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14 Firms in Competitive Markets PRINCIPLES OF ECONOMICS FOURTH EDITION N. G R E G O R Y M A N K I W PowerPoint® Slides by Ron Cronovich © 2007 Thomson South-Western, all rights reserved In this chapter, look for the answers to these questions: What is a perfectly competitive market? What is marginal revenue? How is it related to total and average revenue? How does a competitive firm determine the quantity that maximizes profits? When might a competitive firm shut down in the short run? Exit the market in the long run? What does the market supply curve look like in the short run? In the long run? CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 1 Introduction: A Scenario Three years after graduating, you run your own business. You have to decide how much to produce, what price to charge, how many workers to hire, etc. What factors should affect these decisions? • Your costs (studied in preceding chapter) • How much competition you face We begin by studying the behavior of firms in perfectly competitive markets. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 2 Perfect Competition Firm In perfect competition all firms are too small to have any market power and so they will act as "price-takers" and simply charge the market price. For an industry to be perfectly competitive, there must be freedom of entry and exit, (No barriers) all firms must be price-takers, there must be perfect information, perfect mobility of factors and the products must be homogenous. (The same) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 3 Perfectly Competitive Markets A market made up of a large number of firms producing identical products with total freedom of entry to and exit from the market e.g. wheat. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 4 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 5 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. CHAPTER 14 ∆TR MR = ∆Q FIRMS IN COMPETITIVE MARKETS 6 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 7 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 8 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 9 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 10 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. CHAPTER 14 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 FIRMS IN COMPETITIVE MARKETS 11 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. Costs MC At Qb, MC > MR. So, reduce Q to raise profit. At Q1, MC = MR. Changing Q would lower profit. CHAPTER 14 MR P1 Q a Q1 Q b FIRMS IN COMPETITIVE MARKETS Q 12 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 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Q2 Q 13 Moses Said Profit maximization occurs at the quantity where marginal revenue equals marginal cost. The Golden Rule!!! When MR > MC , thou shalt increase Q When MR < MC , thou shalt decrease Q thus MR = MC , Profit is maximized. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 14 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 15 A Firm’s Short-run Decision to Shut Down If firm shuts down temporarily, • revenue falls by TR • costs fall by VC So, the firm should shut down if TR < VC. Divide both sides by Q: TR/Q < VC/Q So we can write the firm’s decision as: Shut down if P < AVC CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 16 A Competitive Firm’s SR Supply Curve The firm’s SR Costs supply curve is the portion of its MC curve If P > AVC, then above AVC. firm produces Q where P = MC. If P < AVC, then firm shuts down (produces Q = 0). CHAPTER 14 FIRMS IN COMPETITIVE MARKETS MC ATC AVC Q 17 Short Run Rules If Price > ATC, Stay Open with an Economic Profit. (P> ATC) If Price = ATC, Stay Open with a Normal Profit. (P=ATC) If AVC < price < ATC, Stay Open with a loss. If Price <AVC, Shut down. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 18 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 19 A Firm’s Long-Run Decision to Exit If firm exits the market, • revenue falls by TR • costs fall by TC So, the firm should exit if TR < TC. Divide both sides by Q to rewrite the firm’s decision as: Exit if P < ATC CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 20 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 If P = ATC, Firms will remain in business with a Normal Profit (P = ATC) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 22 Long Run Rules If Price > ATC, Firms Enter If Price = ATC, Nothing happens (Stay) If Price < ATC, Firms Exit CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 23 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 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 25 2A: Identifying a firm’s profit ACTIVE LEARNING A competitive firm Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. Costs, P MC MR ATC P = $10 $6 50 Q 26 ACTIVE LEARNING Answers 2A: 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 27 2B: Identifying a firm’s loss ACTIVE LEARNING 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 28 ACTIVE LEARNING Answers 2B: 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 29 Perfect Competition Long-Run Firm (P=ATC) (MC=MR) (MC=ATC) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 30 Firm with Ecn Profit, Adjust to Long-Run CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 31 Firm with Loss, Adjust to Long-Run CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 32 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) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 33 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 quantity supplied by each firm. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 34 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 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 20,000 30,000 35 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. (MC = ATC) • All firms remaining are earning a normal Profit. (P=ATC) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 36 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. (MC = ATC) • All firms remaining are earning a normal Profit. (P=ATC) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 37 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. P= ATC, Normal Profit CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 38 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) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS Q (market) 39 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. Or a Normal Profit (P=ATC) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 40 SR & LR Effects of an Increase in Demand …but then an increase A firm begins in profits to zero …leadingeq’m… to…driving SR Over time, profits induce entry, in demand raises P,… long-run andfirm. restoring long-run eq’m. profits for the shifting S to the right, reducing P… P One firm Market P S1 MC Profit ATC P2 P2 P1 P1 Q (firm) CHAPTER 14 S2 B A C long-run supply D1 Q1 Q2 FIRMS IN COMPETITIVE MARKETS Q3 D2 Q (market) 41 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 42 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 43 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 44 Inputs or Factor Costs Up to now we have assumed that input prices remain constant. Costs rise and fall strictly because of changes in productivity not because of changes in factor costs themselves (wages per hour stay constant for labor). A rise in the price of any of the inputs will lead to the whole set of curves shifting upward. • If it is a rise in the cost of Capital, then AFC & ATC will shift up. • If it is a rise in wages, then AVC, ATC and MC will shift up. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 45 Inputs or Factor Costs A fall in the price of inputs leads to a fall in the curves. If there is an increase in the amount of Capital, then productivity will rise and the AVC, ATC and MC curves will all shift down. • New Technology • More training CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 46 Inputs or Factor Costs Determinates of Supply that shift the cost curves • Input prices (wages) • Productivity (Technology) • Tax & subsidies CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 47 lump-sum A lump-sum tax is a tax that is a fixed amount, no matter the change in circumstance of the taxed entity. It is a regressive tax, such that the lower the income is, the higher the percentage of income applicable to the tax. An example is a poll tax to vote, which is unchanged no matter what the income of the voter. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 48 Lump Sum Tax / Subsidy Increase Lump sum tax ~ AFC, ATC shift up Decrease in Lump sum tax ~ AFC, ATC shift down Increase Lump sum subsidy ~ AFC, ATC shift down Decrease in Lump sum subsidy ~ AFC, ATC shift up Lump sum tax / subsidy do NOT change AVC, MC CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 49 Lump Sum Tax / Subsidy CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 50 Per Unit Tax / Subsidy Increase Per Unit tax ~ AVC, ATC, MC shift up Decrease in Per Unit tax ~ AVC, ATC, MC shift down Increase Per Unit subsidy ~ AVC, ATC, MC shift down Decrease in Per Unit subsidy ~ AVC, ATC, MC shift up CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 51 Per Unit Tax / Subsidy CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 52 CONCLUSION: The Efficiency of a Competitive Market Profit-maximization: Perfect competition: So, in the competitive eq’m: MC = MR P = MR 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. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 53 Allocative efficiency Allocative efficiency refers to the efficiency with which markets are allocating resources. A market will be allocatively efficient if it is producing the right goods for the right people at the right price. An allocatively efficient market is therefore one which has no imperfections. This will be true when marginal cost is equal to average revenue in the market. It occurs where a firm produces at: MC = AR (marginal cost pricing). MC = Price 54 Productive efficiency A firm is said to be productively efficient when it is producing at the lowest point on the average cost curve (MC = ATC). Productive efficiency is closely related to the concept of Technical Efficiency. A firm is technically efficient when it combines the optimal combination of labor and capital to produce a good. i.e. cannot produce more of a good, without more inputs. 55 Allocative & Productive efficiency CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 56 CHAPTER SUMMARY For a firm in a perfectly competitive market, price = marginal revenue = average revenue. If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run. If P < ATC, a firm will exit in the long run. In the short run, entry is not possible, and an increase in demand increases firms’ profits. With free entry and exit, profits = 0 in the long run, and P = minimum ATC. CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 57