1. Chapter 14 Firms in Competitive Markets © 2002 by Nelson, a division of Thomson Canada Limited

2. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 2 Learn what characteristics make a market competitive. Examine how competitive firms decide how much output to produce. Examine how competitive firms decide when to shut down production temporarily. Examine how competitive firms decide whether to exit or entry the market. See how firm behaviour determines a market’s short-run and long-run supply curves. Learn what characteristics make a market competitive. Examine how competitive firms decide how much output to produce. Examine how competitive firms decide when to shut down production temporarily. Examine how competitive firms decide whether to exit or entry the market. See how firm behaviour determines a market’s short-run and long-run supply curves. In this chapter you will…

3. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 3 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 can freely enter or exit the 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 can freely enter or exit the market. WHAT IS A COMPETITIVE MARKET

4. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 4 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. –Each buyer and seller takes the market price as given. 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. –Each buyer and seller takes the market price as given. WHAT IS A COMPETITIVE MARKET

5. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 5 A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. –Buyers and sellers must accept the price determined by the market. A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. –Buyers and sellers must accept the price determined by the market. WHAT IS A COMPETITIVE MARKET

6. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 6 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. 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. 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. 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. The Revenue of a Competitive Firm

7. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 7 In perfect competition, average revenue equals the price of the good. The Revenue of a Competitive Firm

8. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 8 Marginal revenue is the change in total revenue from an additional unit sold. For competitive firms, marginal revenue equals the price of the good. Marginal revenue is the change in total revenue from an additional unit sold. For competitive firms, marginal revenue equals the price of the good. The Revenue of a Competitive Firm MR =  TR/  Q

9. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 9 Table 14-1: Total, Average, and Marginal Revenue for a Competitive Firm 6 64868 6 64267 6 63666 6 63065 6 62464 6 61863 $ 6 61262 $ 6 1 (MR = ∆TR/∆Q)(AR = TR/ Q)(TR = P x Q)(P)(P)(Q)(Q) Marginal Revenue Average Revenue Total RevenuePrice Quantity (in litres)

10. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 10 The goal of a competitive firm is to maximize profit, which equals total revenue minus total cost. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. The goal of a competitive firm is to maximize profit, which equals total revenue minus total cost. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE

11. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 11 Table 14-2: Profit Maximization: A Numerical Example (MR - MC) Change in Profit - 3 - 2 - 1 0 1 96 147488 86 438427 76 630366 66 723305 56 717244 246 61218 3 336 48122 $ 4$ 2$ 6 1561 - $ 3$ 3$ 00 (MC = ∆TC/∆Q) (MR = ∆TR/∆Q)(TR - TC)(TC)(TR)(Q)(Q) Marginal Cost Marginal RevenueProfitTotal Cost Total Revenue Quantity (in litres)

12. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 12 Profit maximization occurs at the quantity where marginal revenue equals marginal cost. When MR > MC  increase Q When MR < MC  decrease Q When MR = MC  Profit is maximized.When MR = MC  Profit is maximized. Profit maximization occurs at the quantity where marginal revenue equals marginal cost. When MR > MC  increase Q When MR < MC  decrease Q When MR = MC  Profit is maximized.When MR = MC  Profit is maximized. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE

13. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 13 Costs and Revenue Quantity 0 MC 1 Q 1 The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC AVC Q MAX MC 2 Q 2 P = MR 1 = 2 P = AR = MR ATC Figure 14-1: Profit Maximization for a Competitive Firm

14. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 14 Price Quantity 0 MC AVC ATC P2P2 Q2Q2 This section of the firm’s MC curve is also the firm’s supply curve. Q1Q1 P1P1 Figure 14-2: Marginal Cost and the Firm’s Supply Curve

15. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 15 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. 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. A Firm’s Short-Run Decisions

16. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 16 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. 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. A Firm’s Short-Run Decisions

17. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 17 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 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 A Firm’s Short-Run Decisions

18. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 18 Price Quantity 0 MC AVC ATC Firm’s short-run supply curve Firm shuts down if P < AVC Figure 14-3: The Competitive Firm’s Short- Run Supply Curve If AVC < P < ATC, firm will produce in the S-R but at a loss. If ATC < P the firm will produce at a profit.

19. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 19 The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve. A Firm’s Short-Run Decisions

20. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 20 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 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 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 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 A Firm’s Long-Run Decision to Enter or Exit

21. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 21 Price Quantity 0 MC AVC ATC Firm’slong-run supply curve Firm shuts down if P < ATC Figure 14-4: The Competitive Firm’s Long- Run Supply Curve

22. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 22 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. 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. THE SUPPLY CURVE IN COMPETITIVE MARKETS

23. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 23 (a) A Firm with Profits (b) A Firm with Losses Price Quantity 0 MC ATC P = AR = MR Profit P ATC Q Quantity 0 MC ATC P = AR = MR Loss P ATC Q Price Figure 14-5: Profit as the Area between Price and Average Total Cost

24. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 24 Market supply equals the sum of the quantities supplied by the individual firms in the market. THE SUPPLY CURVE IN COMPETITIVE MARKETS

25. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 25 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. 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. The Short Run: Market Supply with a Fixed Number of Firms

26. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 26 (a) Individual Firm Supply (b) Market Supply Price Quantity (firm) 0 MC 100 Quantity (market) 0 Price $1.00 $2.00 200 MC 100 000 $1.00 $2.00 200 000 Figure 14-6: Market Supply with a Fixed Number of Firms

27. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 27 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. 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. The Long Run: Market Supply with Entry and Exit

28. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 28 (a) Firm’s Zero-Profit Condition (b) Market Supply Price Quantity (firm) 0 MC Quantity (market) 0 Price P = minimum ATC Supply ATC Figure 14-7: Market Supply with Entry and Exit

29. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 29 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. 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. The Long Run: Market Supply with Entry and Exit

30. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 30 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. 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. Why Stay in Business if You Make Zero Profit?

31. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 31 An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost. An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost. Why Stay in Business if You Make Zero Profit?

32. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 32 (a) Initial Condition Price Quantity (firm) 0 Quantity (market) 0 Price MC P1P1 ATC P Short-run Supply, D 1 Demand, D 1 Long-run Supply P1P1 A Q1Q1 Firm Market Figure 14-8: An Increase in Demand in the Short Run and the Long Run.

33. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 33 (b) Short-Run Response Price Quantity (firm) 0 Quantity (market) 0 Price MC P1P1 ATC Short-run Supply, S 1 D1D1 Long-run Supply P1P1 A Q1Q1 Firm Market P2P2 P2P2 D2D2 Profit B Q2Q2 Figure 14-8: An Increase in Demand in the Short Run and the Long Run.

34. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 34 (c) Long-Run Response Price Quantity (firm) 0 Quantity (market) 0 Price P1P1 S1S1 D1D1 Long-run Supply P1P1 A Q1Q1 Market P2P2 D2D2 B Q2Q2 MC ATC Firm S2S2 P1P1 Long-run Supply P1P1 C Q3Q3 Figure 14-8: An Increase in Demand in the Short Run and the Long Run.

35. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 35 Some resources used in production may be available only in limited quantities. Firms may have different costs Marginal Firm –The marginal firm is the firm that would exit the market if the price were any lower. Some resources used in production may be available only in limited quantities. Firms may have different costs Marginal Firm –The marginal firm is the firm that would exit the market if the price were any lower. Why the Long Run Supply Curve Might Slope Upward

36. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 36 SummarySummary Because 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. To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost. Because 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. To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost.

37. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 37 SummarySummary This is also the quantity at which price equals marginal cost. Therefore, the firm’s marginal cost curve is its supply curve. 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. This is also the quantity at which price equals marginal cost. Therefore, the firm’s marginal cost curve is its supply curve. 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.

38. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 38 SummarySummary 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. 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, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. 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.

39. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 39 SummarySummary In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.

40. Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 40 The End