FIRMS IN COMPETITIVE MARKETS PRINCIPLES OF MICROECONOMICS Dr. Fidel Gonzalez Department of Economics and Intl. Business Sam Houston State University
We will consider four types of markets. Each market will be divided according to the number of sellers and how different is the good between producers. Product Differentiation Unique good (no close substitutes) Homogeneous good One seller Monopoly Oligopoly Number of Sellers Monopolistic Competition Competitive Market Many Sellers
We start by considering the competitive markets: • Many buyers and sellers: this implies that no one firm or buyer can affect the market price. When each of them goes to the market, they take the current price in the market. • Hence, buyers and sellers are price-takers. • Homogeneous good: the goods offered by the firms are the same. For instance, milk from farm A is the same as the milk produced from farm B. The consumers can not distinguish between the good produced by each producer. • Examples of competitive markets: • Milk, Apples, Corn, Eggs, Oranges, so on.
The goal of the firm is to maximize profits. In order to maximize profits, the firm will have to answer three important questions: • How much should the firm produce to maximize profits? • Should the firm stay or leave the market in the short-run? • Should the firm stay or leave the market in the long-run?
How much should the firm produce to maximize profits. Lets observe the firm’s costs and revenue TR (total revenue) = P x Q AR (average revenue) = (P x Q)/Q MR (marginal revenue) = (Change in total revenue)/(Change in Quantity) MC (marginal cost) = (Change in total cost)/(Change in Quantity)
The previous table has the following points: • The price does not change with the quantity produced by the fir. This follows from the fact that this is a competitive market and there are many sellers. • AR is always equal to the price: this follows from the definition of average revenue. AR= (PxQ)/Q = P. This is true for all kind of markets (monopoly, oligopoly, competitive and monopolistic competition) • MR = P, this is true only in competitive markets. • The quantity that maximizes profits (at Q=7) takes place when MR=MC.
MR=MC is known as the profit maximizing condition. Why? Imagine that you are the CEO of this firm and you are producing four units, Q=4. If you increase production by one unit, the marginal cost of the fifth unit will be $4 and the marginal revenue of the fifth unit is $6. You get more money from that unit than what it costs to produce it. Hence, profits increase when you go from Q=4 to Q=5. If you are a good CEO you will continue production as long as the MR>MC. The production of the firm will continue until MR=MC, the money received from one extra unit is equal to the cost of that extra unit. Clearly, if the MR<MC then production must be decreased. For instance the marginal cost of the ninth unit is $8 and the marginal revenue is $6. Producing the ninth unit will actually decrease profits by $2
This is the profit maximizing problem graphically MC $ MC=MR MC>MR MR>MC P P=MR=AR Q*=7 Q
We have answer the first of the three questions: 1 . How much should the firm produce to maximize profits? To maximize profits the firm should produce to the point where MR=MC
Now, lets try to answer the second question 2 . Should the firm stay or leave the market in the short-run? If the firm leaves in the short-run it is said to shut-down. This is a temporary situation, the fill will come back to the market. When the firm leaves the market forever it is said to “exit” the market. If the firm shuts down then the firm still has to pay the fixed cost and gets no revenue: Profits (shutdown) = -FC If the firms stays then it has to pay the fixed and variable cost but it gets the revenue Profits (stay) =TR – FC – VC
The firm will shutdown if Profits (shutdown) > Profits (stay) Subsituting -FC > TR – FC –VC -FC + FC > TR-VC 0 > TR – VC VC > TR The firm will shutdown if the variable cost is higher than the total revenue. Dividing the last equation by Q on both sides we get: VC/Q > TR/Q AVC > AR AVC > P The firm will shutdown if the average variable cost is higher than the price of the good.
This implies that a firm can stay in the market in the short-run even if it has losses as long as it can cover the variable costs (or as long as the price is higher than the average variable costs) Once the firm can not even recover its variable cost then it has to shutdown. We now need a new definition of profit: Profit = TR – FC – VC Divide both sides by Q Profit/Q = TR/Q –TC/Q Profit/Q = AR – ATC Profit/Q = P – ATC Profit = ( P – ATC )x Q New definition of profit
A firm will have positive profits if: Profit > 0 ; (P-ATC) x Q >0 ; P > ATC (profits) A firm will have losses if Profit < 0 ; (P-ATC) x Q <0 ; P < ATC (losses) A firm will break even if Profit = 0 ; (P-ATC) x Q =0 ; P = ATC (break even) A firm will have losses and stay in the market if: ATC > P > AVC losses At least can cover the variable costs, so it stays in the market in the short-run
Graphically, this is a firms that has losses but stays in the market: MC $ ATC AVC ATC Losses P P=MR=AR AVC Q* Q Firm produces where MC=MR At that quantity the ATC > P the firms has losses But since P > AVC the firm can recover the variable cost so it stays in the market in the short-run
A firm the has losses and shuts down: P > ATC > AVC MC ATC $ AVC ATC Losses AVC P P=MR=AR Q* Q Firm produces where MC=MR At that quantity the ATC > P the firms has losses Also since P < AVC the firm can not recover the variable cost so it shuts down in the short-run
Graphically, this is a firms that has losses but stays in the market: Because the firm will stay in the short-run as long as the P > AVC: The MC curve above the AVC is the firm’s supply in the short-run The purple line is the firm’s supply curve in the short-run MC $ Supply Short-Run AVC P P=MR=AR Q
We have answered the second question 2 . Should the firm stay or leave the market in the short-run? The firm will stay in the market in the short run as long as P >AVC The firm will leave the market in the short run if P < AVC (We also obtained an extra result that says that the MC above the AVC is the firm’s supply curve in the short-run)
Now, lets try to answer the third question 3 . Should the firm stay or leave the market in the long-run? In the long-run the can not have negative profits. The firms can loose money for a few months but not forever. In the long-run the firm will stay in the market as long as it is making positive profits that is: Profits > 0 (P –ATC) x Q > 0 P > ATC stays in the market in the long-run If P < ATC exit the market in the long-run (the firm leave the market forever).
Example of a firm that stays in the market in the short-run but leaves the market in the long-run: MC $ ATC AVC ATC Losses P P=MR=AR AVC Q* Q The firm will stay in the short-term because P > AVC but in the long-term leaves the market because ATC > P.
Because the firm will stay in the long-run as long as the P > ATC: The MC curve above the ATC is the firm’s supply in the long-run The purple line is the firm’s supply curve in the long-run MC $ Supply Long-Run ATC P P=MR=AR Q
We have answered the third question 3 . Should the firm stay or leave the market in the long-run? The firm will stay in the market in the long run as long as P >ATC The firm will leave the market in the long run if P < AVC (We also obtained an extra result that says that the MC above the ATC is the firm’s supply curve in the long-run)
Competitive Market: Firm’s Supply and the Market. A final issue needs to addressed, what is the relationship between the firm’s supply and the market in the short and in the long-run. The main difference between the short and long-run is that in the latter new firms can enter the market and old firms can exit the market. In other words, in the long-run there is free entry and exit of firms in the market. Q: Why would firms enter the market? A: Firms will enter a competitive market if the firms that are already in the market have positive profits. For instance, if the farms that produce milk have positive profits then there will be other firms interested on entering the market. In the long-run they will enter the market. When many more firms enter the market that increases the quantity supplied and the equilibrium price goes down, reducing the profits.
Competitive Market: Firm’s Supply and the Market. The process of entering continues until the price drops enough to make profits zero. In a competitive market, in the long-run all firms have zero profits. Q: Why firms do not enter in the short-run? A: Because it takes time to prepare the firm to produce. In the milk example, when a person observes that the farmer have positive profits they want to enter the market. However, they need to buy land, cows, supplies and so on. This takes time, so it is not possible to enter in the short-run. If competitive firms have zero profits in the long-run, does that mean that the firm is not making money?
Competitive Market: Firm’s Supply and the Market. Q: If competitive firms have zero profits in the long-run, does that mean that the firm is not making money? A: No!! Zero profits only means that the firm is getting paid its opportunity cost to produce, it is making money. Remember the distinction between economic profit and accountant profit.
Competitive Market: Firm’s Supply and the Market Short-run Firm’s Supply Short-run Market Supply and Demand Short-run Supply (MC above AVC) Market Supply Market Demand In the short-run the firm’s supply curve and the market supply curve have a positive slope.
Competitive Market: Firm’s Supply and the Market Long-run Firm’s Supply Long-run Market Supply and Demand Long-run Supply (MC above ATC) Market Supply Market Demand In the long-run the firm’s supply curve has a positive slope. However, the market supply curve in the long-run has is a horizontal line. Why? The short answer is because of zero profits. Lets prove it.
Competitive Market: Firm’s Supply and the Market Short and Long-run Firm Market Original Situation. Start at the equilibrium, the firm has zero profits. P MC P ATC S-SR S-LR P D Q Q Q Q* P P MC S-SR Short-Run Response ATC P1 profit P S-LR Market Demand Increases In the short-run the price increases from P to P1 and the firm has positive profits D1 D Q Q* Q Q P P Long-Run Response S-SR MC ATC S-SR1 Supply Increases Because profits are positive more firms enter the market increasing supply in the short-run. This reduces the market price until profits are again zero. S-LR P D1 D Q Q* Q1 Q Q
Competitive Market: Firm’s Supply and the Market. From the previous slide you can see that the market price in the long-run is always going to be the same. Therefore the supply in the long-run is always going to be a flat line. Because firms take some time to enter a market, it is possible in the short-run to have positive profits and an upward sloping market supply.