Firms and competitive markets
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Firms and Competitive Markets. Competitive Market. Properties Many buyers and sellers Trading identical products Each buyer and seller a price taker Free entry/exit of the market. Goal is to maximize profit ∏ = TR - TC Total Revenue Price time quantity: TR = P x Q Average Revenue

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Firms and Competitive Markets

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Firms and Competitive Markets


Competitive Market

  • Properties

    • Many buyers and sellers

    • Trading identical products

    • Each buyer and seller a price taker

    • Free entry/exit of the market


  • Goal is to maximize profit

    • ∏ = TR - TC

  • Total Revenue

    • Price time quantity: TR = P x Q

  • Average Revenue

    • Total Revenue divided by quantity sold

  • Marginal Revenue

    • Change in revenue from additional unit sold

  • For competitive firms

    • Average Revenue = P

    • Marginal Revenue = P


Profit Max

  • Profit Maximization

    • Produce at the quantity that maximizes the difference between TR and TC

    • Compare marginal revenue with marginal cost

      • If MR > MC increase production

      • If MR < MC decrease production

      • If MR = MC profit maximized


Profit Max Decision

Costs and Revenue

MC

Producing here MC > MR so don’t

ATC

MC = MR so profit maxed

AVC

P = MR = AR

Producing here MC < MR so produce more

Q*

Quantity


  • Marginal Cost Curve (MC) determines the quantity a firm would be willing to supply at a given price

  • Therefore it is the firms supply curve


MC Curve as Supply Curve

Costs and Revenue

MC

ATC

P2

AVC

P1

Q1

Q2

Quantity


Shut down and Exit

  • Shut Down

    • Short Run decision not to produce

    • Still have to pay fixed costs though

  • Exit (don’t Enter)

    • Long Run decision

    • No costs


Short Run Decision

  • Focus on

    • Total Revenue

    • Variable costs (fixed costs are fixed, so ignore)

  • Decision

    • Shut down if TR < VC ( or MR/AR < AVC )

  • Competitive Firms Short Run Supply Curve

    • MC curve above the AVC curve


Short Run Supply Curve

Costs

ATC

MC

In short run firms produce on the MC curve if P > AVC

AVC

Quantity

In short run firms shut down if P < AVC


Long Run Decision

  • Exit Market if:

    • TR < TC

    • Or P < ATC

  • Enter Market if:

    • TR > TC

    • Or P > ATC

  • Competitive Firms Long Run Supply Curve

    • Portion of the MC curve above the ATC curve


Long Run Supply Curve

Costs

ATC

MC

In long run firms produce on MC curve if P > ATC

Firms exit market if P<ATC

Quantity


Profit

  • If P > ATC

    • Positive profits

    • ∏ = TR – TC = (P – ATC) x Q

  • If P < ATC

    • Negative profits (losses)

    • Loss = TC – TR = (ATC – P) x Q


Firm with Profits

Firm with Losses

AVC

AVC

MC

MC

Profit

P

Loss

AVC

AVC

P

Q*

Q*

Profit Maximizing Q

Cost Minimizing Q


Market Supply Curve

  • In short run # of firms fixed

  • Each firm supplies where P = MC

  • Each firms supply curve is the MC curve above their AVC curve (otherwise 0)

  • For market supply just add up horizontally

S1

S2

S - Market

+

=


  • In long run # of firms not fixed

    • Free entry/exit

  • If P > ATC

    • Profits are positive

    • Firms enter market

  • If P < ATC

    • Firms taking losses

    • Firms exit the market

  • This means all firms (assuming identical cost curves) will produce at MC = ATC (efficient pt)

    • So MKT supply curve will be horizontal at that point (perfectly elastic)


Long Run Market Supply

Multiple Firms with identical cost curves

Add up supply at MC = ATC level for each to get Market Supply

Price

Price

MC

ATC

P =

Min ATC

Supply

Quantity

Quantity


Some Caveats

And perhaps it could still slope up if by increasing market size they bid up the cost of inputs. This would cause latte entering firms to have higher cost curves.

P

P

Actual Supply would be more like this, with holes and dots denoting when different firms enter. That is it would not be a smooth line.

Or some firms could just be better at it, thus having lower cost curves. But either way LR flatter than SR.

Q

Q


  • So why stay in business if making zero profit?

  • Profit = Total Revenue – Total Costs

  • Total Costs include opportunity costs

  • Zero Profit Equilibrium

    • Zero economic profit

    • Positive accounting profit


Shift in Demand and LR and SR supply response

  • Market in long run eq.

    • P = ATC

    • Zero economic profit

  • Increase in demand

    • Demand shifts out

    • Short Run

      • Higher quantity, higher price

      • P > ATC

      • Positive economic profit


  • Because of positive profits

  • Firms enter in the long run

  • SR supply curve shifts right

  • Price falls back to low point on ATC

  • Quantity increases (because of more firms)

  • Back to efficient scale


Initial State of Equilibrium

Market

Firm

P

P

MC

ATC

D

SR Supply

P’

LR Supply

Q’

Q

Q


Demand Shifts, + Profits

Market

Firm

P

P

Price increases

MC

ATC

D

SR Supply

Which leads to + profits

P’’

LR Supply

Q

Q


Supply Shifts, 0 Profits

Market

Firm

P

P

SR Supply

MC

ATC

D

Profits induce firms to enter market

P’’’

Restoring Long Run Equilibrium, but with more firms

Price falls back

Q

Q


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