Competitive Markets

CHAPTER 5 – Background to Supply: In Competitive Markets

I.                    The costs of production

-          A firm’s costs are key a determinant of its production and pricing decisions.

-          Most firms in the competitive market are small businesses.

-          There are two costs included in cost of production:

1.      Explicit cost – input costs that require a direct outlay of money by the firm.

2.      Implicit cost – input costs that do not require outlay of money by the firm.

II.                  Production and Costs

Time periods – many firms’ division of total costs between fixed and variable costs depend on the time horizon.

1.      Short run, some fixed costs.

2.      Long run, some fixed costs become variable costs.

Production function – the relationship between quantity of inputs used to make a good and the quantity of output of that good.

The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.

Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.

-          Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

III.                The Various Measures of Cost

Fixed costs are those costs that do not vary with the quantity of output produced.

Variable costs are those costs that do vary with the quantity of output produced.

EQUATION:

-          Total Fixed Costs (TFC)

-          Total Variable Costs (TVC)

-          Total Costs (TC)

-          TC = TFC + TVC

Average and Marginal Costs

Average Costs can be determined by dividing the firm’s costs by the quantity of output it produces.

Types of Average Cost

1.      Average Fixed Costs – Fixed cost/Quantity = AFC

2.      Average Variable Costs – Variable cost/Quantity = AVC

3.      Average Total Costs – Total cost/Quantity = ATC

4.      ATC = AFC + AVC

Marginal cost measures the increase in total cost that arises from an extra unit of production. It answers the question: How much does it cost to produce an additional unit of output?

MC = change in total cost/change in quantity

Average total-cost curve is U-shaped.

-          ATC will decline as output increases.

-          ATC will start raising because average variable cost rises substantially.

-          Bottom of ATC U-shaped curve occurs at the quantity that minimizes average total cost. Often called the efficient scale of the firm.

Relationship between MC and ATC:

-          Whenever marginal costs is less than ATC, ATC falls.

-          Whenever marginal cost is greater than ATC, ATC rises.

IV.                Costs In the Short and Long Run

-          Division of TC into fixed and variable costs will vary from firm to firm.

-          Some costs are fixed in the short run, but all are variable in the long run.

-          Long-run is more flexible than the short-run, that is why it lies along the lowest points of the short-run average total-cost-curves.

-          Long-run is more U-shaped, but it is also flatter than the typical short-run curve.

-          In the short-run, some factors of production cannot be changed.

-          In the long-run, all factors of production can be altered.

V.                  Summary

VI.                Returns to Scale

Economies and Diseconomies Scale

-          Constant returns to scale – the property whereby long-run average total cost stays the same as the quantity of output change.

-          Economies of scale – the property whereby long-run average total cost falls as the quantity of output increases.

-          Diseconomies of scale – the property whereby long-run average total cost rises as the quantity of output increases

-          Technical economies of scale – the principle of increased dimensions and multiples

-          Commercial economies of scale – negotiate lower prices for factor inputs

-          Financial economies of scale – larger firms can borrow at lower costs and can also issue bonds

-          Managerial economies of scale – large firms employ specialist managers

-          Risk bearing economies of scale – large firms can diversify and invest more in R&D

EXTERNAL economies of scale

-          The advantages of large-scale production that arise through the growth and concentration of the industry.

-          Diseconomies arise because of coordination and communication problems that are inherent in any large organization.

-          X- efficiency – the failure of a firm to operate at maximum efficiency due to a lack of competitive pressure and reduced incentives to control costs.

Implications: large-scale production that result in lower average or unit costs… that offer opportunity to either increase in profits or reduction in price dependent of level of competition.

VII.              What is a competitive market?

-          A perfectly competitive market has the following: there are many sellers and buyers, goods offered by various sellers are largely the same, firms are price takers, and firms can exit and enter freely.

It also has the outcomes of:

-          The actions of any single buyer or seller in the market have a negligible impact on the market price.

-          Buyers and sellers must accept the price determined by the market.

-          TR = P x Q.

Average revenue tells us how much revenue a firm receives for the typical unit sold. It is found by total revenue divided by quantity. In a perfect world, it equals the price of the good. AR=TR/Q.

Marginal revenue is the change in total revenue from an additional unit sold. MR = Tr/Q.

Economic profit – measured by economists as total revenue minus total cost, including both explicit and implicit.

Accounting profit – measured by accountants as the firm’s total revenue minus only the firm’s explicit costs.

If total revenue exceeds both explicit and implicit costs, the firm earns economic profit—smaller than accounting profit.

VIII.            Profit maximization and the competitive firm’s supply curve.

-          The goal of a competitive firm is to maximize profit.

-          They want to produce the difference between total revenue and total cost.

-          Profit maximization occurs at the quantity where marginal revenue = marginal cost.

MR > MC – the firm should increase Q (output) to increase profit.

MR < MC – the firm should decrease Q (output) to increase profit.

Profit = total revenue – total cost.

Normal profit – the amount required to keep the factors of production in their current use.

Abnormal profit – the profit over and above normal profit.

Marginal cost is upward sloping.

The ATC curve is U-shaped.

And the marginal cost curve crosses the ATC curve at the minimum of average total cost.

Exit – a long-run decision to leave the market.

Exit occurs if:

1.      Total revenue is less than total cost.

2.      Total revenue over quantity is less than total cost over quantity.

3.      Product is less than average total cost.

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

Shutdown occurs if:

1.      Total revenue is less than variable cost.

2.      Total revenue divided by quantity is less than variable cost divided by quantity.

3.      The price is less than average variable cost.

Sunk costs – costs that have already been committed and cannot be recovered.

Enter the market if..

1.      Total revenue is greater than total cost.

2.      Total revenue over quantity is greater than total cost over quantity.

3.      Price is greater than average total cost.

Profit = TR – TC. But because of TR = P x Q and TC = ATC x Q, we rewrite this as:

Profit = (P-ATC) x Q.

IX.                The supply curve in a competitive market

Short-Run Supply Curve

-          Each firm’s short-run supply curve is the portion of its marginal cost curve that lies above average variable cost.

-          To get the supply curve, we add the quantity supplied by each firm in the market at every given price.

Long Run: Market Supply with Entry and Exit

-          At the end of the process of entry and exit, firms that remain must be making zero economic profit.

-          The process of entry and exit ends only when price and average total cost are driven to equality.

-          Long-run equilibrium must have firms operating at their efficient scale.

A shift in demand in the short run and long run

-          An increase in demand raises price and quantity in the short run.

-          Firms earn profits because price now exceeds average total cost.

Why the Long-Run Supply Curve Might Slope Upward

Two possible reasons:

1.      Some resources used in products may be available only in limited quantities.

2.      Firms may have different costs. The marginal firm is the firm that would exit the market if the price were any lower.