Chapter 15: Firms in Competitive Markets

This covers everything that the professor said will be fair game on the final, not everything in the textbook.

competitive market characteristics

(1) market has many buyers and many sellers

(2) the goods offered by the various sellers are largely the same

(3) firms can freely enter or exit the market

in a competitive market, do the actions of any single buyer or seller have an impact on the market price?

no - each buyer and seller takes the market price as given

“price takers”

total revenue

price x quantity

average rveenue

total revenue / quantity

if total revenue = p x q, then average revenue = p x q / q = price

**for ALL types of firms, average revenue = price of the good

marginal revenue

change in total revenue from the sale of each additional unit of output

because total revenue is p x q and price is fixed for a competitive firm (in competitive markets everyone is a price taker), then when Q rises by 1 unit, total revenue rises by P dollars

**for competitive firms, marginal revenue = price of the good

what is the goal of a firm

to maximize profit

profit

total revenue - total cost

total cost

TC = fixed costs + variable costs

how do we find the profit-maximizing quantity for a firm?

compare the marginal revenue and marginal cost of each unit produced bc rational people think at the margin.

MR > MC —> increase production to maximize profit

MR < MC —> decrease production to maximize profit

**remember that MR = price in competitive market

why is the price line horizontal on the graph

because a competitive firm is a price taker and the price of the firm’s output is the same regardless of how much it produces

for a competitive firm, what is price equal to?

price = AR = MR

at what point is the firm maximizing profit?

where MC = MR

if produce past that point, losing profit

if producing less than that point, not realizing all profit

3 rules for profit maximization

(1) if MR > MC —> increase output

(2) if MC > MR —> decrease output

(3) @ profit-maximizing level of output, MR = MC

what happens if the price rises? how does a competitive firm respond to the price increase in terms of their level of output?

increase output until MC = MR

what is the firm’s competitive supply curve?

bc MC curve determines Q of good firm is willing to supply at any price, MC curve = competitive firm’s supply curve

shutdown

short-run decision not to produce anything during a specific period because of current market conditions

**can’t avoid fixed costs in short run, they’re a sunk cost, but can avoid variable costs in SR

a firm that shuts down temporarily still has to pay fixed costs

exit

long-run decision to leave the market

**can avoid fixed costs and variable costs in the LR

a firm that exits the market doesn’t pay any costs at all, fixed or variable

what determines a firm’s shutdown decision?

firm shuts down if revenue it would earn from producing is less than its variable costs of production

**DON’T consider FC in SR bc they’re a sunk cost

shut down if TR < VC

TR/Q < VC/Q —> P < AVC

**compare price and average variable cost

firm still loses money in a shut down but loses less money than it would if it stayed open - firm can reopen in the future

competitive firm’s short-run supply curve

portion of MC curve > AVC

bc AR = MC = P,

and shut down if P<AVC, then supply curve = MC > AVC

sunk cost

a cost that has already been committed and can’t be recovered

**nothing can be done about it —> it’s rational to ignore them when many business decisions

firm’s long-run decision to exit or enter a market

if a firm exits, it loses all revenue but it also saves variable and fixed costs

firm exits if revenue < total cost of production

exit if TR < TC

TR/Q < TC/Q —> P<ATC

exit if P<ATC

enter if P>ATC

competitive firm’s long-run supply curve

portion of MC curve > ATC curve

bc P = MC —> MC > ATC = don’t exit = long-term supply curve

measuring profit in a graph for a competitive firm

profit = TR - TC

profit = (TR/Q - TC/Q) x Q

Profit = (P - ATC) (Q)

**positive if P>ATC

in the short run is the # of firms fixed or variable?

fixed

short run market supply

bc there’s a fixed # of firms, as long as P > AVC, each firm’s MC curve = supply curve

**quantity of output supplied to market = sum of quantities supplied by each of the 1000 identical firms

in long run is # of firms fixed or variable

variable - firms can enter and exit

long run market supply

firms can enter and exit market and assume all firms have same production tech —> all have same cost curves

if firms in market are profitable, new firms enter —> increased # of firms —> increased quant supplied —> decrease in price

if firms in market are making losses, firms exit —> decreased # of firms —> decreased quant supplied —> increase in price

**bc of this process, firms that remain in the market must be making 0 economic profit

in the long-run equilibrium of a competitive market w/ free entry and exit, firms operate at their efficient scale which is where MC = ATC = P

when does the process of entry and exit end in a long run market

only when price = ATCwhy

why do firms stay in business if they make zero profit?

bc we’re considering implicit and explicit costs which means that there’s a different accounting profit

in this case, we’re accounting for opportunity costs and accounting profit is still positive