Download Econ 2100 Chapt 14 P..

Chapter 13: Firms in Competitive
Markets
Econ 2100
FIRMS IN COMPETITIVE MARKETS
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Course Outline
What; why;
who?
What works in
the public
sector?
How markets
work?
Why are you
hired?
Are markets
good?
How firms
behave?
Chapters 13 - 17
Chapter 14 Outline
What is a Perfectly Competitive Market?
Marginal vs
Total vs Average
Revenue
Profit
Maximizing
Output
LR Decision:
Exit/Enter
SR Decision:
Shut Down
Market Supply:
SR & LR
FIRMS IN COMPETITIVE MARKETS
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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.
 Because of 1 & 2, each buyer and seller is a
“price taker” – takes the price as given.
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Chapter 14 Outline
What is a Perfectly Competitive Market?
Marginal vs
Total vs Average
Revenue
Profit
Maximizing
Output
LR Decision:
Exit/Enter
SR Decision:
Shut Down
Market Supply:
SR & LR
FIRMS IN COMPETITIVE MARKETS
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The Revenue of a Competitive Firm
• Total revenue (TR)
TR = P x Q
• Average revenue (AR)
TR
=P
AR =
Q
• Marginal revenue (MR):
The change in TR from
selling one more unit.
∆TR
MR =
∆Q
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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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Chapter 14 Outline
What is a Perfectly Competitive Market?
Marginal vs
Total vs Average
Revenue
Profit
Maximizing
Output
LR Decision:
Exit/Enter
SR Decision:
Shut Down
Market Supply:
SR & LR
FIRMS IN COMPETITIVE MARKETS
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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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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
FIRMS IN COMPETITIVE MARKETS
Q
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MC and the Firm’s Supply Decision
If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
Costs
MC
The MC curve
determines the
firm’s Q at any price.
Hence,
P2
MR2
P1
MR
the MC curve is the
firm’s supply curve.
Q1
FIRMS IN COMPETITIVE MARKETS
Q2
Q
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Chapter 14 Outline
What is a Perfectly Competitive Market?
Marginal vs
Total vs Average
Revenue
Profit
Maximizing
Output
LR Decision:
Exit/Enter
SR Decision:
Shut Down
Market Supply:
SR & LR
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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 key difference:
– If shut down in SR, must still pay FC.
– If exit in LR, zero costs.
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A Firm’s Short-run Decision to Shut Down
• Cost of shutting down: revenue loss = TR
• Benefit of shutting down: cost savings = VC
(firm must still pay FC)
• So, shut down if TR < VC
• Divide both sides by Q:
TR/Q < VC/Q
• So, firm’s decision rule is:
Shut down if P < AVC
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A Competitive Firm’s SR Supply Curve
The firm’s SR
supply curve is
the portion of
its MC curve
above AVC.
Costs
MC
If P > AVC, then
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).
FIRMS IN COMPETITIVE MARKETS
ATC
AVC
Q
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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.
FIRMS IN COMPETITIVE MARKETS
A sunk cost
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Chapter 14 Outline
What is a Perfectly Competitive Market?
Marginal vs
Total vs Average
Revenue
Profit
Maximizing
Output
LR Decision:
Exit/Enter
SR Decision:
Shut Down
Market Supply:
SR & LR
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A Firm’s Long-Run Decision to Exit
• Cost of exiting the market: revenue loss = TR
• Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
• So, firm exits if TR < TC
• Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ATC
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A New Firm’s Decision to Enter Market
• In the long run, a new firm will enter the
market if it is profitable to do so: if TR > TC.
• Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC
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The Competitive Firm’s Supply Curve
The firm’s
LR supply curve is
the portion of
its MC curve
above LRATC.
Costs
MC
LRATC
Q
FIRMS IN COMPETITIVE MARKETS
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ACTIVE LEARNING
2
Identifying a firm’s profit
Determine
this firm’s
total profit.
Identify the
area on the
graph that
represents
the firm’s
profit.
A competitive firm
Costs, P
MC
MR
ATC
P = $10
$6
50
Q
21
ACTIVE LEARNING
2
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
3
Identifying a firm’s loss
Determine
this firm’s
total loss,
assuming
AVC < $3.
A competitive firm
Costs, P
MC
ATC
Identify the
area on the
graph that
represents
the firm’s
loss.
$5
MR
P = $3
30
Q
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ACTIVE LEARNING
3
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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Chapter 14 Outline
What is a Perfectly Competitive Market?
Marginal vs
Total vs Average
Revenue
Profit
Maximizing
Output
LR Decision:
Exit/Enter
SR Decision:
Shut Down
Market Supply:
SR & LR
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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 SR 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 quantities supplied by all firms.
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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
FIRMS IN COMPETITIVE MARKETS
20,000 30,000
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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 shifts right.
– P falls, reducing profits and slowing entry.
• If existing firms incur losses,
– some firms exit, SR market supply shifts left.
– P rises, reducing remaining firms’ losses.
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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.
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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.
• In the zero-profit equilibrium,
– firms earn enough revenue to cover these costs
– accounting profit is positive
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The LR Market Supply Curve
The LR market supply
curve is horizontal at
P = minimum ATC.
In the long run,
the typical firm
earns zero profit.
P
One firm
MC
P
Market
LRATC
P=
min.
ATC
long-run
supply
Q
(firm)
FIRMS IN COMPETITIVE MARKETS
Q
(market)
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SR & LR Effects of an Increase in Demand
P
One firm
S1
MC
S2
3
Profit
P2
P1
Market
P
4
ATC
P2
P1
2
B
A
C
5
long-run
supply
1
Q
(firm)
D1
Q1 Q2
FIRMS IN COMPETITIVE MARKETS
Q3
D2
Q
(market)
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Why the LR Supply Curve Might Slope Upward
• 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.
FIRMS IN COMPETITIVE MARKETS
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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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2) Costs Rise as Firms Enter the Market
• In some industries, the supply of a key input is
limited (e.g., amount of land suitable for
farming is fixed).
• 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.
FIRMS IN COMPETITIVE MARKETS
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Test Bank Questions
FIRMS IN COMPETITIVE MARKETS
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Questions 6 & 18
6. A market is competitive if
(i)
(ii)
(iii)
a.
b.
c.
d.
firms have the flexibility to
price their own product.
each buyer is small compared
to the market.
each seller is small compared
to the market.
(i) and (ii) only
(i) and (iii) only
(ii) and (iii) only
(i), (ii), and (iii)
18.
In a competitive market, no
single producer can influence the
market price because
a. many other sellers are offering a
product that is essentially identical.
b. consumers have more influence over
the market price than producers do.
c. government intervention prevents
firms from influencing price.
d. producers agree not to change the
price.
FIRMS IN COMPETITIVE MARKETS
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Questions 29, 30 & 31
29.
Refer to Table 14-1.
For a firm operating in a
competitive market, the price is
a.
b.
c.
d.
Quantity
0
1
2
3
4
$0.
$7.
$14.
$21.
30.
Refer to Table 14-1.
For a firm operating in a
competitive market, the marginal
revenue is
a. $0.
b. $7.
c. $14.
d. $21.
Total
Revenue
$0
$7
$14
$21
$28
31.
Refer to Table 14-1. For a
firm operating in a competitive market,
the average revenue is
a.
b.
c.
d.
FIRMS IN COMPETITIVE MARKETS
$21.
$14.
$7.
$0.
40
Questions 20 & 21
Quantity
20.
Refer to Table 14-4. The firm
will produce a quantity greater than 4
because at 4 units of output, marginal
cost
0
1
2
3
4
5
6
7
a. is less than marginal revenue.
b. equals marginal revenue.
c. is greater than marginal
revenue.
d. is minimized.
21.
Refer to Table 14-4.
What is the firm’s profit-maximizing
strategy?
a.
b.
c.
d.
Total
Revenue
$0
$7
$14
$21
$28
$35
$42
$49
Total
Cost
$3
$5
$8
$12
$17
$23
$30
$38
produce 1 unit of output because marginal cost
is minimized
produce 4 units of output because marginal
revenue exceeds marginal cost
produce 6 units of output because marginal
revenue equals marginal cost
produce 8 units of output because total revenue
is maximized
FIRMS IN COMPETITIVE MARKETS
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Questions 88, 89 & 90
88.. If the market price is P2, in the
short run, the perfectly competitive firm
will earn
a. positive economic profits.
b. negative economic profits but will
try to remain open.
c. negative economic profits and will
shut down.
d. zero economic profits.
89. If the market price is P3, in the short
run, the perfectly competitive firm will earn
a. positive economic profits.
b. negative economic profits but
will try to remain open.
c. negative economic profits and
will shut down.
d. zero economic profits.
10
Price
MC
9
ATC
8
AVC
7
P1
6
5
P2
P3
4
3
P4
2
1
1
2
3
4
5
6
7
8
Quantity
90. If the market price is P4, in the short
run, the perfectly competitive firm will earn
a. positive economic profits.
b. negative economic profits but
will try to remain open.
c. negative economic profits and
will shut down.
d. zero economic profits.
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Questions 95, 96 & 98
95. If the market price is $10, what is the
firm’s short-run economic profit?
a.
b.
c.
d.
$9
$15
$30
$50
96. If the market price is $10, what is the firm’s
total cost?
a. $15
b. $30
c. $35
d. $50
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Price
MC
ATC
1
2
3
4
5
6
7
8
Quantity
98. The firm will earn zero
economic profit if the market price is
FIRMS IN COMPETITIVE MARKETS
a.
b.
c.
d.
$0
$6
$7
$10
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Questions 56 & 60
Price
Price
(a)
(b)
MC
S0
S1
ATC
B
P2
P2
P1
P1
A
C
D
P0
P0
D1
D0
Q1
Q2
Quantity
56. Assume that the market starts in
equilibrium at point A in panel (b). An increase
in demand from D0 to D1 will result in
QA QBQD QC
Quantity
60. Suppose a firm in a competitive market,
like the one depicted in panel (a), observes
market price rising from P1 to P2. Which of
the following could explain this observation?
a. a new market equilibrium at point D.
b. an eventual increase in the number of firms in
a. The entry of new firms into the market.
the market and a new long-run equilibrium at
b. The exit of existing consumers from the
point C.
market.
c. rising prices and falling profits for existing
c. An increase in market supply from S0 to S1.
firms in the market.
d. An increase in market demand from D0 to D1.
d. falling prices and falling profits for existing
FIRMS IN COMPETITIVE MARKETS
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firms in the market.