Download Microeconomic Exam #3 Study Guide (Chapter 14-18)

Microeconomic Exam #3 Study Guide (Chapter 14-18)
Chapter 14
 If a firm can influence the market price of the good it sells, it has “market power”
 Competitive market (perfectly competitive market)
 Goal: maximize profit (Total revenue – Total cost)
 Many buyers and sellers (price takers = accept the price the market
determines)
 Homogeneous product
 Firms can freely enter or exit the market (shape the LR outcome)
o Analyzing revenue of the competitive firm
 Total revenue = P (fixed cost) *Q
 If the firm is small compared to the world market, it takes the price as given by
market conditions
 Price doesn’t depend on the quantity of output
 If quantity rises, Total Revenue rises
 Total revenue is proportional to the quantity of output
 For average revenue, consider this question: How much revenue does the
firm receive for the typical unit sold?
 For all firms, Total revenue (P/Q) / Quantity = Price
 Average revenue = price
 For marginal revenue, consider this question: How much change is there in
total revenue from the sale of each additional unit of output?
 For competitive firms, Total revenue = P (fixed cost) *Q and when Q
rises by 1 unit, total revenue rises by P.
 Marginal revenue = price
 Profit maximization and the competitive firm’s supply curve
o Profit Maximization
 One way:
 Total cost = Fixed cost – Variable cost (quantity produced)
 Profit = Total Revenue – Total cost
 Second way:
 Change in profit = Marginal revenue – Marginal cost = 0
 Marginal revenue > Marginal cost
o Raise profit
o Marginal Cost Curve & Firm’s Supply Decision
 Marginal Cost Curve: upward
 Average Total Cost Curve: U-shaped
 MC crosses ATC at the minimum of ATC
 Average Variable Cost Curve
 Price (price taker) = Marginal Revenue = Average Revenue
 Q1 = MR>MC, raising production increase profit
 Q2 = MR<MC, reducing production increase profit
 QMAX = (MR=MC) profit-maximizing

When price increase:
 Q2 = MR>MC, increase production
 New profit-maximizing quantity Q2
 Therefore:
 Because MC curve determines the quantity of the good the firm is
willing to supply at any price, MC curve = competitive firm’s Supply
Curve
o Firm’s Short-Run Decision to Shut Down
 Shutdown
 Short-run decision not to produce anything during a specific period of
time b/c of current market conditions
 Pay fixed cost (or, sunk cost)
 Loses all revenue from the sale of its product
 Saves the variable costs of making its product
 What determines a firm to shutdown?
 TR < VC (costs that do vary with the quantity of output produced)
 TR/Q < VC/Q
 AR < AVC
 P < AVC
o If the price of the good is less than the AVC of production
 Reopen when conditions change so that P > AVC
o Sunk Cost
 a cost that has already been committed and can’t be recovered
o Firm’s Long-Run Decision to Exit or Enter a Market
 Exit
 Long-run decision to leave the market
 Loses all revenue from the sale of its product
 Save variable cost & fixed cost (b/c they can sell the land)
 What determines a firm to exit?
 TR < TC
 TR/Q < TC/Q
 AR < ATC
 P < ATC
o If the price of the good is less than the ATC of production
 What determines a firm to enter?
 TR > TC
 TR/Q > TC/Q
 AR > ATC
 P > ATC
o If the price of the good is more than the ATC of production


Measuring profit in graph for the competitive firm
 Profit = TR – TC
 Profit = (TR/Q – TC/Q) * Q
 Profit = (AR – ATC) * Q
 Profit = (P – ATC) * Q
The Supply Curve in a Competitive Market
o Short-Run
 Market with a fixed number of firms
 When P > AVC, MC is the Supply curve
 Q of output supplied = Sum of the quantities supplied by each firm
o Long-Run
 Market in which the number of firms can change as old firms exit the market
and new firms enter
 Decisions about entry and exit depend on the incentives facing the owners of
existing firms and the entrepreneurs who could start new firms
 If the original firms are profitable, new firms enter
o Expand the number of firms
o Increase the quantity of the good supplied
o Decrease prices and profits
 If the original firms are making losses, firms will exit
o Reduce the number of firms
o Decrease the quantity of the good supplied
o Increase prices and profits
 At the end, firms that remain in the market must be making zero
economic profit
 Profit = (P – ATC) * Q
 Zero profit if and only if the P = ATC
 P > ATC, profit
 P < ATC, loss (encourage firms to exit)
 Process of entry and exit ends only when P = ATC
 Long-Run equilibrium of a competitive market with free entry and exit must
have firms operating at their efficient scale
 Firms maximize profit when P = MC
 Free entry and exit forces P = ATC

MC = ATC, only when firm is operating at the minimum of ATC
(efficient scale)
 Equilibrium
 P = MC, firm is profit-maximizing
 P = ATC, profits are zero
 No incentives to enter or exit
 Only one price consistent = minimum of ATC
 Long-Run market supply curve = horizontal at the price (perfectly
elastic supply)
o A Shift in Demand in the Short-Run and Long-Run
 The response of a market to a change in demand depends on the time
horizon
 Increase in demand raises P and Q, making more profit, in SR
 Encourages new firms to enter
 Increase the amount of product
 Decrease the price to the minimum of ATC
 Profits are zero
 Firms stop enter
 Reaches new Long-Run equilibrium
 P returned to the original
 But, Q raised
 Producing at its efficient scale
 But, because more firms joined, Q raised