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Lecture Notes: Econ 203 Introductory Microeconomics
Lecture/Chapter 14: Competitive Markets
M. Cary Leahey
Manhattan College
Fall 2012
Goals
• Analysis of one extreme pole of corporate behavior – perfect
competition; the other pole – monopoly is the subject of the next
chapter
• First application of the “buzz words” developed in the prior chapter:
•
Production function
•
Price and marginal revenue (MR) and cost (MC)
•
Marginal costs and average total costs (ATC)
•
Fixed versus variable costs
•
Distinction between short- and long-runs
2
Introduction: revenue, price and costs of a competitive firm
• Total revenue (T)
TR = P X Q
• Average revenue (AR) AR = TR/Q = P
• Marginal revenue (MR) MR = ∆TR/ ∆Q
• Since a competitive firm can keeping changing output without
changing price (a price taker), each marginal (one unit) change in
revenue is equal to the product of one unit of output. So
•
MR = P for competitive markets
3
Profit maximization
• Profit maximization is found at the margin (the last unit produced).
• So increasing Q by one unit increases costs by MC and revenue by
MR
• If MR > MC, then increase Q to raise profit.
• If MR , MC, then reduce Q to raise profit.
4
Profit maximization
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
5
Profit =
MR – MC
$10 $4
$6
10
6
4
10
8
2
10
10
0
10
12
–2
Marginal cost and the firm’s supply decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
So, increase Q
to raise profit.
Costs
MC
At Qb, MC > MR.
So, reduce Q
to raise profit.
At Q1, MC = MR.
Changing Q
would lower profit.
MR
P1
Q a Q1 Q b
Q
Marginal cost and the firm’s supply decision
If price rises to P2,
then the profit-maximizing
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
Shutdown versus exit
• Shutdown refers to temporary decision not to produce output
because of market condtions. (This can be a long time such a firm
such as Caterpillar).
• Exit refers to the long-run decision to leave the market.
• The key difference is if a firm shuts down, the firm must pay (cover)
FC. If exit in the long run, zero costs.
• Costs of shutting down, loss of revenue TR
• Benefit of shutting down, cost saving of variable cost (VC)
• So shut down is TR < VC, or
•
TR/Q < VC/Q, or
•
P < AVC
8
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.
ATC
AVC
If P < AVC, then firm shuts
down (produces Q = 0).
Q
The irrelevance of sunk cost
• Fixed costs are sunk costs: costs that have already been committed
and cannot be recovered (water under the bridge)
• Sunk costs are irrelevant to decision-making, as they are paid
regardless of your choice
• So fixed costs do not enter the decision to shut down.
• Only variable costs matter for the shut down decision.
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When to exit or enter the market
•
•
•
•
•
•
Long run decision to exit
Costs of exiting is revenue loss TR
Benefits of exiting is the cost saving TC (zero FC in long run)
Firm exits if TR < TC or
TR/Q < TC/Q or
P < ATC
• Conversely to decide to enter the market.
• In the long-run, a new firm will enter if it is profitable, or TR > TC
•
Divide by Q, then TR/Q > TC/Q or 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
Market supply: assumptions and market supply curve
• All existing firms and possible entrants have identical costs.
• Each firms costs do not change as other firms enter/leave market.
• The number of firms in the market is
•
Fixed in short run due to fixed costs
•
Variable in the long run due to ‘free” entry and exit
• As long as P > AVC, each firm will produce it profit-maximizing
output where MC = MR
• Market supply is the sum of the quantities supplied by all firms.
13
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
Entry and exit in the long run
• In the long run, the number of firms can change due to entry/exit.
• If existing firms earn profits, then new firms enter, SR supply curve
shifts to the right. P falls, reducing profits and slowing entry.
• If existing firms suffer losses, some firms exit, SR supply curve shifts
left, P rises , reducing remaining firms losses.
• All existing firms and possible entrants have identical costs.
15
Zero profit condition in the long run
• In the long-run equilibrium is obtained when the entry/exit process is
complete and the remaining firms earn economic profit.
• Zero economic profit occurs when P = ATC
• Since production occurs where P = MR = MC = ATC in long run,
•
since MC equals ATC at minimum ATC
• So in long run P = minimum ATC
• Firms stay in business with zero profit, since it includes all costs
including the opportunity cost of the owners time and money.
• So economic profit = zero; accounting profit > zero
16
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)
Q
(market)
SR & LR effects of an increase in demand
A firm begins in
…but then an increase in …leading to SR profits
long-run eq’m…
Over time, profits induce entry,
shifting S to the right, reducing P…
P
for the firm.
demand raises P,…
…driving profits to zero
and restoring long-run eq’m.
One firm
Market
P
S1
MC
Profit
S2
ATC
P2
P2
P1
P1
Q
(firm)
B
A
C
long-run
supply
D1
Q1 Q2
Q3
D2
Q
(market)
Why is the long run supply curve positively sloped?
• The long run supply could be horizontal like the short run curve if:
Costs do not change in response to entry/exit
• Otherwise the supply curve is the “normal” positive slope
• If firms have different costs, lower cost firms enter before those with
higher costs, Further changes in P make it worthwhile for less
efficient firms to enter the market increasing quantity supplied. So
for the marginal firm, P = minimum ATC and profit = 0. For lower
cost firms, profit > 0
• If costs change as firms enter the market (as more farmers till a
fixed number of acres), costs rise and prices rise. The cost for all
firms rise, giving a positively sloped curve, as prices have to rise to
increase aggregate supply.
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Summary and conclusion
• Competitive market is efficient
•
Profit maximization
MC = MR
•
Perfect competition
P = MR
•
With competitive equilibrium
P = MC
• Since MC is the cost of the last extra unit equal to the value to
buyers of that marginal unit, then the competitive equilibrium
maximizes total (consumer and producer) surplus
• Shutdown; a will shut down is P < AVC
• Exit, a firm will exit if
P < ATC
• With free entry and exit profits are zero in the long-run, where
•
P = minimum ATC (= MC)
20