Firms in Competitive Markets Notes

Characteristics of Perfectly Competitive Markets

• Criteria for Perfect Competition:

  • The market contains many buyers and many sellers.

  • Firms trade identical products.

  • Firms can freely enter or exit the market.

• Price Takers: Because of these characteristics, individual buyers and sellers must accept the market price as given.

Revenue and Profit Maximization

• Revenue Calculations:

  • Total Revenue ($TR$): $TR = P \times Q$

  • Average Revenue ($AR$): $AR = \frac{TR}{Q} = P$

  • Marginal Revenue ($MR$): $MR = \frac{\Delta TR}{\Delta Q}$

• Profit Maximization Rule: A firm maximizes profit at the quantity ($Q$) where Marginal Revenue equals Marginal Cost ($MR = MC$).

  • In a competitive firm: $P = MR = AR$.

  • If MR > MC, increasing quantity raises profit.

  • If MR < MC, decreasing quantity raises profit.

Short-Run and Long-Run Supply Decisions

• Short-Run Shutdown: A temporary decision to produce nothing due to market conditions.

  • Firms must still pay Fixed Costs ($FC$).

  • Condition: Shut down if TR < VC or P < AVC.

  • Sunk Costs: Costs that are already committed and unrecoverable (e.g., $FC$ in the short run) should be ignored in decision-making.

• Long-Run Exit/Entry: A permanent decision to leave or enter the market.

  • Exit Condition: Exit if TR < TC or P < ATC.

  • Entry Condition: Enter if TR > TC or P > ATC.

• Firm's Supply Curve:

  • Short Run: The portion of the $MC$ curve above the Average Variable Cost ($AVC$).

  • Long Run: The portion of the $MC$ curve above the Average Total Cost ($ATC$).

Market Supply and the Zero-Profit Condition

• Short Run: Market supply is the sum of quantities supplied by all individual firms.

• Long Run Market Dynamics:

  • If firms earn positive profit, new firms enter, shifting market supply right and lowering price.

  • If firms incur losses, firms exit, shifting market supply left and raising price.

• Zero-Profit Equilibrium: In the long run, entry and exit continue until firms earn zero economic profit, where $P = \text{min } ATC$. At this point, the firm operates at its efficient scale.

• Economic vs. Accounting Profit: Zero economic profit implies accounting profit is positive because economic costs include implicit costs like opportunity costs.

• Long-Run Supply Curve Slopes: Typically horizontal at $P = \text{min } ATC$. It may slope upward if key input supplies are limited or if firms have different cost structures.

Efficiency and Competitive Equilibrium

• Efficiency: The competitive equilibrium is efficient because $P = MC$.

• This ensures the value to the buyer ($P$) matches the cost of production ($MC$) for the marginal unit, maximizing total surplus.

Questions & Discussion

• Active Learning 1: Your favorite concert

  • Question: You paid $55$ for a hoodie two sizes too small. You decide to sell it to a cousin but must pay $15$ for delivery. What is the lowest price you should ask?

  • Answer: $15$ for the new cost, because the original $55$ is a sunk cost.

• Active Learning 2: Identifying profit or loss

  • Scenario: $P = 3$, $Q = 30$, $ATC = 5$ at that quantity, and $AVC$ is below $3$.

  • Outcome: The firm incurs a loss of $(5 - 3) \times 30 = 60$. Because P > AVC, the firm should continue producing in the short run.

• Active Learning 3: Price Levels and Equilibrium

  • P1 ($Q=5$): P < AVC; firm should shut down in the short run.

  • P2 ($Q=10$): $P = AVC$; this is the short-run shut-down point.

  • P3 ($Q=15$): P < ATC but P > AVC; the firm incurs a loss but continues to produce.

  • P4 ($Q=20$): $P = \text{min } ATC$; this represents the efficient point and long-run equilibrium.

  • P5 ($Q=25$): P > ATC; the firm earns a short-run profit.