Microeconomics Chapter 15
Firms in Competitive Markets
Overview of Perfectly Competitive Markets
Definition: A perfectly competitive market is a market characterized by a large number of buyers and sellers trading identical products, leading to price-taking behavior among buyers and sellers.
Key Characteristics:
Many Buyers and Sellers: Ensures no single buyer or seller can influence the market price.
Identical Products: Each firm offers products that are perfect substitutes for one another.
Free Entry and Exit: Firms can enter or exit the market without significant barriers or constraints.
Revenue Concepts in Competitive Firms
Total Revenue (TR):
Formula: TR = P \times Q
Average Revenue (AR):
Formula: AR = \frac{TR}{Q}
Definition: Revenue received per unit sold.
Marginal Revenue (MR):
Formula: MR = \frac{\Delta TR}{\Delta Q}
Definition: Additional revenue from selling one more unit.
Relation between AR, MR, and P: For competitive firms, AR = P = MR
Profit Maximization in Competitive Firms
Objective: Firms aim to maximize profit which is defined by:
Formula: Profit = TR - TC
Where TR = P \times Q and TC = FC + VC (Fixed Costs (FC) + Variable Costs (VC)).
Maximizing Quantity (Q): A firm should consider:
If increasing Q results in higher MR than MC, it should increase output.
If decreasing Q results in higher profit, it should reduce output.
Profit maximization occurs where MR = MC.
Supply Decision of the Firm
Market Price Dynamics:
If market price is at P1 = MR1:
At quantity Q_a where MC < MR, increase Q.
At quantity Q_b where MC > MR, decrease Q.
At quantity Q_1 where MC = MR, profit is maximized.
Shutdown vs. Exit Decisions
Shutdown (Short-run decision):
Definition: Temporary cessation of production where Q = 0; a firm may choose to shut down but must still pay fixed costs (FC).
Exit (Long-run decision):
Definition: Leaving the market entirely, resulting in zero costs. Firms exit if they cannot cover total costs in the long run.
Short-run Supply Curve
The firm’s short-run supply curve reflects the portion of its MC curve above the Average Variable Cost (AVC).
If P > AVC, produce at quantity where P = MC.
If P < AVC, shut down, producing Q = 0.
Sunk Costs
Definition: Sunk costs are irrevocable costs that cannot be recovered, hence they should not influence ongoing business decisions regarding production or exit.
Long-Run Decisions for Firms
In long-run scenarios:
Exit the Market: If TR < TC (equivalently, P < ATC).
Enter the Market: If TR > TC (equivalently, P > ATC).
Long-Run Supply Curve
The long-run supply curve of a firm is the portion of the MC curve above the Average Total Cost (ATC).
If P > ATC, the firm produces where P = MC. If P < ATC, the firm exits the market.
Examining Amari's Apple Orchard
Example of Revenue Calculation:
Amari's Apple Orchard: Produces up to 10 bushels at $20 per bushel.
Total Revenue (TR): Calculated for quantities from 0 to 10 bushels.
Average Revenue (AR): Remains constant at $20 for each bushel sold.
Marginal Revenue (MR): Also $20 for each additional unit.
Example of Profit Maximization:
Q (bushels)
TR
TC
Profit
MR
MC
0
$0
$6
-$6
1
$20
14
$6
$20
$6
2
$40
24
$16
$20
$10
3
$60
36
$24
$20
$12
4
$80
50
$30
$20
$14
5
$100
66
$34
$20
$16
6
$120
85
$35
$20
$19
7
$140
105
$35
$20
$20
8
$160
127
$33
$20
$22
9
$180
150
$30
$20
$24
10
$200
176
$24
$20
$26
Market Supply in Competitive Settings
Assumptions:
All firms have identical cost curves.
Firms’ costs remain unchanged as firms enter or exit the market.
Number of firms varies: fixed in the short run, variable in the long run.
Short-Run Market Supply Curve:
Derived from each firm's individual supply curves, summing quantities supplied by all firms for any given price.
Entry and Exit Dynamics in Long-Run Market
A shift in market supply can also occur due to changes in demand.
Positive economic profits encourage new entrants, pushing supply right, which lowers price.
Losses lead to firms exiting, which shifts supply left, raising prices until zero economic profit is achieved.
Long-Run Equilibrium and Zero-Profit Condition
In long-run equilibrium, firms earn zero economic profit, characterized by:
P = min(ATC)
Firms produce where P = MC, intersecting ATC at minimum ATC.
Zero-Profit Equilibrium:
Economic profit is zero, yet accounting profit remains positive.
Efficiency in Competitive Markets
The point where firms maximize profit occurs where MC = MR.
In perfect competition, P = MR, leading to competitive equilibrium price that equals marginal cost, thus achieving optimal resource allocation.
Active Learning and Application Questions
Recap scenarios demonstrating understanding of profit maximization, shutdown points, and adjustments in response to market conditions. Include decision-making applicable to real-world market scenarios, such as persistence of business practices despite zero profits.
Conclusion: Long-run Dynamics in Competitive Firms
In most competitive markets, the equilibrium returns to zero economic profit over time as firms enter and exit, encouraging efficient production defined by minimum average total costs. The long-run supply curve can be horizontal or upward-sloping depending on uniformity of costs and resource limitations across firms.