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chpt.14
14Chapter Overview with Helpful Hints
Introduction In this chapter, we examine the behavior of competitive firms—firms that cannot influence the market price and thus do not have market power. The cost curves developed in the previous chapter shed light on the decisions that lie behind market supply curves in a competitive markets.
What Is a Competitive Market?
A competitive market has two main characteristics:
There are many buyers and sellers in the market.
The goods offered for sale are largely the same.
The result of these two conditions is that each buyer and seller is a price taker. A third condition sometimes thought to characterize perfectly competitive markets is:
Firms can freely enter or exit the market.
Firms in competitive markets try to maximize profit, which equals total revenue minus total cost. Total revenue is . Because a competitive firm is small compared to the market, it takes the price as given. Thus, total revenue is proportional to the amount of output sold—doubling output sold doubles total revenue.
Average revenue equals total revenue divided by the quantity of output or . Because , then . That is, for all firms, average revenue equals the price of the good.
Marginal revenue equals the change in total revenue from the sale of an additional unit of output or . When rises by one unit, total revenue rises by dollars. Therefore, for competitive firms, marginal revenue equals the price of the good.
Profit Maximization and the Competitive Firm’s Supply Curve
Firms maximize profit by comparing marginal revenue and marginal cost. For the competitive firm, marginal revenue is fixed at the price of the good and marginal cost is increasing as output rises. There are three general rules for profit maximization:
If marginal revenue exceeds marginal cost, the firm should increase output to increase profit.
If marginal cost exceeds marginal revenue, the firm should decrease output to increase profit.
At the profit-maximizing level of output, marginal revenue and marginal cost are equal.
Assume that we have a firm with typical cost curves. Graphically, marginal cost is upward sloping, average total cost is U-shaped, and crosses at the minimum of . If we draw on this graph, then we can see that the firm will choose to produce a quantity that will maximize profit based on the intersection of and . That is, the firm will choose to produce the quantity where . At any quantity lower than the optimal quantity, and profit is increased if output is increased. At any quantity above the optimal quantity, and profit is increased if output is reduced.
If the price were to increase, the firm would respond by increasing production to the point where the new higher is equal to . That is, the firm moves up its curve until again. Therefore, because the firm’s marginal-cost curve determines how much the firm is willing to supply at any price, it is the competitive firm’s supply curve.
A firm will temporarily shut down (produce nothing) if the revenue that it would get from producing is less than the variable costs of production. Examples of temporary shutdowns are farmers leaving land idle for a season and restaurants closing for lunch. For the temporary shutdown decision, the firm ignores fixed costs because these are considered to be sunk costs, or costs that are not recoverable because the firm must pay them whether they produce output or not. Mathematically, the firm should temporarily shut down if . Divide by and get , which is . That is, the firm should shut down if . Therefore, the competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above the average-variable-cost curve.
In general, beyond the example of a competitive firm, all rational decision makers think at the margin and ignore sunk costs when making economic decisions. Rational decision makers undertake activities where the marginal benefit exceeds the marginal cost.
In the long run, a firm will exit the market (permanently cease operations) if the revenue it would get from producing is less than its total costs. If the firm exits the industry, it avoids both its fixed and variable costs, or total costs. Mathematically, the firm should exit if . Divide by and get , which is . That is, the firm should exit if . Therefore, the competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above the average-total-cost curve.
A competitive firm’s . Divide and multiply by and get or . If price is above , the firm is profitable. If price is below , the firm generates losses and would choose in the long run to exit the market.
The Supply Curve in a Competitive Market
In the short run, the number of firms in the market is fixed because firms cannot quickly enter or exit the market. Therefore, in the short run, the market supply curve is the horizontal sum of the portion of the individual firm’s marginal-cost curves that lie above their average-variable-cost curves. That is, the market supply curve is simply the sum of the quantities supplied by each firm in the market at each price. Because the individual marginal-cost curves are upward sloping, the short-run market supply curve is also upward sloping.
In the long run, firms are able to enter and exit the market. Suppose all firms have the same cost curves. If firms in the market are making profits, new firms will enter the market, increasing the quantity supplied and causing the price to fall until economic profits are zero. If firms in the market are making losses, some existing firms will exit the market, decreasing the quantity supplied and causing the price to rise until economic profits are zero. In the long run, firms that remain in the market must be making zero economic profit. Because , profit equals zero only when . For the competitive firm, and intersects at the minimum of . Thus, in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. Also, because firms enter or exit the market if the price is above or below minimum , the price always returns to the minimum of for each firm but the total quantity supplied in the market rises and falls with the number of firms. Thus, there is only one price consistent with zero profits, and the long-run market supply curve must be horizontal (perfectly elastic) at that price.
Competitive firms stay in business even though they are making zero economic profits in the long run. Recall that economists define total costs to include all the opportunity costs of the firm, so the zero-profit equilibrium is compensating the owners of the firm for their time and their money invested.
In the short run, an increase in demand increases the price of a good and existing firms make economic profits. In the long run, this attracts new firms to enter the market causing a corresponding increase in the market supply. This increase in supply reduces the price to its original level consistent with zero profits but the quantity sold in the market is now higher. Thus, if at present firms are earning high profits in a competitive industry, they can expect new firms to enter the market and prices and profits to fall in the future.
Although the standard case is one where the long-run market supply curve is perfectly elastic, the long-run market supply curve might be upward sloping for two reasons:
If an input necessary for production is in limited supply, an expansion of firms in that industry will raise the costs for all existing firms and increase the price as output supplied increases.
If firms have different costs (some are more efficient than others) in order to induce new less efficient firms to enter the market, the price must increase to cover the less efficient firm’s costs. In this case, only the marginal firm earns zero economic profits while more efficient firms earn profits in the long run.
Regardless, because firms can enter and exit more easily in the long run than in the short run, the long-run market supply curve is more elastic than the short-run market supply curve.
Conclusion: Behind the Supply Curve
The supply decision is based on marginal analysis. Profit-maximizing firms that supply goods in competitive markets produce where marginal cost equals price equals minimum average total cost.
Helpful Hints
We have determined that, in the short run, the firm will produce the quantity of output where as long as the price equals or exceeds average variable cost. An additional way to see the logic of this behavior is to recognize that because fixed costs must be paid regardless of the level of production, any time the firm can at least cover its variable costs, any additional revenue beyond its variable costs can be applied to its fixed costs. Therefore, in the short run, the firm loses less money than it would if it shut down if the price exceeds its average variable costs. As a result, the short-run supply curve for the firm is the portion of the marginal-cost curve that is above the average-variable-cost curve.
Recall that rational decision makers think at the margin. The decision rule for any action is that we should do things for which the marginal benefit exceeds the marginal cost and continue to do that thing until the marginal benefit equals the marginal cost. This decision rule translates directly to the firm’s production decision in that the firm should continue to produce additional output until marginal revenue (the marginal benefit to the firm) equals marginal cost.
In this chapter, we derived the equation for profit as . It helps to remember that, in words, this formula says that profit simply equals the average profit per unit times the number of units sold. This holds true even in the case of losses. If the price is less than average total cost, then we have the average loss per unit times the number of units sold.
