1. Firms and Competitive Markets

2. Competitive Market Properties Many buyers and sellers
Trading identical products
Each buyer and seller a price taker
Free entry/exit of the market

3. Goal is to maximize profit Total Revenue Average Revenue
∏ = TR - TC
Total Revenue
Price time quantity: TR = P x Q
Average Revenue
Total Revenue divided by quantity sold
Marginal Revenue
Change in revenue from additional unit sold
For competitive firms
Average Revenue = P
Marginal Revenue = P

4. Profit Max Profit Maximization
Produce at the quantity that maximizes the difference between TR and TC
Compare marginal revenue with marginal cost
If MR > MC increase production
If MR < MC decrease production
If MR = MC profit maximized

5. Profit Max Decision Costs and Revenue MC
Producing here MC > MR so don’t
ATC
MC = MR so profit maxed
AVC
P = MR = AR
Producing here MC < MR so produce more Q*
Quantity

6. Marginal Cost Curve (MC) determines the quantity a firm would be willing to supply at a given price
Therefore it is the firms supply curve

7. MC Curve as Supply Curve
Costs and Revenue MC
ATC P2
AVC P1 Q1 Q2
Quantity

8. Shut down and Exit Shut Down Exit (don’t Enter)
Short Run decision not to produce
Still have to pay fixed costs though
Exit (don’t Enter)
Long Run decision
No costs

9. Short Run Decision Focus on Decision
Total Revenue
Variable costs (fixed costs are fixed, so ignore)
Decision
Shut down if TR < VC ( or MR/AR < AVC )
Competitive Firms Short Run Supply Curve
MC curve above the AVC curve

10. Short Run Supply Curve Costs ATC MC
In short run firms produce on the MC curve if P > AVC
AVC
Quantity
In short run firms shut down if P < AVC

11. Long Run Decision Exit Market if: Enter Market if:
TR < TC
Or P < ATC
Enter Market if:
TR > TC
Or P > ATC
Competitive Firms Long Run Supply Curve
Portion of the MC curve above the ATC curve

12. Long Run Supply Curve Costs ATC MC
In long run firms produce on MC curve if P > ATC
Firms exit market if P<ATC
Quantity

13. Profit If P > ATC If P < ATC Positive profits
∏ = TR – TC = (P – ATC) x Q
If P < ATC
Negative profits (losses)
Loss = TC – TR = (ATC – P) x Q

14. Firm with Profits
Firm with Losses
AVC
AVC MC MC
Profit P
Loss
AVC
AVC P Q* Q*
Profit Maximizing Q
Cost Minimizing Q

15. Market Supply Curve In short run # of firms fixed
Each firm supplies where P = MC
Each firms supply curve is the MC curve above their AVC curve (otherwise 0)
For market supply just add up horizontally S1 S2
S - Market + =

16. In long run # of firms not fixed If P > ATC
Free entry/exit
If P > ATC
Profits are positive
Firms enter market
If P < ATC
Firms taking losses
Firms exit the market
This means all firms (assuming identical cost curves) will produce at MC = ATC (efficient pt)
So MKT supply curve will be horizontal at that point (perfectly elastic)

17. Long Run Market Supply Multiple Firms with identical cost curves
Add up supply at MC = ATC level for each to get Market Supply
Price
Price MC
ATC
P =
Min ATC
Supply
Quantity
Quantity

18. Some Caveats
And perhaps it could still slope up if by increasing market size they bid up the cost of inputs. This would cause latte entering firms to have higher cost curves. P P
Actual Supply would be more like this, with holes and dots denoting when different firms enter. That is it would not be a smooth line.
Or some firms could just be better at it, thus having lower cost curves. But either way LR flatter than SR. Q Q

19. So why stay in business if making zero profit?
Profit = Total Revenue – Total Costs
Total Costs include opportunity costs
Zero Profit Equilibrium
Zero economic profit
Positive accounting profit

20. Shift in Demand and LR and SR supply response
Market in long run eq.
P = ATC
Zero economic profit
Increase in demand
Demand shifts out
Short Run
Higher quantity, higher price
P > ATC
Positive economic profit

21. Because of positive profits
Firms enter in the long run
SR supply curve shifts right
Price falls back to low point on ATC
Quantity increases (because of more firms)
Back to efficient scale

22. Initial State of Equilibrium
Market
Firm P P MC
ATC D
SR Supply P’
LR Supply Q’ Q Q

23. Demand Shifts, + Profits
Market
Firm P P
Price increases MC
ATC D
SR Supply
Which leads to + profits
P’’
LR Supply Q Q

24. Supply Shifts, 0 Profits Market Firm P P SR Supply MC ATC D
Profits induce firms to enter market
P’’’
Restoring Long Run Equilibrium, but with more firms
Price falls back Q Q