# 9/2/2010

Lecture 9 In this chapter, look for the answers to
these questions:
 What is a perfectly competitive market?
Firms in Competitive Markets  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?
1

Introduction: A Scenario Characteristics of Perfect Competition
 Three years after graduating, you run your own
business. 1. Many buyers and many sellers

 You have to decide how much to produce, what 2. The goods offered for sale are largely the same.
price to charge, how many workers to hire, etc.
3. Firms can freely enter or exit the market.
 What factors should affect these decisions?
• Your costs (studied in preceding chapter)  Because of 1 & 2, each buyer and seller is a
• How much competition you face “price taker” – takes the price as given.
 We begin by studying the behavior of firms in
perfectly competitive markets.

2 3

The Revenue of a Competitive Firm A C T I V E L E A R N I N G 1:
Exercise
Fill in the empty spaces of the table.
 Total revenue (TR) TR = P x Q
Q P TR AR MR
TR
 Average revenue (AR) AR = =P
Q 0 \$10 n.a.
 Marginal Revenue (MR): 1 \$10 \$10
∆TR
The change in TR from MR =
∆Q 2 \$10
selling one more unit.
3 \$10

4 \$10 \$40
\$10
5 \$10 \$50
4 5

1

If increase Q by one unit. 10 12 –2 5 50 45 5 8 9 MC and the Firm’s Supply Decision MC and the Firm’s Supply Decision Rule: MR = MC at the profit-maximizing Q. Q would lower profit. P1 MR firm’s Q at any price. raises profit. Hence. Q2 Qa Q1 Qb Q1 10 11 2 . MC < MR. each one-unit increase in Q causes revenue 0 \$10 \$0 n. then increase Q to raise profit.. the MC curve is the Changing Q Q firm’s supply curve. 9/2/2010 A C T I V E L E A R N I N G 1: MR = P for a Competitive Firm Answers Fill in the empty spaces of the table. P2 MR2 At Qb. P1 MR At Q1. Q TR TC Profit MR MC Profit = At any Q with “Think at the margin. 1 10 9 1 cost rises by MC.e. MC > MR. Q P TR = P x Q AR = MR = Q ∆Q  So.” MR – MC MR > MC. If price rises to P2. 10 6 4 2 20 15 5  If MR > MC. MR = P.a. 3 \$10 \$30 \$10 \$10 4 \$10 \$40 \$10 \$10 5 \$10 \$50 \$10 6 7 Profit Maximization Profit Maximization  What Q maximizes the firm’s profit? (continued from earlier exercise)  To find the answer. reduce Q determines the to raise profit. MC = MR. At Qa. \$10 1 \$10 \$10 \$10 Notice that \$10 2 \$10 \$20 \$10 MR = P is only true for MR = P \$10 firms in competitive markets. then reduce Q to raise profit. Costs then the profit. rises to Q2. 0 \$0 \$5 –\$5 increasing Q \$10 \$4 \$6 revenue rises by MR.  A competitive firm can keep increasing its output TR ∆TR without affecting the market price. reducing Q 4 40 33 7 raises profit. 3 30 23 7 10 10 0  If MR < MC. i. The MC curve So. to rise by P. increase Q maximizing quantity MC MC to raise profit. Costs So. At any Q with 10 8 2 MR < MC.

Q 14 15 A Firm’s Long-Run Decision to Exit A New Firm’s Decision to Enter Market  If firm exits the market. the firm should exit if TR < TC. its MC curve you must pay them regardless of your choice. 9/2/2010 Shutdown vs. fixed or variable. FC should not matter in the decision to shut If P < AVC. firm produces Q ATC  FC is a sunk cost: The firm must pay its fixed where P = MC. • costs fall by TC  Divide both sides by Q to express the firm’s  So.  In the long run. the firm should shut down if TR < VC. then above AVC. Exit A Firm’s Short-run Decision to Shut Down  Shutdown:  If firm shuts down temporarily. then down. A short-run decision not to produce anything • revenue falls by TR because of market conditions. AVC  So. firm shuts down (produces Q = 0). costs whether it produces or shuts down. A firm that exits the market does  So we can write the firm’s decision as: not have to pay any costs at all. entry decision as:  Divide both sides by Q to rewrite the firm’s Enter if P > ATC decision as: Exit if P < ATC 16 17 3 . A long-run decision to leave the market.  Divide both sides by Q: TR/Q < VC/Q  A firm that shuts down temporarily must still pay its fixed costs. If P > AVC. Shut down if P < AVC 12 13 A Competitive Firm’s SR Supply Curve The Irrelevance of Sunk Costs  Sunk cost: a cost that has already been The firm’s SR committed and cannot be recovered supply curve is Costs the portion of MC  Sunk costs should be irrelevant to decisions. a new firm will enter the market if • revenue falls by TR it is profitable to do so: if TR > TC. • costs fall by VC  Exit:  So.

P Costs LR supply curve this firm’s MC MC is the portion of total profit. It’s a new customer who wants to buy one unit of your product. you have landed a job in production management for Universal Clothes. Should you accept this offer? 22 b. P are responsible for the entire company on weekends. Your new customer offers Q 30 you \$450 to produce the extra unit. = \$4 x 50 Q Q = \$200 50 30 20 21 A C T I V E L E A R N I N G 2B: A C T I V E L E A R N I N G 3: Answers A competitive firm As a recent graduate of this college. a. Q Q 50 18 19 A C T I V E L E A R N I N G 2A: A C T I V E L E A R N I N G 2B: Answers Identifying a firm’s loss A competitive firm A competitive firm Costs. 9/2/2010 The Competitive Firm’s Supply Curve A C T I V E L E A R N I N G 2A: Identifying a firm’s profit A competitive firm The firm’s Determine Costs. MC Your costs are shown below. All 500 units \$5 have been ordered by your regular customers. = P – ATC P = \$10 MR = \$10 – 6 Identify the profit ATC ATC = \$4 area on the \$6 graph that \$5 represents Total profit the firm’s P = \$3 MR = (P – ATC) x Q loss. LRATC ATC area on the graph that \$6 represents the firm’s profit. its MC curve P = \$10 MR Identify the above LRATC. Total loss Quantity Average Total Cost = (ATC – P) x Q 500 200 = \$2 x 30 ATC 501 201 = \$60 Your current level of production is 500 units. loss loss per unit = \$2 P = \$3 MR The phone rings. What is the net change in the firm’s profit? 25 4 . This means you would have to increase production to 501 units. P this firm’s profit per unit MC MC total loss. You Costs. P Determine Costs. Inc.

 In the LR. reducing firms’ profits. the zero-profit condition is P = MC = ATC. the market quantity supplied is the 3) The number of firms in the market is sum of quantity supplied by each firm. been driven to zero. 9/2/2010 Market Supply: Assumptions The SR Market Supply Curve 1) All existing firms and potential entrants have  As long as P ≥ AVC. One firm Market  If existing firms earn positive economic profit. where MR = MC. P1 P1 • Entry stops when firms’ economic profits have been driven to zero. • fixed in the short run (due to fixed costs) • variable in the long run (due to free entry and exit) 26 27 The SR Market Supply Curve Entry & Exit in the Long Run Example: 1000 identical firms.  Since firms produce where P = MR = MC.  If existing firms incur losses. P = minimum ATC. P3 P3 • SR market supply curve shifts right. P2 AVC P2 • P falls. • SR market supply curve shifts left. The process of entry or exit is complete – remaining firms earn zero economic profit. • P rises.000 20.000 28 29 Entry & Exit in the Long Run The Zero-Profit Condition  In the LR. market Qs = 1000 x (one firm’s Qs) to entry & exit. 2) Each firm’s costs do not change as other firms  Recall from Chapter 4: enter or exit the market.  Zero economic profit occurs when P = ATC.000 30. • Exit stops when firms’ economic losses have  Recall that MC intersects ATC at minimum ATC. P P MC S • New firms enter. each firm will produce its identical costs. At each price. 30 31 5 . Q Q 10 20 30 (firm) (market) 10. the number of firms can change due  Long-run equilibrium: to entry & exit. the number of firms can change due At each P. • Some will exit the market. in the long run. reducing remaining firms’ losses.  Hence. profit-maximizing quantity.

there’s a fixed amount of land suitable for farming).g. an increase in P is required to increase • For the marginal firm. reducing P… 1) all firms have identical costs. raises P. S2 Profit ATC B  If either of these assumptions is not true.  This increases all firms’ costs. the market quantity supplied. • For lower-cost firms. firms with lower costs enter the market  In some industries.  Hence. profit > 0. LRATC P= long-run min. like the earns zero profit.  Further increases in P make it worthwhile for higher-cost firms to enter the market. is upward-sloping. The LR market supply  Recall.  The entry of new firms increases demand for this which increases market quantity supplied. input. so the supply curve P = minimum ATC and profit = 0. opportunity cost of the owner’s time and money. A C long-run P1 P1 supply D2 D1 Q Q (firm) Q1 Q2 Q3 (market) 34 35 1) Firms Have Different Costs 2) Costs Rise as Firms Enter the Market  As P rises. supply ATC Q Q (firm) (market) 32 33 SR & LR Effects of an Increase in Demand Why the LR Supply Curve Might Slope Upward A firm begins in …but then an increase long-run to…driving …leadingeq’m… SR profits to zero Over time.  Hence. limited (e. profits in demandinduce entry. 9/2/2010 The LR Market Supply Curve Why Do Firms Stay in Business if Profit = 0? In the long run.  At any P. firms earn enough P MC P revenue to cover these costs. the supply of a key input is before those with higher costs. economic profit is revenue minus all the typical firm curve is horizontal at costs – including implicit costs. LR market supply curve slopes upward. P = minimum ATC. P2 P2 then LR supply curve slopes upward. and P One firm P Market 2) costs do not change as other firms enter or MC S1 exit the market. causing its price to rise..…  The LR market supply curve is horizontal if and restoring long-run profits for the firm. right. shifting S to theeq’m. 36 37 6 . One firm Market  In the zero-profit equilibrium.

9/2/2010 CONCLUSION: The Efficiency of a Competitive Market CHAPTER SUMMARY  Profit-maximization: MC = MR  For a firm in a perfectly competitive market. will shut down in the short run.  If P < ATC. P is value to buyers of the marginal unit.  In the short run. profits = 0 in the long run.  In the next chapter. entry is not possible. a firm will exit in the long run.  So.  Perfect competition: P = MR price = marginal revenue = average revenue. in the competitive eq’m: P = MC  If P > AVC. maximizes total surplus. regulation. the competitive eq’m is efficient. 38 39 7 .  So. monopoly: pricing &  With free entry and exit. and P = minimum ATC. production decisions. deadweight loss. a firm maximizes profit by producing the quantity where MR = MC. a firm  Recall. If P < AVC. MC is cost of producing the marginal unit. and an increase in demand increases firms’ profits.