1. Copyright © 2004 South-Western WHAT IS A COMPETITIVE MARKET? A perfectly competitive market….. There are many buyers and sellers in the market. The goods offered by the various sellers are the same. Firms can freely enter or exit the market. Perfect information and resource mobility. The actions of any single buyer or seller have a negligible impact on the market price. Each buyer and seller takes the market price as given.

2. Copyright © 2004 South-Western PROFIT MAXIMIZATION A competitive firm’s goal 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.

3. Profit Maximization: A Numerical Example Copyright©2004 South-Western

4. PROFIT MAXIMIZATION If MR > MC increase Q If MR < MC decrease Q If MR = MC Profit is maximized.If MR = MC Profit is maximized. Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

5. Copyright © 2004 South-Western PROFIT MAXIMIZATION Profit equals total revenue minus total costs. Profit = TR – TC TR = Price times Quantity TC = FC + VC (opportunity cost, implicit, explicit) The perfect competitor will receive economic profit if the market price results in TR > TC. This cannot be a long-run equilibrium.

6. Copyright © 2004 South-Western The Firm’s Decisions (SR, LR) A shutdown refers to short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to long-run decision to leave the market.

7. Copyright © 2004 South-Western The Firm’s Short-Run Decision In the short run firms in an industry will shut down if the revenue they would get from producing in this market is less than the variable cost of producing (MR = MC). Shut down if TR < VC Revenues don’t cover cost of variable inputs (wages)

8. Copyright © 2004 South-Western The Firm’s Long-Run Decision In the long run, firms will exit an industry if the revenue they would get from producing in this market is less than the total cost of producing (MR = MC). Exit if TR < TC Revenues don’t cover all costs (don’t re-new lease) The grass is greener elsewhere Resources move away from low value use

9. Copyright © 2004 South-Western The Firm’s Long-Run Decision In the long run firms will enter an industry if such an action would be profitable. Enter if TR > TC Revenues more than cover all costs (re-new lease) The grass is greener here Resources move toward high value use

10. Copyright © 2004 South-Western The Long Run: Market Entry and Exit In the long run firms will enter or exit the market until profit is driven to zero. At the end of the this process (entry/exit), firms that remain will be making zero economic profit. No incentive for firms to enter or exit (balance) Lollipop activity I Love Lucy – Hamburger Diner

11. Copyright © 2004 South-Western Why Do Competitive Firms Stay in Business If They Make Zero Profit? Profit equals TR - TC. TC includes all of the opportunity costs. - implicit and explicit At the zero-profit equilibrium, the firm’s revenue compensates the owner for the time & money to keep the business going (normal profit).

12. Copyright © 2004 South-Western A Demand Shift: SR & LR Analysis An increase in demand raises price and quantity in the short run. Firms earn profits at higher price (TR > TC). This will lead to entry and the price will decrease back to the original price (higher output). Can you tell the story for a decrease in demand?

13. Copyright © 2004 South-Western Summary To maximize profit, a firm chooses the quantity of output where marginal revenue = marginal cost. In the short run, when a firm cannot cover its variable costs, they will choose to shut down. In the long run, when a firm cannot cover both fixed and variable costs, they will choose to exit.

14. Copyright © 2004 South-Western Summary In a price-taking market with free entry and exit, profits are driven to zero in the long run. Changes in demand result in industry adjustments. In the long run, the price and number of firms adjusts the market to the zero-profit equilibrium. -balance, no incentive to enter or exit