1. © 2007 Thomson South-Western, all rights reserved N. G R E G O R Y M A N K I W PowerPoint ® Slides by Ron Cronovich 14 P R I N C I P L E S O F F O U R T H E D I T I O N Firms in Competitive Markets

2. 1 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS In this chapter, look for the answers to these questions:  What is a perfectly competitive market?  What is marginal revenue? How is it related to total and average revenue?  How does a competitive firm determine the quantity that maximizes profits?  When might a competitive firm shut down in the short run? Exit the market in the long run?  What does the market supply curve look like in the short run? In the long run?

3. 2 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Introduction: A Scenario  Three years after graduating, you run your own business. Your decisions:  How much do I offer for sale at each price?  Should I “shut down” for a period of time, losing my Fixed Costs in this interim period?  Should I quit this business, i.e. “exit” this market?

4. 3 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Characteristics of Perfect Competition 1. Many buyers and many sellers 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. 1. Many buyers and many sellers 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market.  Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given.

5. 4 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Revenue of a Competitive Firm  Total revenue (TR)  Average revenue (AR)  Marginal Revenue (MR): The change in TR from selling one more unit.  A competitive firm can keep increasing its output without affecting the market price.  Each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. ∆TR ∆Q∆Q MR = TR = P x Q TR Q AR = = P

6. A C T I V E L E A R N I N G 1 : Exercise Fill in the empty spaces of the table. 5 $50$105 $40$104 3 2 1 n.a.$100 TRPQ MRAR $10

7. A C T I V E L E A R N I N G 1 : Answers Fill in the empty spaces of the table. 6 $50$105 $40$104 3 2 1 n.a. $30 $20 $10 $0$100 TR = P x QPQ ∆TR ∆Q∆Q MR = TR Q AR = $10 Notice that MR = P

8. 7 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Profit Maximization  What Q maximizes profits?  Profits = Total Revenue – Total Costs  Solving one way: calculate revenue and costs at each level of output and pick the highest Q.  Another way: think at the margin, seeing how profits change if I raise or lower Q by one unit:

9. 8 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Profit Maximization 505 404 303 202 101 45 33 23 15 9 $5$00  Profit = MR – MC MCMRProfitTCTRQ Brute force: compare TR and TC at each Q. 5 7 7 5 1 –$5 10 –2 0 2 4 $6 12 10 8 6 $4$10 … illustrating the two ways to solve! Think margin: at any Q compare MR with MC and alter Q to raise profit.

10. 9 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Profit Maximization --- thinking at the margin.  What Q maximizes the firm’s profit?  To find the answer, “Think at the margin.” If increase Q by one unit, revenue rises by MR, cost rises by MC.  If MR > MC, then increase Q to raise profit.  If MR < MC, then reduce Q to raise profit.

11. 10 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS P1P1 MR MC and the Firm’s Supply Decision -- how much does the firm offer to sell at P(1)? 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.

12. 11 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS P1P1 MR P2P2 MR 2 MC 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, at any price.

13. 12 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Shutdown vs. Exit  Shutdown (in the short run): A short-run decision not to produce anything because of (present) market conditions. A firm that shuts down temporarily must still pay its fixed costs.  Exit: A long-run decision to leave the market.  A firm that exits the market does not have to pay any costs at all, fixed or variable.

14. 13 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS A Firm’s Short-Run Decision to Shut Down for an Interim Period Profit = Total Revenue – Total Costs = Tot. Rev. – Variable Costs – Fixed Costs  The firm should shut down if TR < VC. Note that I lose my fixed costs if I shut down.  Divide both sides by Q: TR/Q < VC/Q  So we can write the firm’s decision as: Shut down if P < AVC

15. 14 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS The firm’s SR supply curve is the portion of its MC curve above AVC. Q Costs A Competitive Firm’s Short Run Supply Curve – depending on P, does this firm make money? MC ATC AVC If P > AVC, then firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0).

16. 15 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS The Irrelevance of Sunk Costs  Sunk cost: a cost that has already been committed and cannot be recovered  Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice.  FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down.  So, FC should not matter in the decision to shut down.

17. 16 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS A summer waitering… Dear dad,  I have been waitering at Ocean City for a month, and I am down $1,200. My tips of $60/day do not cover my daily rent ($30) and other daily costs ($70).  Yesterday, and for the rest of the summer, I can earn $110/day. Still, it appears I will LOSE MONEY this summer!  My landlord already collected my summer’s rent (thanks to your loan), and will not refund any.  Should I come home? p.s. I love the life here when I am not working.

18. 17 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS The Short Run Market Supply Curve  As long as P ≥ AVC, each firm will produce its profit-maximizing quantity, where MR = MC.  Recall from Chapter 4: At each price, the market quantity supplied is the sum of quantity supplied by each firm.  (In the short run, the number of firms is fixed, those presently participating in the market.)

19. 18 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 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 P1P1 20 10 P1P1 30,000 10,000 20,000

20. 19 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Long run decision to Exit and Enter: deriving the Long Run Supply Curve  Exit and entry decisions compare the sum of both fixed and variable costs, i.e. total costs, to total revenue.  Exit if TR < TC. (and vice versa).  Divide both sides by Q to rewrite the firm’s decision as: Exit if Price less than ATC   Enter if Price greater than ATC. Exit if P < ATC

21. 20 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS A C T I V E L E A R N I N G 2 A : Identifying a firm’s profit Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. 20 Q Costs, P MC ATC P = $10 MR 50 $6 A competitive firm

22. 21 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS profit A Firm With Profits Q Costs, P MC ATC P MR Q ATC profit per unit = P – ATC revenue per unit = cost per unit = profit-maximizing quantity

23. 22 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS profit A C T I V E L E A R N I N G 2 A : Answers 22 Q Costs, P MC ATC P = $10 MR 50 $6 A competitive firm profit per unit = P – ATC = $10 – 6 = $4 Total profit = (P – ATC) x Q = $4 x 50 = $200

24. 23 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS loss MR P = $3 A C T I V E L E A R N I N G 2 B : What happens if P is only $3? 23 Q Costs, P MC ATC A competitive firm loss per unit = $2 Total loss = (ATC – P) x Q = $2 x 30 = $60 $5 30

25. 24 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS The firm’s LR supply curve is the portion of its MC curve above LRATC. Q Costs The Competitive Firm’s LR Supply Curve MC LRATC

26. 25 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Entry & Exit in the Long Run ENTRY: If existing firm earn positive economic profits, more firms enter. Entry shifts supply curve to right. P falls, reducing firms’ profits Entry stops when profits fallen to zero.  EXIT: If existing firms incur losses, Some will exit the market. SR market supply curve shifts left. P rises, reducing remaining firms’ losses. Exit stops when firms’ economic losses have been driven to zero.

27. 26 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Reaching Long Run Equilibrium  Review carefully the text: Figure 7, p. 303… deriving the long run supply curve Figure 8. p. 305 … how the market reaches a new short run and long run equilibrium with a change in demand or supply.

28. 27 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS The Zero-Profit Condition  Long-run equilibrium: The process of entry or exit is complete – remaining firms earn zero economic profit.  Zero economic profit occurs when P = ATC.  Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC.  Recall that MC intersects ATC at minimum ATC.  Hence, in the long run, P = minimum ATC.

29. 28 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 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.

30. 29 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Why Do Firms Stay in Business if Profit = 0?  Recall, economic profit is revenue minus all costs – including implicit costs, like the opportunity cost of the owner’s time and money (a “normal rate of return” on its capital).  In the zero-profit equilibrium, firms earn enough revenue to cover these costs.  QUESTION: Does this mean every firm earns the same average rate of return – e. 7%? What rate of return should I expect as the “normal” rate?

31. 30 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Risk and the Normal Rate of Return  Some businesses have more risk than others – i.e. revenues and costs may fluctuate more, some years good or bad for reasons beyond the firm’s control -- such as…?  Investors must be compensated for assuming more risk.  In reality, a “normal rate of return” will take into account the risk of the business. Risky investments with highly varied returns require that owners receive a higher average return – to compensate them for their risk.

32. 31 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Entry and Exit in Reality  How do firms/investors learn about opportunities for profits in other sectors, and whether they should invest? What information exists about companies that are not publicly traded?  What affects firms’ decisions in reality to ultimately exit an industry?

33. 32 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Entry/Exit Decisions HOW DIFFICULT IS IT TO EXIT? Firing employees and friends, terminating contracts, selling assets with limited value, giving up hope for a successful future, and admitting mistakes.  LEARNING IF PROFITS BEING EARNED: Public disclosure, contacts within the industry, and business intuition. Employees leave firm and create competitor firm -- the role of “non- compete “ employee contracts.  Buying a competitor firm, or a firm that either supplies you inputs, or markets your products.

34. 33 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Role of Financial Markets  Pressure from lenders, cancel bank lines of credit. Eventually your capital runs out.  Friendly or hostile buyouts: Outside firms bid for your company, expecting to liquidate it, reorganize to make profitable. Buyers may be in same business or unrelated businesses.  Reorganization following buyouts/merger is often wholesale reduction of work force at all levels, especially upper management.

35. 34 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 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…A firm begins in long-run eq’m… …but then an increase in demand raises P,… …leading to SR profits for the firm.…leading to SR profits for the firm. An industry begins in equilibrium at P1. A demand increase bids up prices to P2, and profits are earned. Over time, profits induce entry, shifting S to the right, prices fall to P1… …driving profits to zero and restoring long-run eq’m.…driving profits to zero and restoring long-run eq’m. A B C

36. 35 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Why the LR Supply Curve Might Slope Upward  Some firms have higher costs than others– and new entry attracts firms with higher costs, who only offer goods for sale at higher prices.  Expanding output with new entrants raises the price of key inputs, hence the costs for all firms.  If either of these conditions occurs, then LR supply curve slopes upward.  This is a complex detail, since many factors shift the long run cost curve over time (technology, input prices, regulation/taxes, entry and exit).

37. 36 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 1) Firms Have Different Costs  As P rises, firms with lower costs enter the market before those with higher costs.  Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied.  Hence, LR market supply curve slopes upward.  At any P, For the marginal firm, P = minimum ATC and profit = 0. For lower-cost firms, profit > 0.

38. 37 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 2) Costs Rise as Firms Enter the Market  In some industries, the supply of a key input may be limited. Entry of new firms may increase demand for certain scarce inputs. Or, acquiring key inputs may become more expensive as more is demanded – e.g. oil companies have to drill deeper and incur more costs to extract more oil and natural gas.  The entry of new firms causes input prices to rise, hence increasing all firms’ costs.  Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping.

39. 38 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS CONCLUSION: The Efficiency of a Competitive Market (Again)  Profit-maximization:MC = MR  Perfect competition: P = MR  So, in the competitive eq’m: P = MC  MC is cost of producing the marginal unit. P is value to buyers of the marginal unit.  So, the competitive eq’m is efficient, and maximizes total surplus. (Since efficiency requires MB = MC in every sector.)

40. 39 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS CHAPTER SUMMARY  For a firm in a perfectly competitive market, price = marginal revenue = average revenue.  If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run.  If P < ATC, a firm will exit in the long run.  In the short run, entry is not possible, and an increase in demand increases firms’ profits.  With free entry and exit, profits = 0 in the long run, and P = minimum ATC.

41. 40 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Review: Illustrative test questions … referring to the prod. function for cookies  As the number of workers increases:  A) total output increases, but at a decreasing rate  B) marg. product increases, but at a decreasing rate  C) marg. Product increases at an increasing rate  D) total output decreases.

42. 41 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS For the total cost function for cookies  The changing shape of the total cost curve reflects:  A) decreasing average variable cost  B) decreasing average total costs  C) decreasing marginal product  D) increasing fixed cost.

43. 42 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Cost concepts….  Which of the following costs do not vary with the amount of output a firm produces?  A) average fixed costs  B) fixed costs and average fixed costs  C) marginal costs and average fixed costs  D) fixed costs

44. 43 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Calculating costs…  For a firm, when 4 units are produced, the total cost if $175 and the average variable cost if $33.75. What would the average fixed costs be if ten units were produced?  A) $10  B) $40  C) 135  D) $4

45. 44 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS For the cost curves shown…  When prices falls from P(3) to P(1), the firm finds that  A) fixed cost is higher at a production level of Q(1), than it is a Q(3)  B) it should produce Q(1) units of output.  C) It should produce Q(3) units.  D) it should shut down immediately.

46. 45 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Continuing prior question  When prices rises from P(3) to P(4) the firm finds that  (A) fixed costs are lower at a production level of Q(4)  (B) it can earn a positive profit by increasign production to Q(4)  (C) profit is still maximized at output of Q(3)  (D) average revenue exceeds marginal revenue at output Q(4)

47. 46 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Analysis of a competitive market …  In a competitive market the current price is $7, and the typical firm in the market has ATC=$7.50 and AVC=$7.15  A) in the short run firms will shut down and in the long run firms will leave the market  B) In the short run firms will continue to operate, but in the long run firms will leave the market  C) new firms will likely enter this market to capture any remaining economic profits  D) in the long run the market will cease to exist.