Chapter 8: Competitive Firms & Markets

Market structure is a function of:

• # of firms in the market

• # of buyers

• Ease of entry/exit

• Ability of firms to differentiate their products

Perfectly competitive firms are

price takers

• because of this, the demand curve of a firm is perfectly elastic (horizontal line)

5 key characteristics that force perfectly competitive markets to be price takers

1. Many small buyers and sellers

2. Firms sell identical products

3. Buyers and sellers have full information about price and product

4. Low transaction costs

5. Firms can freely enter/exit the market

What is economic profit?

Profit = R - C

What is the firm’s profit function? π

π(q) = R(q) - C(q)

To maximize its profit, any firm must answer two questions

1. Output decision - what output level, q*
   maximizes its profit or minimizes its loss?

2. Shutdown decision - is it more profitable to produce q* or shutdown?

1st output decision rule:

1. The firm sets its output where its profit is
   maximized.

2nd output decision rule:π

2. The firm sets marginal profit equal to zero.

   (necessary condition) marginal profit = dπ(q*)/dq = 0

(second order condition) if second derivative of marginal profit is negative

3rd output decision rule:

Set output where MR = MC

What are the shutdown rules in the SR?

1. Assume profit < 0

2. In SR, C = F + VC

   if VC = 0, R = 0 → shutdown

   if R > VC or P > AVC → stay open

What are the shutdown rules in the LR?

In the long-run, all costs are avoidable, therefore a firm should shutdown if making a loss

In perfect competition, MR is equal to

MR = D = P

In perfect competition, to maximize profit P =

P = MC(q^*)

What does a positive profit in the SR look like for perfect competition

P > AC

What is the formula to calculate profit given a cost function? π

π(q) = (P - [AC(q)])q

When do you have negative profit in the short run?

if P < AC

What does a negative profit in the SR look like for perfect competition

P < AC

Another way to calculate FC
(*Think graphically)

FC = (AC - AVC)q

As long as P is above ____, stay open

AVC

Whenever P is below AVC,

shut down

When is a firm breaking even?

When P = AC

(or MC = AC)

In the SR: the competitive firm’s short-run supply curve is its

MC curve above minimum AVC curve

In the SR, number of firms __

does not change
(so no entry or exit)

the more identical firms producing at a given price, the _____ the short-run market supply curve at that price

flatter (more elastic)

How to find the total amount the market produces with identical costs in the SR?

You have n (number of firms), cost function, market demand

Find:
MC

Set MC = P (to find q, firm’s SR supply curve)

Given that Q = nq find market supply Q(P)

Find equilibrium P and Q (set market demand = market supply)

In the short-run, what is the effect on the supply curve when there is a specific per unit tax? (4)

• The AVC shifts by the tax

• Supply shifts left by size of tax

• Q decreases, P increases

• Incidence of tax is paid shared by consumers and producers (more so depending on which side is more inelastic)

  

When do firms enter and exit the market in the long-run?

If profits > 0 → firms enter

If profits < 0 → firms exit

(firms indifferent if profit = 0)

In the LR, firms make ____ economic profit

0

Where do LR competitive firms operate?

marginal profit = 0 & where MR = MC

If firms can freely enter and exit the market (and input prices are constant and firms have identical costs), what does the LR market supply curve look like?

No matter what happens, profit always leads to 0, which leads to the flat LR market supply curve

What does the LR market supply curve look like when entry is limited?

it slopes upward

(The number of firms is limited if the government restricts the number, if firms need a scarce resource, or if entry is costly.)

Can there be downward sloping LR market supply curves?

Yes, it may be a decreasing cost industry as it grows