following characteristics:
There are many buyers and sellers in the market.
The goods offered by the various sellers are largely the same.
Firms are price takers.
Firms can freely enter or exit the market.
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3. What Is A Competitive Market?
As a result of its characteristics, the perfectly competitive market has the following outcomes:
The actions of any single buyer or seller in the market have a negligible impact on the market price.
Buyers and sellers must accept the price determined by the market.
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4. The Revenue of a Competitive Firm
Total revenue for a firm is the selling price times the quantity sold.
TR = (P  Q)
Total revenue is proportional to the amount of output.
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5. The Revenue of a Competitive Firm
Average revenue tells us how much revenue a firm receives for the typical unit sold.
Average revenue is total revenue divided by the quantity sold.
In perfect competition, average revenue equals the price of the good.
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6. The Revenue of a Competitive Firm
Marginal revenue is the change in total revenue from an additional unit sold.
MR =TR/ Q
For competitive firms, marginal revenue equals the price of the good.
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7. Table 4 Total, Average, and Marginal Revenue for a Competitive Firm
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8. Economic Profit versus Accounting Profit
Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.
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9. Economic Profit versus Accounting Profit
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.
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10. Figure 6 Economic versus Accountants
How an Economist
How an Accountant
Views a Firm
Views a Firm
Revenue
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Total
opportunity
costs
Explicit
costs
Explicit
costs
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11. Profit Maximization And The Competitive Firm’s Supply Curve
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.
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12. Profit Maximization
Profit maximization occurs at the quantity where marginal revenue equals marginal cost.
When MR > MC the firm should increase Q to increase profit
When MR < MC the firm should decrease Q to increase profit
When MR = MC profit is maximized.
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13. Table 5 Profit Maximization: A Numerical Example
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14. Figure 7 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
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15. Normal And Abnormal Profit
Profit is equal to total revenue minus total cost.
To an economist, total cost includes all of the opportunity costs of the firm.
When a firm is earning zero profit, this must mean that the firm's revenues are compensating the firm's owners for the time and money that they have expended to keep their businesses going.
Definition of abnormal profit: the profit over and above normal profit.
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16. The Marginal-Cost Curve and the Firm’s Supply Decision
Features of Cost curves.
The marginal cost curve is upward sloping.
The average total cost curve is u-shaped.
The marginal cost curve crosses the average total cost curve at the minimum of average total cost.
Marginal and average revenue can be shown by a horizontal line at the market price.
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17. The Marginal-Cost Curve and the Firm’s Supply Decision
Profit maximising level of output.
If marginal revenue is greater than the marginal cost, the firm can increase its profit by increasing output.
If marginal cost is greater than marginal revenue, the firm can increase its profit by decreasing output
At the profit-maximizing level of output, marginal revenue is equal to marginal cost.
The firm’s MC curve above ATC = firm’s supply curve.
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18. Figure 8 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
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19. 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.
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20. The Firm’s Short-Run Decision to Shut Down
The firm shuts down if the revenue it gets from producing is less than the variable cost of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC
The portion of the marginal cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.
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21. Figure 9 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
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22. Sunk Costs
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.
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23. The Firm’s Long-Run Decision to Exit or Enter a Market
In the long run, the firm exits if the revenue it would get from producing is less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
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24. The Firm’s Long-Run Decision to Exit or Enter a Market
A firm will enter the industry if such an action would be profitable.
Enter if TR > TC
Enter if TR/Q > TC/Q
Enter if P > ATC
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25. Figure 10 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
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26. Measuring Profit Profit = TR - TC.
Because TR = P x Q and TC = ATC x Q, we can rewrite this equation
Profit = (P – ATC) x Q.
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27. Figure 11a. 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)
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28. Figure 11b. 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)
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29. The Supply Curve In A Competitive Market
The competitive firm’s long-run supply curve is the portion of its marginal cost curve that lies above average total cost.
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30. Figure 10 The Competitive Firm’s Long-Run Supply Curve
Costs MC
Firm ’
s long-run
supply curve
ATC
Quantity
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31. The Supply Curve In A Competitive Market
Short-Run Supply Curve
The portion of its marginal cost curve that lies above average variable cost.
Long-Run Supply Curve
The marginal cost curve above the minimum point of its average total cost curve.
Market supply equals the sum of the quantities supplied by the individual firms in the market.
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32. The Short Run: Market Supply with a Fixed Number of Firms
For any given price, each firm supplies a quantity of output so that its marginal cost equals price.
The market supply curve reflects the individual firms’ marginal cost curves.
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33. Figure 12 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)
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34. The Long Run: Market Supply with Entry and Exit
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.
The long-run market supply curve is horizontal at this price.
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35. Figure 13 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)
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36. The Long Run: Market Supply with Entry and Exit
At the end of the process of entry and exit, firms that remain must be making zero economic profit.
The process of entry and exit ends only when price and average total cost are driven to equality.
Long-run equilibrium must have firms operating at their efficient scale.
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37. Why Do Competitive Firms Stay in Business If They Make Zero Profit?
Profit equals total revenue minus total cost.
Total cost includes all the opportunity costs of the firm.
In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.
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38. A Shift in Demand in the Short Run and Long Run
An increase in demand raises price and quantity in the short run.
Firms earn profits because price now exceeds average total cost.
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39. Figure 14a. 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)
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40. Figure 14b. 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)
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41. Figure 14c. 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 P
Long-run 1 1
supply D 1
Quantity (firm) Q Q
Quantity (market) 1 2
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42. Why the Long-Run Supply Curve Might Slope Upward
Some resources used in production may be available only in limited quantities.
Firms may have different costs.
The marginal firm is the firm that would exit the market if the price were any lower.
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43. Summary
The goal of firms is to maximize profit, which equals total revenue minus total cost.
When analysing a firm’s behavior, it is important to include all the opportunity costs of production.
Some opportunity costs are explicit while other opportunity costs are implicit.
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44. Summary
A competitive firm is a price taker; its revenue is proportional to the amount of output it produces.
The price of the good equals both the firm’s average revenue and its marginal revenue (MR).
To maximize profit, a firm chooses the quantity of output such that MR equals MC.
This is also the quantity at which price equals marginal cost (MC).
Therefore, the firm’s marginal cost curve is its supply curve.
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45. Summary
In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale.
Changes in demand have different effects over different time horizons.
In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.
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46. Summary
In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost.
In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.
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47. Summary A firm’s costs reflect its production process.
A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.
A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.
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48. Summary
Average total cost is total cost divided by the quantity of output.
Marginal cost is the amount by which total cost would rise if output were increased by one unit.
The marginal cost always rises with the quantity of output.
Average cost first falls as output increases and then rises.
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49. Summary The average total cost curve is U-shaped.
The marginal cost curve always crosses the average total cost curve at the minimum of ATC.
A firm’s costs often depend on the time horizon being considered.
In particular, many costs are fixed in the short run but variable in the long run.
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