Download (a) Firm - Econ101-s13-Horn

14
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Introduction: Scenario
• A new drug is invented which can cure lymphoma.
• What will be true of the price of the drug when it first
comes out? (high or low?)
• What will happen to the price in 20 years when the
patent expires? (decrease or increase?)
• What changes when the patent expires?
• In this chapter we study the behavior of firms in
perfectly competitive markets
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Assumptions: Perfect Competition
• A perfectly competitive market has the
following characteristics:
• There are many buyers and sellers in the market.
• Firm is a price taker
• The goods offered by the various sellers are largely
the same.
• Ex/There are many different companies selling milk
• Firms can freely enter or exit the market. (no
barriers to entry)
• Which means that the government does not restrict the
number of firms in the market
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Profit Maximization
• Question 1: What is my firm’s total revenue?
• Total revenue for a firm is the selling price
times the quantity sold.
TR = (P  Q)
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Profit Maximization
• Question 2: How much revenue does a typical
unit generate?
• Average revenue tells us how much revenue a
firm receives for the typical unit sold.
AR = TR / Q
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Profit Maximization
• In perfect competition, average revenue equals
the price of the good.
Total revenue
Average Revenue=
Quantity
Price  Quantity

Quantity
= Price
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Profit Maximization
• Question 3: How much revenue does an
additional unit generate?
• Marginal revenue is the change in total revenue
from an additional unit sold.
(P * Q1) - (P * Q2)
∆TR
=
=
MR =
∆Q
(Q1 - Q2)
P (Q1 - Q2)
(Q1 - Q2)
• For competitive firms, marginal revenue equals
the price of the good.
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The Revenue of a Competitive Firm
• Total revenue (TR)
• Average revenue (AR)
TR = P x Q
AR =
TR
Q
=P
∆TR
=P
• Marginal Revenue (MR): MR =
∆Q
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ACTIVE LEARNING
Exercise
1:
Fill in the empty spaces of the table.
Q
P
TR
0
$10
n.a.
1
$10
$10
2
$10
3
$10
4
$10
AR
MR
$40
$10
5
$10
$50
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ACTIVE LEARNING
Answers
1:
Fill in the empty spaces of the table.
Q
P
TR = P x Q
0
$10
$0
AR =
TR
Q
MR =
∆TR
∆Q
n.a.
$10
1
2
3
$10
$10
$10
Notice that
$20
$10
MR = P
$10
$30
$10
$10
$10
$10
$10
4
$10
$40
$10
$10
5
$10
$50
$10
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MR = P for a Competitive Firm
• A competitive firm can keep increasing its
output without affecting the market price.
• So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
MR = P is only true for
firms in competitive markets.
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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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Profit Maximization
• 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.
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Profit Maximization
(continued from earlier exercise)
At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.
Q
TR
TC
0
$0
$5
–$5
1
10
9
1
2
20
15
5
3
30
23
7
4
40
33
7
5
50
45
Profit MR MC
Profit =
MR – MC
$10 $4
$6
10
6
4
10
8
2
10
10
0
10
12
–2
5
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The Marginal Cost-Curve and the Firm’s
Supply Decision
• 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.
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MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
So, increase Q
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit.
Costs
MC
MR
P1
At Q1, MC = MR.
Changing Q
would lower profit.
Q a Q1 Q b
Q
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MC and the Firm’s Supply Decision
If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
The MC curve
determines the
firm’s Q at any price.
Costs
MC
P2
MR2
P1
MR
Hence,
the MC curve is the
firm’s supply curve.
Q1
Q2
Q
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Figure 1 Profit Maximization for a Competitive Firm
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
Suppose the market price is P.
MC
If the firm produces
Q2, marginal cost is
MC2.
ATC
MC2
P = MR2
AVC
If the firm
produces Q1,
marginal cost is
MC1.
MC1
0
Q1
QMAX
Q2
Quantity
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Figure 2 Marginal Cost as the Competitive Firm’s Supply
Curve
As P increases, the firm will
Price
P2
So, this section of the
firm’s MC curve is
also the firm’s supply
curve.
select its level of output
along the MC curve.
MC
ATC
P1
AVC
0
Q1
Q2
Quantity
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Figure 1 Profit Maximization for a Competitive Firm
Price
What if the market price
moves down to P?
MC
ATC
AVC
P = MR2
0
Quantity
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Shutdown vs. Exit
• Shutdown:
A short-run decision not to produce anything
because of market conditions.
• Exit:
A long-run decision to leave the market.
• A firm that shuts down temporarily must still
pay its fixed costs. A firm that exits the market
does not have to pay any costs at all, fixed or
variable.
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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
• Divide both sides by Q:
• Shut down if TR/Q < VC/Q
• Therefore,
• Shut down if P < AVC
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Figure 3 The Competitive Firm’s Short-Run Supply Curve
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
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Spilt Milk and Other Sunk Costs
• Sunk costs are costs that have already been
committed and cannot be recovered.
• FC is a sunk cost in the short-run: The firm
must pay its fixed costs whether it produces or
shuts down.
• So, FC should not matter in the decision to shut
down.
• In the long-run, however, there are no fixed
costs.
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A Competitive Firm’s Short-Run Supply Curve
The firm’s SR
Costs
supply curve is
the portion of
its MC curve
If PAVC.
> AVC, then
above
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).
MC
ATC
AVC
Q
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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. (because there are no more fixed costs)
• Exit if TR < TC
• Again, divide both sides by Q:
• Exit if TR/Q < TC/Q
• Therefore,
• Exit if P < ATC
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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
• Again, divide both sides by Q:
• Enter if TR/Q > TC/Q
• Therefore,
• Enter if P > ATC
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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.
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Figure 4 The Competitive Firm’s Long-Run Supply Curve
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
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2A:
Identifying a firm’s profit
ACTIVE LEARNING
A competitive firm
Determine
this firm’s
total profit.
Costs, P
Identify the
area on the
graph that
represents
the firm’s
profit.
P = $10
MC
MR
ATC
$6
50
Q
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ACTIVE LEARNING
2A:
Answers
A competitive firm
Costs, P
Profit per unit
= P – ATC
= $10 – 6
= $4
MC
MR
ATC
P = $10
profit
$6
Total profit
= (P – ATC) x Q
= $4 x 50
= $200
50
Q
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ACTIVE LEARNING
2B:
Identifying a firm’s loss
A competitive firm
Determine
this firm’s
total loss.
Identify the
area on the
graph that
represents
the firm’s
loss.
Costs, P
MC
ATC
$5
MR
P = $3
30
Q
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ACTIVE LEARNING
2B:
Answers
A competitive firm
Costs, P
MC
Total loss
= (ATC – P) x Q
= $2 x 30
= $60
ATC
$5
P = $3
loss
loss per unit = $2
MR
30
Q
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Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other
firms enter or exit the market.
3) The number of firms in the market is
•
•
fixed in the short run
(due to fixed costs)
variable in the long run
(due to free entry and exit)
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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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The SR Market Supply Curve
Example: 1000 identical firms.
At each P, market Qs = 1000 x (one firm’s Qs)
P
One firm
MC
P
P3
P3
P2
P2
AVC
P1
Market
S
P1
10 20 30
Q
(firm)
Q
(market)
10,000
20,000 30,000
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The Long Run: Market Supply with Entry
and Exit
• Firms will enter or exit the market until profit is
driven to zero. (remember assumption of perfect
competition is no barriers to entry)
• 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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Economists versus Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
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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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Figure 7 Long-Run Market Supply
(a) Firm’s Zero-Profit Condition
(b) Market Supply
Price
Price
MC
ATC
P = minimum
ATC
0
Supply
Quantity (firm)
0
Quantity (market)
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Figure 7 Long-Run Market Supply
(a) Firm’s Zero-Profit Condition
(b) Market Supply
Price
Price
MC
ATC
0
Quantity (firm)
0
Quantity (market)
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Entry & Exit in the Long Run
• In the LR, the number of firms can change due
to entry & exit.
• If existing firms earn positive economic profit,
• New firms enter.
• SR market supply curve shifts right.
• P falls, reducing firms’ profits.
• Entry stops when firms’ economic profits have been
driven to zero.
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Entry & Exit in the Long Run
• In the LR, the number of firms can change due
to entry & 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.
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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 has firms operating at
their efficient scale.
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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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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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Figure 8 An Increase in Demand in the Short Run and Long
Run
(a) Initial Condition
Market
Firm
Price
Price
MC
Short-run supply, S1
A
P1
Long-run
supply
ATC
P1
Demand, D1
0
Q1
Quantity (market)
A market begins in long run
equilibrium.
0
Quantity (firm)
And firms earn zero profit.
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Figure 8 An Increase in Demand in the Short Run and Long
Run
Discovery of miraculous health
benefits for milk leads to an
increase in market demand…
The higher P encourages firms to
produce more…
(b) Short-Run Response
Market
Firm
Price
Price
B
P2
P1
MC
S1
ATC
P2
A
Long-run
supply
P1
Quantity (market)
0
D2
D1
0
Q1
Q2
…raising price and output.
Quantity (firm)
…and generates short-run profit.
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Figure 8 An Increase in Demand in the Short Run and Long
Run
Profits induce entry and
market supply increases.
(c) Long-Run Response
Market
Firm
Price
Price
S1
B
P2
A
C
P1
S2
Long-run
supply
MC
ATC
P1
D2
D1
0
Q1
Q2
Q3
Quantity (firm)
The increase in supply lowers
market price.
0
Quantity (market)
In the long run market
price is restored, but
market supply is greater.
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Why the Long-Run Supply Curve Might
NOT be Horizontal
• The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or exit the
market.
• If either of these assumptions is not true,
then LR supply curve slopes upward.
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Relaxing our assumptions:
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.
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Relaxing our assumptions
2) Costs Rise as Firms Enter the Market
• In some industries, the supply of a key input is
limited (e.g., there’s a fixed amount of land
suitable for farming).
• The entry of new firms increases demand for
this input, causing its price to rise.
• This increases all firms’ costs.
• Hence, an increase in P is required to increase
the market quantity supplied, so the supply
curve is upward-sloping.
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CONCLUSION: The Efficiency of a
Competitive Market
• Profit-maximization:
MC = MR
• Perfect competition:
P = MR
• So, in the competitive eq’m:
P = MC
• Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
• So, the competitive eq’m is efficient, maximizes total
surplus.
• In the next chapter, monopoly: pricing & production
decisions, deadweight loss, regulation.
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