Chapter 14 Perfect Competition
The Meaning of Competition • A perfectlycompetitive market has the following characteristics: • Many buyers and sellers • Homogenous good • Free entry and exit
The Meaning of Competition • As a result of its characteristics, the perfectly competitive market has the following outcomes: • The actions of any single buyer or seller in the market have a negligible impact on the market price. • Each buyer and seller takes the market price as given.
The Competitive Firm’s supply • 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.
The Revenue of a Competitive Firm • Average revenueis how much revenue a firm receives for the typical unit sold. In a perfect competitive market average revenue equals the price of the good.
The Revenue of a Competitive Firm • 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.
TR If the firm produces Q2, profit=0. If the firm produces Q1, profit is maximized. TR 1 Q 1 Profit Maximization Costs and TC Revenue TC 1 Quantity Q2 0
Profit Maximization: MR=MC • Profit maximization occurs at the quantity where marginal revenue equals marginal cost. • When MR > MC, increasing Q raises profit • When MR < MC, decreasing Q raises profit • When MR = MC, profit is maximized.
The firm maximizes profit by producing the quantity at which MC marginal cost equals marginal revenue. If the firm produces Q2, marginal cost is MC2. MC 2 ATC = = = = P MR MR P AR MR 1 2 AVC If the firm produces Q1, marginal cost is MC1. MC 1 Q Q Q 1 MAX 2 Profit Maximization Costs Suppose the market price is P. and Revenue Quantity 0
So, this section of the firm’s MC curve is also the firm’s supply curve. MC P 2 ATC P 1 AVC Q Q 1 2 Marginal Cost as the Supply Curve As P increases, the firm will select its level of output along the MC curve. Price Quantity 0
TR Total cost is always higher than total revenue. The firm realizes minimum losses at Q1. TC 1 Q 1 Firm making losses: not shut down Costs and TC Revenue MR=MC gives the optimum production point TR 1 Quantity 0
TR The loss at MR=MC is not the minimum. TC 1 Q 1 Firm realizing losses: shut down Costs and Revenue TC MR=MC does not always give the optimum production point TR 1 Quantity 0
Is MR=MC enough? • MR=MC gives the optimum output level, if the firm is to produce any output level greater than zero. • Sometimes a firm makes losses at the quantity where MR=MC. • The question then is: • Should the firm stay in business or shut down?
The Shut down Decision Should a firm continue to produce when it is realizing losses? • A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. • Exit refers to a long-run decision to leave the market.
More Formally, • Fixed costs are sunk costs • The firm shuts down if the revenue is less than the variable cost of production. • Shut down if : • Profit if in business <Profit if shut down TR-VC-FC < 0-FC TR<VC Divide both sides by Q: TR/Q < VC/Q Shut down if P < AVC
If P > AVC, firm will continue to produce in the short run. AVC Short-Run Supply Curve Costs P Quantity 0
If P < AVC, firm will shut down. AVC Short-Run Supply Curve Costs P Quantity 0
If P > ATC, the firm will continue to produce at a profit. MC Firm ’ s short-run supply curve ATC If P > AVC, firm will continue to produce in the short run. AVC Firm shuts down if P AVC < Short-Run Supply Curve Costs Quantity 0
The Firm’s Short-Run Decision to Shut Down • The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.
Summary • To find the profit maximizing quantity: • Compare P and MC • To check shut down • Compare P and AVC
Long-Run Decision to Exit or Enter a Market • In the long run, the firm exits if the revenue it would get from producing is less than its total cost, i.e. if • Profit in business <Profit if exit TR-TC < 0 TR<TC Divide both sides by Q: TR/Q < TC/Q Exit if P < ATC
MC = long-run S Firm ’ s long-run supply curve Firm enters if ATC P > ATC Firm exits if P < ATC Long-Run Supply Curve Costs Quantity 0
Summary: The Supply Curve • 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.
MC Supply $2.00 $2.00 1.00 1.00 100,000 200,000 100 200 Short-Run Market Supply (a) Individual Firm Supply (b) Market Supply Price Price Quantity (firm) Quantity (market) 0 0 If the industry has 1000 identical firms, then at each market price, industry output will be 1000 times larger than the representative firm’s output.
The Long Run and Firm Profit • When a perfect competitive industry realizes profit , entry by new firms occurs. • When a perfect competitive industry realizes losses, firms within the industry exit the market. • Firms will enter or exit the market until profits are driven to zero. • In the long run, price equals the minimum of average total cost.
MC ATC Total Cost Revenue Profit P P = AR = MR Q Positive profit creates entry (a) A Firm with Profits Price Quantity 0 (profit-maximizing quantity)
MC ATC ATC P P = AR = MR Loss Q Negative profit creates exit (b) A Firm with Losses Price Quantity 0 (loss-minimizing quantity)
Long Run Equilibrium • The conditions characterizing the long run equilibrium P and Q: • The total quantity demanded equals the total quantity supplied Quantity Demanded=Quantity Supplied • Each firm maximizes profit. Price=Marginal cost • No entry or Exit, i.e., zero profit Price=Average total cost
MC ATC Long-Run Market Supply (a) Firm ’ s Zero-Profit Condition (b) Market Supply Price Price D P* S Quantity (market) Quantity (firm) 0 0 q Q
MC ATC Describe the Long Run Equilibrium • firms that remain must be making zero economic profit. • Firms produce at the lowest possible unit cost, i.e. firms are operating at their efficient scale. (a) Firm ’ s Zero-Profit Condition Price P* Quantity (firm) 0 Q*
Why Do Competitive Firms Stay in Business If they Make Zero Profit? • In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going. • Total cost includes all the opportunity costs of the firm.
Comparative Statics: A Shift in Demand in the Short Run and Long Run • An increase in demand raises price and quantity in the short run. • Firms earn profits because price now exceeds average total cost.
MC ATC Short-run supply, S 1 A P P 1 1 Demand, D 1 Q 1 An Increase in Demand in the Short Run and Long Run (a) Initial Condition Market Firm Price Price Quantity (firm) Quantity (market) 0 0 A market begins in long run equilibrium. And firms earn zero profit.
ATC S MC 1 B P P 2 2 A P Long-run 1 supply D 2 D 1 Q Q 2 1 An Increase in Demand in the Short Run and Long Run The higher P encourages firms to produce more… …and generates short-run profit. An increase in market demand… …raises price and output. (b) Short-Run Response Market Firm Price Price P1 0 0 Quantity (market) Quantity (firm)
MC S 2 C D 2 Q 3 An Increase in Demand in the Short Run and Long Run Profits induce entry and market supply increases. (c) Long-Run Response Market Firm Price Price S1 ATC B P2 A P P 1 1 D1 Q1 Q2 Quantity (firm) 0 Quantity (market) 0 The increase in supply lowers market price. In the long run market price is restored, but market supply is greater.
MC P Quantity 0
MC S D Firm Market Price Price Quantity (firm) Quantity (market) 0 0