Chapter 14Perfectly competitive Market

• But first lets look at this

Profit Maximization

Profit Maximization

• This occurs where marginal revenue (MR) = marginal cost (MC).

MR = MC

• Marginal revenue is the extra revenue earned when one additional unit is produced

• The MC curve is also the firms supply curve

Profit Maximization Outcomes

• If MC < MR, the firm should increase output

• If MC > MR, the firm should decrease output

• If Price > ATC, the firm makes profit

• If Price < ATC, the firm makes losses

• If Price = ATC, the firm earns zero profit (normal profit)

The market price is always $6.Quantity Total

Revenue

Total Cost Profit Marginal

Revenue

Marginal

Cost

0 $3-

1 5

2 8

3 12

4 17

5 23

6 30

7 38

8 47

Review: Key Concepts for Competitive Markets

• Market price = MR and AR

• Profit maximization occurs where MR = MC

• If MR > MC, the firm should increase output

• If MR < MC, the firm should decrease output

• If where MR = MC is above ATC = firm makes profit

• If where MR = MC is below ATC = firm makes losses

• The MC curve is also the firms supply curve

Market Structures

MONOPOLY

OLIGOPOLY

MONOPOLISTIC COMPETITION

Competitive Markets

What is a market structure?

• The way consumers and producers are organized in a market

– Amount of firms?

– Variety of goods?

– Control over prices?

– Barriers to entry?

How many firms are in the market?

Variety of goods

• How different are the goods in the market?

Control over prices

• How much control does a firm have over their prices?

Competitive Markets (Perfect Competition)

Chapter 14

What does this have to do with competition?

Do you think economists would consider this a competitive market?

What are competitive markets?

• Main conditions that must be met:

–Many buyers and sellers

–Goods offered are identical or largely the same

–Consumers have complete control over price

–Firms can freely enter and exit the market

Economists sometimes call competitive markets perfect

competition. So, whether you hear a firm is in a competitive market or in a perfectly competitive market, it is the

same thing!

There are very few markets that compete perfectly

The market for wheat is a competitive market. This is because there are many buyers and sellers of wheat AND all

wheat is largely identical.

Most markets are not perfectly competitive, but very close.

The burger market is close to perfectly competitive because there are many buyers and sellers, but the product they sell is NOT identical. So, these firms are monopolistically competitive.

Monopolistic Competition

• Firms that produce differentiated products.

– Products in a particular market that are slightly different than one another

We’ll talk more about monopolistic competition in chapter 17!

So which market do you think buyers have more control over price?

The perfectly competitive firm

If Joe the farmer sells wheat for $5 a bushel, then I’ll just

go buy wheat from Bob instead who sells it for $4 a bushel. What do I care? All wheat is the same so I just want the cheapest price!

Price Takers• Firms that are competing in a perfectly

competitive market are the “price takers.”

• The firms have no control over price, so the only thing they can control is how much they produce.

• They must charge the market price

Nike has SOME control over the price of

sweaters because they can offer a slightly

different version than their competitors.

Joe the farmer has NOcontrol over prices because

his wheat is exactly the same as his competitors. So if he

raises the price of his wheat, the customers will buy from

his competitors instead. Therefore, Joe the farmer is a

price taker.

Political Cartoon Contest• Think of a market that is monopolistically

competitive. (Products have some differences)

• Draw a political cartoon of what that market would look like if it was perfectly competitive.– Make it unique and eye catching

– Creativity and humor definitely helps

– Using popular figures also helps dramatically

• The top three will be chosen by my best friends

• Then, the class will vote for the best cartoon in the class

Firms shut down vs. exit decision

Firm Activity Question?• You run a drive in movie theater. In the month of November,

if you stayed open it would cost you $150 to operate your theater. In that month, you would earn $100 in revenue. Your fixed cost is $100.

• How much profit/loss if you stayed open during November?

• How much profit/loss if you shut down during November?

Stay Open = loss of $50Shut Down= loss of $100

Because in the SHORT RUN there are still fixed costs to pay, it is rational to stay open in the short run because less money is lost.

What does shut down mean?

• Shutting down is a short-run decision not to produce anything for a specific period of time

• When firms decide to close down forever and leave the market, that is called an exit.

Most golf courses shut down in the winter.

In 2011, Borders exited the book market.

The Supply Curve (MC) for a Firm

• Short-Run Supply Curve

– The portion of its marginal cost curve that lies above average variable cost.

– Firm compares price to AVC

• Long-Run Supply Curve

– The marginal cost curve above the minimum point of its average total cost curve.

– Firm compares price to ATC

MC

ATC

AVC

Costs

and

Revenue

Quantity

Short run supply curve starts here

Long run supply curve starts here

Lets analyze a firm’s cost and revenue graph to understand the shut down

decision

Q3

P3

Optimal

Optimal

At what market price(s) will this firm have guaranteed profit?

P1 and P2

Q4

P4

Q3

P3

Optimal

Optimal

At what market price(s) will this firm have guaranteed losses?

P3 and P4

Q4

P4

Q3

P3

Optimal

Optimal

If market price was at P4, should the firm shut down?

NO!

Q4

P4

Shutting Down

• If Price > or equal to AVC, the firm does notshut down

• If Price < AVC, the firm does shut down

Q3

P3

Optimal

Optimal

At P4, the MR is greater than AVC. That means the quantity produced at P4 will cover all of the firm’s

variable costs plus some of its fixed costs.

So, this is better than shutting down and having to pay all of the firm’s fixed costs

Q4

P4

Q3

P3

Optimal

Optimal

If market price was P3, should the firm shut down?

Yes!

Q4

P4

Q3

P3

Optimal

Optimal

At P3, the MR is less than AVC. That means the quantity produced at P3 will not cover all of the

firm’s variable costs.

So, the firm won’t be able to cover its variable costs and even its fixed costs. Shut down!

Q4

P4

Review: Shut Down Key Concepts

• The short run supply curve is the portion of the MC curve that lies above AVC.

• The shut down decision only happens when a firm is comparing revenue to AVC.

• If Price > AVC, the firm does not shut down

• If Price < AVC, the firm does shut down

sh

Q3

P3

Optimal

Optimal

Q4

P4

Questions?

The firms long run decision to exit the market

MC

ATC

Costs

Quantity

Long run supply curve starts here

Remember, the long run supply curve starts at the MC curve above the minimum point of ATC curve

So firms compare revenue to ATC when making long run decisions.

The rules of long run decisions

• When Price < ATC, the firm exits the market

• When Price > ATC, new firms enter the market

MC

ATC

Costs

Quantity

P1

P2

P3

Q3Q2Q1

If market price was P1, the firm should exit the market because the revenue does not cover the total costs.

MC

ATC

Costs

Quantity

P1

P2

P3

Q3Q2Q1

If market price was P3, more firms will enter the market because the revenue not only covers the costs, but earns

profit for the firm.

MC

ATC

Costs

Quantity

P1

P2

P3

Q3Q2Q1

What would happen if market price was P2?

MC

ATC

Costs

Quantity

P1

P2

P3

Q3Q2Q1

If market price was P2, no firms would exit or enter the market. This is because profits in this market have been driven to zero.

Competitive Markets in the Long Run

Oh, please be good to me invisible hand

Competitive Markets in the Long Run

• In the long run, Price = ATC

– Firms earn zero profit (normal).

• Firms will enter or exit the market until profit is driven to zero.

• The long-run market supply curve is perfectly elastic at this price (horizontal).

So lets look at Joe the farmer’s competitive corn market

The beginning days the energy shot

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P 1

ATC

Long-runsupplyP 1

1Q

A

MC

The corn market began in long run equilibrium…

And Joe’s farm (the firm) earned zero profit.

Then, teens start to get hooked on corn

Market Firm

(b) Short-Run Response

Quantity (firm)0

Price

P 1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S 1

P 2

Q 1

A

Q 2

P 2

BATCMC

An increase in market demand…

…raises price and output.

The higher P encourages firms to produce more…

…and generates short-run profit.

New firms enter the corn market

P 1

Firm

(c) Long-Run Response

Quantity (firm)0

Price

MCATC

Market

Quantity (market)

Price

0

P 1

P2

Q1 Q2

Long-runsupply

B

D1

D 2

S1

AS 2

Q 3

C

Profits induce entry and market supply increases.

The increase in supply lowers market price. In the long run market price is restored, but market supply is greater.

We are now back on long run equilibrium

In the short run, I made profit and produced more.

But, in the long run, I’m back to making zero profit (normal) and I even have

more competitors!