# Chapter 14 ± Firms in Competitive Market12/30/2010 10:43:00 AM

Many firms supply gas to the local market, but only 1 firm supplies water. As you might expect, this difference in market structure shapes the pricing and production decisions of the firms that operate in these markets. A market is competitive if each buyer and seller is small compares to the size of the market and, thus has little ability to influence market prices. By contrast, if a firm can influence the market price of the good it sells, it is said to have market power. Market supply curve is closely linked to firm¶s costs of production. The Meaning of Competition A competitive market (aka perfectly competitive market) has 3 characteristics: 1) There are many buyers and sellers in the market 2) The goods offered by various sellers are largely the same 3) Firms can freely enter or exit the market As a result the actions of any single buyer/seller in the market has no impact ob the market price. Each buyer/ seller is a price-taker (taking the market price as given). In this market sellers can sell all they want at the going price, but have little reason to charge less, and if they charge more, buyers will go elsewhere.

The Revenue of a Competitive Firm To analyze the profit-max of a competitive firm, consider the Vaca Family Dairy Farm. The farm¶s total revenue(TR) = P X Q and it takes the price as given, meaning that the price of milk doesn¶t depend on the output of milk. Total revenue is proportional tot the amount of output. Average revenue(AR) = TR/Q = (P x Q)/Q = P

also shows a horizontal line at the market price (P). For a competitive firm.8. If the MR >MC. For competitive firms. If MR<MC. MR>MC. at 6. at 1. tells the change in TR from an additional unit sold. At production of Q1. the average revenue equals the price of the good. and the line horizontal because the firm is price-taker. marginal revenue equals the price of the good. increasing the Q raises profit. price (P) is fixed and thus when Q rises by 1 unit. . The Marginal Cost Curve and The Firm¶s Supply Decision The figure in Fig.For all firms. Marginal Revenue(MR) = ¨TR/¨Q. P = MR = AR.7. Change in profit = MR ± MC As long as MR > MC. Profit Maximization and the Competitive Firm¶s Supply Curve A Simple Example of Profit Max The Vacas can find profit-max Q by comparing the MR and MC from each unit produced. the additional revenue (MR1). would exceed the additional cost (MC1) and profit would increase. For a competitive firm. 3. which means that if the firm raised its level production by 1 unit. 2. TR rises by P dollars. the Vacas should decrease production. the Vacas should increase the production of milk cause it will put more money in their pockets(MR) than it takes out(MC). 1.

where MC = P. 3)At the profit-max level of output. where MC = the new higher price P2. its MR = MC. which means that if the firm reduced production by 1 unit. the firm produces Q1. which is Qmax in Fig. the firm should increase its output. . MR and MC are equal. the MC curve is also the competitive firm¶s supply curve. Cause a competitive firm is price-taker. 2)If MR<MC. 2 . The Firm¶s Short-Run Decision to Shut Down Shutdown: short-run decision not to produce anything during a specific period of time cause of current market conditions. 1.The new profit max is at Q2. the firm¶s profit max Q of output is found by looking at the intersection of the price with the MC curve. Exit: a long-run decision to leave the market. MR<MC. Fig. . In essence. the costs saved (MC2) would exceed the revenue lost(MR2) and profit would increase. Suppose the prevailing price in the market rises cause of an increase in market demand. cause the firm¶s MC curve determines the quantity of the good the firm is willing to supply at any price. so for any given price. Short-run and long-run decisions differ cause most firms can¶t avoid their fixed costs in the short run but can do so in the long run. the firm finds that MR is now higher than MC at the previous level of output. the firm should decrease its output. 3 General rules for profit maximization: 1)If MR>MC.When the price rises to P2. .At production of Q2. so the firm increases production.When the price is P1.

Ex: the costs of land is 1 of a farmer¶s fixed costs. -When making long-run decisions whether to exit the market. TR < VC. -If the farmer decides to leave farming. The Firm¶s Long-Run Decision to Exit/Enter a Market If a firms exits. . If the farmer decides not to produce crops 1 season. can be ignored when making decisions. but would lose more it stayed open. the land lies fallow. and he can¶t recover this cost. the firm compares the price it receives for the typical unit to the AVC of production of that unit. If the price doesn¶t cover the AVC. he can sell the land.This means that a firms that shuts down temporarily still has to pay its fixed costs. If a firm shuts down. Shut down if TR/Q < VC/Q. The firm will lose money (since still have to pay FC). the fixed cost of land is a sunk cost. When choosing to produce. 3 Sunk Cost: a cost that has already been committed and can¶t be recovered. whereas a firm that exits the market doesn¶t have to pay fixed or variable costs. the firm is better off not producing. The competitive firm¶s short run supply curve is the portion of its MC curve that lies above the AVC. -When making the short-run decision whether to shut down. it will again lose all revenue from the sale of its product. same as P < AVC. Fig. it loses all revenue from the sale of its product. The firm shuts down if the revenue that it would get from producing is less than its variable costs of production. But it saves the variable cost of making its product. but now it will save variable costs of production and its fixed costs. the cost of land isn¶t sunk.

Measuring Profit in Our Graph for the Competitive Firm Profit = (TR/Q ± TC/Q) x Q = (P ± ATC) x Q In Fig. -Q of output supplied to market = sum of Qsupplied each individual firm. Enter if TR/Q > TC/Q. 5(b). 6(a). where the firm maxes profit by minimizing losses and making P = MC.The firm exits if the revenue it would get from producing is less than its total costs. we add the Qsupplied by each firm in the market. each firm¶s MC curve is its supply curve. For any given price. Fig. -As long as P > AVC. -Thus to get market supply curve. same as P > ATC The competitive firm¶s long-run supply curve is the portion of its MC curve that lies above the ATC. the firm is earning (±) economic profit. it¶ll exit the market in the long run. the firm is earning (+) economic profit. 4 Exit if TR/Q < TC/Q. and the height of the rectangle is (ATC ± P) times the width which is Q equals the losses. 5(a). -Cause the firm isn¶t making enough revenue to cover ATC. same as P < ATC. and the height of the rectangle is (P ± ATC) times the width which is Q equals the profit. . TR < TC. The Supply Curve in a Competitive Market The Short Run: Market Supply with a Fixed Number of Firms Consider a market w/ 1000 identical firms. each firm supplies Q of output so that P = MC shown in Fig. Fig. where the firm maxes profit at P = MC.

If P< ATC. As a result the long run market supply curve must be horizontal at this price as seen in Fig. The process of entry and exit ends only when P = ATC. so profits are zero. -If P > ATC. The Long Run: Market Supply with Entry and Exit Let¶s suppose that everyone has access to the same technology for producing the good and access to the same markets to buy the inputs into production. leading to entry and an increase in the total Qsupplied. firms that stay in the market must be making zero economic profit. . profit is (±). new firms have no incentive to enter and old firms have no incentive to exit. 7(a). Any price above this level would create profit. the minimum of ATC. Thus.-Thus in Fig. At the end of this process of entry and exit. Thus. 6(b). all firms and all potential firms have the same cost curves. which encourages new firms to enter. which encourages old firms to exit. In Fig. then MC = ATC. By the equation for profit. there is only one price consistent with zero profit. which only happens when the firm is operating at the minimum of ATC. profit is (+). the Qsupplied to the market is 1000 times the quantity supplied by each firm. In the long-run equilibrium of a competitive market with free entry and exit. 7(b). we see a firm in such a long run EQ. In a market with free entry and exit. Since P = MC and ATC. firms must be operating at their efficient scale (lowest ATC). where P = MC so the firm is profit max and also = ATC. a firm has zero profit if and only if the price of the good equals ATC of making that good.

where firms are earning zero profit and P = min of ATC. so the firms are making (+) profit. Q rises from Q1 to Q2. -Demand for milk rises so demand curve for milk shifts from D1 to D2 in Fig. Suppose the market for milk starts in a long run EQ. where the price of milk has returned to P1 and the Q made has risen to Q3. -Eventually the price is driven to min of ATC. 8(c). the response of a market to a change in demand depends on the time horizon. the price of it rises thus raising the cost to all producers. the short run supply curve shifts from S1 to S2. For any given price. A Shift in Demand in the Short Run and Long Run Cause firms can enter and exit in the long run but not in the short run.In the zero-profit EQ. 2)Firms may have different costs. causing the price of milk to fall as seen in Fig. . those with lower costs are more likely to enter than those with higher costs. 8(a) as point A. shown in Fig. -In the new short run EQ. 8(b). and how much they each increase production is determined by MC curve. Why the Long Run Supply Curve Might Slope Upward 1)Some resource used in production may be available only in limited quantities. -The market now reaches a new long run EQ at point C. profits are zero. As the number of firms grows. the firm¶s revenue must compensate the owners for these opportunity costs found in TC. As more ppl want this limited resource. P > ATC. and firms stop entering. -All firms respond to the higher price by raising the amount produced. -Short run EQ moves from A to B. and price rises from P1 to P2.

Because firms can enter and exit more easily in the long run than in the short run. the long run supply curve is typically more elastic than the short run supply curve. .

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12/30/2010 10:43:00 AM .