firms in competitive markets

FIRMS IN COMPETITIVE FIRMS IN COMPETITIVE MARKETSMARKETS

Characteristics of Perfect CompetitionCharacteristics of Perfect Competition

1. There are many buyers and sellers in the market.

2. The goods offered by the various sellers are largely the same.

3. Firms can freely enter or exit the market.

4. The individual firm produces a small portion of total market output.

5. The firm cannot have any influence over the price it charges.

6. The individual firm in a perfectly competitive market is a price taker.

7. It takes the price determined by the market as the price that it will receive for its output.

Revenue of a Competitive FirmRevenue of a Competitive Firm

• Total revenue for a firm is the selling price times the quantity sold.

TR = (P X Q)


• Total revenue is proportional to the amount of output.


• Average revenue tells us how much revenue a firm receives for the typical unit sold.


• In perfect competition, average revenue equals the price of the good.


• In perfect competition, average revenue equals the price of the good.

Average revenue=Total revenue

Quantity

=(Price Quantity)

Quantity

=Price


• Marginal revenue is the change in total revenue from an additional unit sold.

MR =TR/Q


• For competitive firms, marginal revenue equals the price of the good.

Profit Maximization for the Profit Maximization for the Competitive FirmCompetitive Firm

• The goal of a competitive firm is to maximize profit. This means that the firm will want to

produce the quantity that maximizes the difference between total revenue and

total cost.


• Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

If MR > MC, increase Q to increase profit.

If MR < MC, decrease Q to increase profit.

If MR = MC, profit is maximized.


Quantity0

Costsand

Revenue


Quantity0

Costsand

Revenue

ATC

AVC


Quantity0

Costsand

RevenueMC

ATC

AVC


Quantity0

Costsand

RevenueMC

ATC

AVC P P = AR = MR


Quantity0

Costsand

RevenueMC

ATC

AVC

QMAX

P = AR = MR

The firm maximizesprofit by producingthe quantity at whichmarginal cost equalsmarginal revenue.

P


• A competitive firm will adjust its production level until quantity reaches QMAX where profit is maximized.


Quantity0

Costsand

RevenueMC

ATC

AVC

QMAX

P = AR = MR P


Quantity0

Costsand

RevenueMC

ATC

AVC

MC1

Q1 QMAX

P = MR1 P = AR = MR


Quantity0

Costsand

RevenueMC

ATC

AVC

MC1

Q1 QMAX

P = MR1 P = AR = MR

MR > MC,

increase Q


Quantity0

Costsand

RevenueMC

ATC

AVC

MC2

Q2QMAX

P = MR2 P = AR = MR


Quantity0

Costsand

RevenueMC

ATC

AVC

MC2

Q2QMAX

P = MR2 P = AR = MR

MR < MC,

decrease Q

The Firm’s Decision to Shut The Firm’s Decision to Shut DownDown

• A shutdown refers to a short-run decision not to produce anything during a specific period of time.

• Exit refers to a long-run decision to leave the market.


• The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down.

Sunk costs are costs that have already been committed and cannot be

recovered.


• The firm shuts down if the revenue it gets from producing is less than the variable cost of production.

Shut down if TR < VC

Shut down if TR/Q < VC/Q

Shut down if P < AVC


Quantity0

Costs


Quantity

MC

ATC

AVC

0

Costs


Quantity

MC

ATC

AVC

0

Costs

If P > ATC, keep producing at a profit.


Quantity

MC

ATC

AVC

0

Costs


If P > AVC, keep producing in the short run.


Quantity

MC

ATC

AVC

0

Costs


If P < AVC, shut down.



• The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.


Quantity

MC

ATC

AVC

0

Costs



If P < AVC, shut down.


Quantity

MC

ATC

AVC

0

Costs

Firm’s short-runsupply curve

The Long-Run Decision to Exit The Long-Run Decision to Exit an Industryan Industry

• In the long-run, the firm exits if the revenue it would get from producing is less than its total cost.

Exit if TR < TC

Exit if TR/Q < TC/Q

Exit if P < ATC

The Long-Run Decision to The Long-Run Decision to Enter an IndustryEnter an Industry

• A firm will enter the industry if such an action would be profitable.

Enter if TR > TC

Enter if TR/Q > TC/Q

Enter if P > ATC

The Competitive Firm’s Long-The Competitive Firm’s Long-Run Supply CurveRun Supply Curve


Quantity0

Costs


Quantity

MC

ATC

AVC

0

Costs


Firm enters if P > ATC

Quantity

MC

ATC

AVC

0

Costs



Firm exitsif P < ATC

Quantity

MC

ATC

AVC

0

Costs


• The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.




Quantity

MC

ATC

AVC

0

Costs


Quantity

MC

ATC

AVC

0

Costs

Firm’s long-runsupply curve

The Firm’s Short-Run and The Firm’s Short-Run and Long-Run Supply CurvesLong-Run Supply Curves

• Short-Run Supply Curve The portion of its marginal cost curve that lies

above average variable cost.

• Long-Run Supply Curve The marginal cost curve above the

minimum point of its average total cost curve.

Profit as the Area Between Price Profit as the Area Between Price and Average Total Costand Average Total Cost


Quantity0

Price


Quantity0

Price

ATCMC


Quantity0

Price

P = AR = MR

ATCMC

P


Quantity0

Price

ATCMC

P

ATC

Q

Profit-maximizingquantity

P = AR = MR


Quantity0

Price

ProfitATCMC

P

ATC

Q

Profit-maximizingquantity

P = AR = MR

Loss as the Area Between Price Loss as the Area Between Price and Average Total Costand Average Total Cost


Quantity0

Price

ATCMC


Quantity0

Price

ATCMC

P P = AR = MR


Quantity0

Price

ATC

ATCMC

Q

Loss-minimizing quantity

P P = AR = MR


Quantity0

Price

ATC

Loss

ATCMC

Q

Loss-minimizing quantity

P P = AR = MR

Quick Quiz!Quick Quiz!

• How does the price faced by a profit-maximizing competitive firm compare to its marginal cost?

Quick Quiz!Quick Quiz!

• When will a profit-maximizing firm decide to shut down?

Supply in a Competitive Supply in a Competitive MarketMarket

• Market supply equals the sum of the quantities supplied by the individual firms in the market.

Supply in a Competitive Supply in a Competitive Market Market

• Market Supply with a Fixed Number of Firms

For any given price, each firm supplies a quantity of output so that price equals its marginal cost.

The market supply curve reflects the individual firms’ marginal cost curves.

Supply in a Competitive Supply in a Competitive MarketMarket

• Market Supply with Entry and Exit Firms will enter or exit the market until

profit is driven to zero.

In the long-run, price equals the minimum of average total cost.

The long-run market supply curve is horizontal at this price.

The Supply Curve in a The Supply Curve in a Competitive MarketCompetitive Market

(a) Firm’s Zero-Profit Condition

Quantity(firm)

0

Price

P =minimum

ATC

(b) Market Supply

Quantity(market)

Price

0

Supply

MC

ATC

Increase in Demand in the Increase in Demand in the Short RunShort Run

• An increase in demand raises price and quantity in the short run.

• Firms earn profits because price now exceeds average total cost.

Initial ConditionInitial Condition

MarketFirm

Quantity(firm)

0

Price

Quantity(market)

Price

0

Initial ConditionInitial Condition

MarketFirm

Quantity(firm)

0

Price

MC ATC

P1

Quantity(market)

Price

0

D1

P1

Q1

A

S1

Long-runsupply

Short-Run ResponseShort-Run Response

MarketFirm

Quantity(firm)

0

Price

P1

Quantity(market)

Price

0

D1

D2

P1

Q1

A

S1

Long-runsupply

MC ATC

P1

B


MarketFirm

Quantity(firm)

0

Price

MC ATC

P1

P2

Quantity(market)

Price

0

D1

D2

P1

Q1 Q2

P2 A

B S1

Long-runsupply


MarketFirm

Quantity(firm)

0

Price

MC ATCProfit

P1

P2

Quantity(market)

Price

0

D1

D2

P1

Q1 Q2

P2 A

B S1

Long-runsupply

Increase in Demand in the Increase in Demand in the Long RunLong Run

• Over time, the short-run supply curve shifts as profits encourage new firms to enter the market.


• Price falls as new firms enter the market.


• In the new long-run equilibrium profits return to zero and price returns to minimum average total cost.


• The market has more firms to satisfy the greater demand.

Long-Run ResponseLong-Run Response

MarketFirm

Quantity(firm)

0

Price

MC ATCProfit

P1

P2

Quantity(market)

Price

0

D1

D2

P1

Q1 Q2

P2 A

B S1

Long-runsupply


MarketFirm

Quantity(firm)

0

Price

MC ATCProfit

P1

P2

Quantity(market)

Price

0

P1

Q1 Q2

P2 A

B

Long-runsupply

S2

D1

D2

S1


MarketFirm

Quantity(firm)

0

Price

MC ATC

P1

Quantity(market)

Price

0

D1

D2

P1

Q1 Q2

P2 A

B S1

Long-runsupply

S2

Increase in Demand in the Increase in Demand in the Short and Long RunShort and Long Run

MarketFirm

Quantity(firm)

0

Price

MC ATC

P1

Quantity(market)

Price

0

D2

P1

Q1

D1

Q2

A

B S1

Long-runsupply

S2

Q3

C

Why the Long-Run Supply Why the Long-Run Supply Curve Might Slope UpwardCurve Might Slope Upward

• Some resources used in production may be available only in limited quantities.

• Firms may have different costs.

ConclusionConclusion

• Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces.

• The price of the good equals both the firm’s average revenue and its marginal revenue


• To maximize profit a firm chooses the quantity of output where marginal revenue equals marginal cost.

• This is also the quantity at which price equals marginal cost.


• In the short run, the firm will choose to shut down temporarily if the price of the good is less than average variable cost.

• In the long run, it will choose to exit if the price is less than average total cost.


• If firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production in the long run.

• The number of firms adjusts to drive the market back to the zero-profit equilibrium.


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

FIRMS IN COMPETITIVE FIRMS IN COMPETITIVE MARKETSMARKETS

End of Chapter 14

Quantity0

Costsand

RevenueMC

ATC

AVC

MC2

MC1

Q1 Q2QMAX

P = MR1 = MR2 P = AR = MR

The firm maximizesprofit by producingthe quantity at whichmarginal cost equalsmarginal revenue.

Figure 14-1

Quantity0

Price

MC

ATC

AVC

P2

P1

Q1 Q2

Figure 14-2

Quantity

MC

ATC

AVC

0

Costs

Firmshutsdown ifP < AVC

Firm’s short-runsupply curve

Figure 14-3


Quantity

MC

ATC

AVC

0

Costs

Firm’s long-runsupply curve

Figure 14-4

(a) A Firm with Profits

Quantity0

Price

P = AR = MR

ProfitATCMC

P

ATC

Q(profit-maximizing quantity)

Figure 14-5a

(b) A Firm with Losses

Quantity0

Price

ATC

Loss

ATCMC

Q(loss-minimizing quantity)

P P = AR = MR

Figure 14-5b

(a) Individual Firm Supply

Quantity (firm)0

Price

MC

$2.00

1.00

100 200

(b) Market Supply

Quantity (market)0

Price

Supply

$2.00

1.00

100,000 200,000

Figure 14-6

(a) Firm s Zero-Profit Condition

Quantity (firm)0

Price

PP= minimumATC

(b) Market Supply

Quantity (market)

Price

0

Supply

MC

ATC

Figure 14-7

Firm(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Long-runsupply

Price

0

Demand

Short-run supply

P1 P

MC ATC

P1PA

Q1

MarketFirm(b) Short-Run Response

Quantity (firm)0

Price

MC ATCProfit

P1

P2

Quantity (market)

Long-runsupply

Price

0

D 1D 2

P1

Q1 Q2

P2A

B S1

P1

Firm(c) Long-Run Response

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P1

P2

Q1 Q2

Long-runsupply

Q3

C

B

D 1

D 2

S1

AS2

Figure 14-8

Firm

(a) Initial Condition

0

PriceMarket

Long-runsupply

Price

0

Demand, D1

Short-run supply, S1

P1 P

MC ATC

P1PA

Q1

Figure 14-8a

Quantity(market)

Quantity(firm)

(b) Short-Run Response

Figure 14-8b

MarketFirm

Quantity(firm)

0

Price

MC ATCProfit

P1

P2

Quantity(market)

Price

0

D1

D2

P1

Q1 Q2

P2 A

B S1

Long-runsupply

(c) Long-Run Response

Figure 14-8c

P1

Firm

0

Price

MC ATC

MarketPrice

0

P1

P2

Q1 Q2

Long-runsupply

Q3

C

B

D1

D2

S1

AS2

Quantity(firm)

Quantity(market)

firms in competitive markets

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