Lecture 9: Chapter 13: Firms in Competitive Markets

Perfect Competition

Market structure where there is a large number of sellers offering identical products

• No single firm is able to influence the market price

Characteristics of Perfect Competition

1. There are many buyers and many sellers

2. Goods for sale are the same and identical

3. Firms can freely enter or exit the market

In a perfect competition, why is each buyer and seller a “price taker”?

Each buyer and seller is a price taker, since there are so many buyers and sellers and the goods offered for sale are the same, so they can’t influence the price

Total Revenue Formula

TR= P x Q

Average Revenue Formula

AR= TR/ Q = P

What is average revenue equal to?

Average revenue= to price

Marginal Revenue (MR)

The change in total revenue from selling one more unit

Marginal Revenue (MR) Formula":

MR= change in TR/ change in Q

What can a competitive firm do to it’s output?

A competitive firm can keep increasing its output without affecting the market price

• Increase in Q causes the revenue to rise by P

• MR= P

What is true about firms in competitive markets?

For firms in competitive markets, MR= P

• MR= Change in TR/ Change in Q

What happens when Q increases by 1 unit?

When Q increases by 1 unit, the revenue increases by MR and cost increases by MC

What happens if MR is more than MC?

If MR is greater than MC, increase Q to raise profit

• Revenue from each additional unit is greater than the cost of producing it

• Firm should increase production

What happens if MC is more than MR?

If MC is greater than MR, decrease Q to raise profit

• Cost from each additional unit is greater than the revenue of it

• Firm should decrease production

What is the relationship between MC and MR at the profit maximizing Q?

MR= MC at profit maximizing Q

• Cost of producing one more unit is exactly equal to the additional revenue from selling that unit

• Firm has maximized its profit and should produce at that specific output level

Graph with MC and MR

• Cost on Y axis and quantity on the X axis

MC: upwards sloping

MR= AR= P: horizontal line

Why does MC= P at profit maximizing point?

• MR (marginal revenue) is the extra money you make from selling one more item.

• In perfect competition, the price of the product stays the same no matter how much you sell.

• So, every extra item you sell just earns you the same price, because the market sets it.

In perfectly competitive markets, what is the MC curve also?

• MC = cost to make one more unit

• In perfect competition, the firm produces where Price = MC

• So the MC curve shows how much the firm will supply based on price

• ✅ In short: MC curve = MR curve= supply curve

Shutdown

A short run decision not to produce anything because of market conditions

Exit

A long run decision to leave the market

What is the difference between shutdown and exit?

If a firm shuts down in the SR, it must pay FC.

If a firm shuts down in the LR, it pays zero costs

Formula that determines whether a firm shuts down in the short run (full break down)

Cost of shutting down in the SR: Revenue Loss (TR)

Benefit of shutting down in the SR: Saves cost (VC), still has to pay FC

So, it will shut down if TR < VC (Variable Cost is more than Total Revenue)

Firm will shut down if P < AVC

When will a firm shut down in the short run?

A firm will shut down in the short run if P < AVC

• Average variable cost is greater than price

In the short run, what will a competitive firm do if P> AVC?

The firm will produce Q where P= MC

What is the firm’s SR supply curve?

The firm’s SR supply curve is the portion of it’s MC curve above the AVC cost curve

Why does only the part of the MC curve above AVC counts as the short-run supply curve?

1. AVC = Average Variable Cost

   • These are the costs that change with production. 

2. Shutdown rule:

   • If Price < AVC, the firm can’t even cover its variable costs.

   • Producing would make the firm lose more money than if it just shut down.

   • So the firm produces 0 in this range.

3. Price ≥ AVC:

   • The firm can at least cover variable costs and maybe some fixed costs.

   • Produces where P = MC

   • The short-run supply curve is the MC curve only where P ≥ AVC

Sunk Cost

A cost that has already been committed and cannot be recovered

• Are irrelevant to decisions, since they must be paid

• Fixed Costs are an example of a sunk cost

Why are fixed costs a sunk cost?

Fixed costs are a sunk cost, since the firm must pay it whether it produces or shuts down

• FC shouldn’t matter in the decision to shut down

Reasoning behind a firm’s long run decision to exit

Cost of exiting the market: Loss of revenue (TR)

Benefit of exiting the market: Saves costs (TC)

Firm exits: TR < TC 

so a firm exits if P < ATC

When will a firm exit in the long run?

A firm will exit in the long run if P < ATC

When will a firm enter a market in the long run?

A firm will enter a market in the long run if it’s profitable to do so and if TR > TC

• Divided by Q= P > ATC

Formula for when a firm will enter the market in the long run

P > ATC

What is the firm’s long run supply curve?

The firm’s long run supply curve is the portion of its MC curve above the LRATC

Why is the LR supply curve the part of the Mc curve above LRATC?

• If price is below LRATC, producing would lose money, so the firm exits → supply = 0.

• If price is above LRATC, the firm produces where P = MC → supply comes from that part of MC above LRATC.

Market Supply

The total quantity of a good or service that all producers in a market are willing and able to offer for sale at each price level

What assumptions do we make about market supply?

1. All existing firms and potential entrants have identical costs

2. Each firm’s costs don’t change as other firms enter or exit the market

3. The number of firms in the market is fixed in the short run (due to fixed cost) and variable in the long run (due to free entry and exit)

How does the SR Market Supply curve look like for one firm, compared to a market?

For one firm, the quantity is lower and to get the market, the quantity is just proportionally higher.

What happens to the number of firms in the Long Run?

In the long run, the number of firms can change due to entry and exit.

What happens in the long run, if existing firms have positive economic profit?

In the long run, if firms in the market have economic profit:

• New firms will enter, causing the SR market supply to shift right

• P will fall, reducing profits and slowing entry

What happens in the long run, if existing firms have losses?

If existing firms have losses, some firms will exit and the SR market supply shifts left]

• P rises and reduces the remaining firm’s losses

Long Run Equilibrium

Equilibrium reached when the process of entry or exit is complete and remaining firms earn 0 economic profit

• Zero economic profit is when P= ATC

When does zero economic profit occur in the long run and the firm reaches long run equilibrium?

Zero economic profit and long run equilibrium occur when P=ATC

• Price= average total cost 

In the long run, what is Price= to?

In the long run, P= minimum ATC

Why in the long run is P= minimum ATC?

In the long run, 

Firms produce where P = MC → profit-maximizing output.

• Long-run zero economic profit → P = ATC.

• So in equilibrium: P = MC = ATC

• P = minimum ATC → firms earn just enough to cover all costs, no incentive to enter or exit.

Why do firms stay in business if profit= 0?

Economic profit= Total revenue - all costs

• In zero profit equilibrium, we look at economic profit, accounting profit is positive, allowing firms to stay in business

What does the LR market supply look like?

The LR market supply curve is horizontal at P= minimum ATC

What happens when demand increases?

When demand increases, firms earn profits in the short run.

• These profits attract new firms which increase the market supply and decrease prices until profits= 0 in the long run

• In perfect competition, profits in the short run always disappear in the long run

Why is the LR market supply curve horizontal?

The LR market supply curve is horizontal if:

• All firms have identical costs 

• Costs don’t change as other firms enter/ exit the market

How does firms having different costs affect the LR market supply curve?

• As prices (P) rise due to increase in demand, firms with lower costs enter the market, before firms with higher costs

• Increases in price due to demand, make it worthwhile for firms with higher costs to enter the market, increasing the market quantity supplied

• LR market supply curve slopes upward

How does costs rising as firms enter the market affect the LR market supply curve?

When there is a key input and introduction of new firms increases the demand for the input, the price rises for all firms

• Increase all firm’s cost

• Increase in P is necessary to increase the Qs, so supply is upward sloping

Market Power

Power of a firm to influence the market price of the good it sells

• In a competitive market, firms do not have market power

In a competitive market, do actions of a buyer/ seller have an impact on the market price?

No, in a competitive market, buyers and sellers must accept the market price. 

• They are price takers

What is the revenue of a competitive firm?

For a competitive firm, revenue is P x Q ( price x quantity)

• Price doesn’t depend on the quantity 

• Total revenue= proportional to the amount of output

Change in Profit Formula

Profit= MR - MC

• As long does marginal revenue is greater than MC, increasing the quantity produced increases profit

Marginal Cost curve shape and reasoning

Marginal Cost curve= upward sloping

• Marginal cost= the cost of producing 1 more unit of output

• At first with a higher quantity, resources are used are efficiently, so costs decrease

• Too much quantity makes inputs less efficient, causing each unit to become more expensive

Average Total Cost curve shape + reasoning

ATC curve= U shaped

• At first fixed costs are spread over more units as quantity increases, which decreases average cost

• Resources are less efficient and marginal cost increases, which increases ATC

When does a operating firm have 0 profit in the long run?

A firm has zero profit if and only if the price of the good= the ATC of making the good in the long run

• P= ATC

• Firms stop entering and exiting only when the price and ATC are equal

What does a perfectly competitive firm do?

A perfectly competitive firm takes its price as given by market conditions

A competitive firm maximizes profit by choosing the quantity at which in the long run?

P= ATC

• In the long run, a firm cannot make more than zero economic profit because any positive profit attracts new entrants, which drives price down.

• The price where firms just break even (P = ATC) is the only sustainable long-run price.

A competitive firm’s short run supply curve is its ___ cost curve above its ____ cost curve

Competitive firm’s short run supply curve is its marginal cost curve above it’s average variable cost curve

• A firm maximizes profit where P = MC.

• But it only produces if P ≥ AVC (to cover variable costs).

• Therefore, the firm’s short-run supply curve is the part of MC that lies above AVC.

If a profit maximizing competitive firm produces at a quantity where marginal cost is between the AVC and the ATC, it will?

AVC < MC < ATC

• AVC< P

• Since P is greater than AVC, the firm will continue produce in the short run, since it can cover variable costs

• P< ATC, the firm will not produce in the long run, it will exit

In the long run equilibrium of a competitive market with identical firms, what are the relationships among price (P), marginal cost (MC), and average total cost (ATC)?

In the long run, P=MC= ATC