Download Firm Behavior and the Organization of Industry

Firm Behavior and
the Organization of
Industry
Firms in Competitive
Markets
Outline
 What
is a competitive market?
 How do competitive markets decide
the quantity of production?
 When do firms decide to shut down
and exit the market?
 How does the firm’s behavior
determine the firm’s SR and LR
supply curves?
What is a competitive market?
There are many buyers and sellers in
the market
 The goods offered by the sellers are
largely similar or identical
 Buyers and sellers are price takers
 Firms can freely enter or exit the
market
 Complete information

What is a competitive firm?
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Firm must be small relative to the size of
the market
Individual firms cannot affect the market
price
The objective of the firm is to maximize
profits
As the price is set in the market as a whole,
the individual firm adjusts its output to
maximize its profit at the given market price
Profit maximization
Profit=TR-TC
 TR=PQ
 Since P is given the TR will be a straight
line from the origin
 AR=PQ/Q; AR=P
 MR=change in TR/ change in Q
 Since price is given, MR=P

Profit maximization and the Firm’s
Supply Curve
 Profit
maximization occurs by producing
the quantity at which MR=MC
 The firm’s MC curve determines the
quantity of the good that the firm is
willing to supply at any given price
 Therefore, MC curve becomes the
supply curve of the firm
Firm’s SR Decision to Shut Down
Shutdown refers to a SR decision not to
produce anything during a specific period of
time
 Firm shuts down if its P<AVC
 The firm has to continue incurring the fixed
costs
 Sunk cost is a cost that has already been
committed and cannot be recovered in the SR

Firm’s SR Supply Curve
The firm’s short run supply curve will be its
MC curve above its AVC curve and the size of
the FC has no impact on the SR supply
decision
 If P is equal to or greater than Min AVC the
firm will produce where P = MR = MC
 If P < Min AVC the firm’s loss minimizing
strategy is to shut down. Loss will equal TFC
(sunk cost)
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SR Market Supply Curve with a Fixed
Number of Firms
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The supply curve of each firm is its MC curve
above its min AVC point
The market supply curve is the horizontal sum
of the quantity supplied by the fixed number of
firms in the industry
Firm’s LR Decision to Exit or Enter a
Market
In the long run firms can change the size of
their plants and move along their LAC curves
 Firms can enter or leave the industry. They
will enter if there is economic profit and leave
if they are suffering economic losses
 The firm will exit the market if P<ATC
 The firm will enter the market if P>ATC
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Market’s LR Supply Curve with Entry
and Exit
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The firm’s LR supply curve is the portion of the
MC curve that lies above ATC curve
Market price must adjust (via shifts in the short
run supply curve) until all firms are making zero
economic profit (normal profit)
With normal profit there is no economic profit to
attract new entrants and no economic losses to
encourage existing firms to exit
Market’s LR Supply Curve with Entry
and Exit
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The process of entry and exit ends only when
P=ATC and there is zero economic profit
This equilibrium occurs at the minimum point of
ATC
The LR equilibrium of a competitive market
with free entry and exit must have firms
operating at their efficient scale
LR supply curve for the market is horizontal at
P=min ATC
SR demand
Market demand curve is the horizontal sum of
all the demand curves of individuals
 Short run market supply curve is the
horizontal sum of all the short run supply
curves of all the firms currently in the industry
 Each individual firm will produce at its profit
max point of MR = MC
 Equilibrium is at the intersection of demand
and supply curves

Shifts in demand in the LR
 Occur
as shifts in demand in the SR and
thus raise profits (losses) for existing
firms
 This results in entry of new firms or exit
of existing firms
 An individual firm continues to produce
at zero economic profit
Shifts in demand in the SR
Shifts in demand will create a movement
along the market short run supply curve,
changing market price
 Each individual firm will adjust output to its
new profit max level as price changes,
moving along its own short run supply curve
 When the demand for a good increases,
market price remains same but quantity
increases due to increase in the number of
firms
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Why the LR Market Supply Curve
may Slope Upwards?
 Two
reasons:
Production input may be available in limited
quantities
 Firms may have different costs
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 In
the above cases LR market supply
curve will slope upwards even with free
entry
LR Market Supply Curve Slopes
Upwards: Profits in the LR
Firms with different costs have different
profits even in the LR
 Here, P= ATC of the marginal firm
 The marginal firm earns zero profit
 Entry does not eliminate the profits
 Conclusion: Due to ease of entry and exit in
the LR, the LR supply curve is more elastic
than the SR supply curve
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Possible Long Run Supply Curves
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Constant cost industry -- horizontal LRS.
Changes in the size of the industry do not affect
firms’ costs of production
Increasing cost industry – upward sloping LRS.
As an industry grows a factor price rises as a
result, increasing costs for all firms
Decreasing cost industry – downward sloping
LRS. As an industry grows a factor price falls as
a result, decreasing costs for all firms
Technological change shifts the LRS