Firms in Competitive Markets

Competitive Market

  • Definition: A market with numerous buyers and sellers trading identical products, where firms can freely enter or exit.
  • Price Takers: Both buyers and sellers accept the market price.

Revenue of a Competitive Firm

  • Total Revenue (TR):
    • Calculated as price (P) times quantity (Q): TR = P \times Q
    • It's proportional to the amount of output.
  • Goal: Firms aim to maximize profit.
  • Profit Calculation: Total revenue minus total cost.

Average and Marginal Revenue

  • Average Revenue (AR): Total revenue divided by the quantity sold.
  • Marginal Revenue (MR): Change in total revenue from selling one additional unit.
  • For Competitive Firms:
    • Average revenue equals the price: AR = P
    • Marginal revenue equals the price: MR = P

Profit Maximization

  • Key Principle: Maximize profit by producing the quantity where total revenue minus total cost is greatest.
  • Marginal Analysis: Compare marginal revenue (MR) with marginal cost (MC).
    • If MR > MC, increase production.
    • If MR < MC, decrease production.
    • Profit is maximized when MR = MC.

Rules for Profit Maximization

  • If MR = MC, the firm is at its profit-maximizing level of output.
  • Marginal-Cost Curve:
    • The price equals marginal revenue, which equals marginal cost (P = MR = MC).
    • The MC curve indicates a competitive firm's profit-maximizing production level for all prices.
    • The MC curve serves as the supply curve for a competitive firm.

Shutdown vs. Exit

  • Shutdown: A short-run decision to temporarily cease production, but the firm still pays fixed costs.
  • Exit: A long-run decision to leave the market entirely, eliminating all costs.

Short-Run Shutdown Decision

  • Total Revenue (TR): Total revenue from production
  • Variable Costs (VC): Costs that vary with the level of production
  • Shutdown Condition: A firm should shut down if TR < VC, which is equivalent to P < AVC (Price is less than Average Variable Cost).
  • Competitive Firm’s Short-Run Supply Curve: The segment of its marginal-cost curve that lies above the average variable cost.

Sunk Costs

  • Definition: Costs that have already been committed and cannot be recovered.
  • Decision-Making: Sunk costs should be ignored when making future decisions.

Profits

  • Profit Calculation:
    • Profit = Revenue – Costs
    • Profit = Total Revenue (TR) – Total Cost (TC)
    • \text{Profit} = PQ - (ATC)Q = (P - ATC)Q

Firm's Long-Run Decision

  • All costs are variable in the long run, so all costs matter.
  • Produce if P > ATC (Price is greater than Average Total Cost).
  • Competitive Firm’s Long-Run Supply Curve: The portion of its marginal-cost curve that lies above average total cost.

Long-Run Supply Curve

  • Entry and Exit:
    • If P > ATC, firms make positive profit, leading to new firms entering the market.
    • If P < ATC, firms make negative profit, causing firms to exit the market.
  • Equilibrium: Entry and exit continue until firms in the market make zero economic profit (P = ATC).
  • Efficient Scale: Firms produce where MR = MC and since P=MR, firms produce at MC = ATC, which is the efficient scale.

Long Run Entry and Exit

  • Stops when P=ATC which is the same as when MC = ATC due to profit maximizing condition (MR=MC) & P = MR in competition
  • Profits in the long run are driven to zero
  • Production process in the long run is efficient
  • Producing at MC=ATC → efficient scale

Zero-Profit Equilibrium

  • Why Firms Stay in Business: Even with zero economic profit, firms continue to operate because:
    • Profit = total revenue – total cost includes all opportunity costs.
    • Economic profit is zero, but accounting profit is positive.
  • Lesson: If an industry consistently generates profits, competition isn't functioning correctly.

Increase in Demand: Short Run and Long Run

  • Initial Condition: The market starts in a long-run equilibrium where each firm makes zero profit, and the price equals the minimum average total cost.
  • Short-Run Response: An increase in demand raises the price above average total cost, leading to short-run profits.
  • Long-Run Response: Profits induce new firms to enter, increasing supply and reducing the price until it returns to the minimum average total cost. In the new long-run equilibrium, profits are zero, but the market has more firms to meet the greater demand.

Market in Long-Run Equilibrium

  • P = minimum ATC
  • Zero economic profit
  • Increase in Demand:
    • Demand curve shifts outward.
    • Short Run:
      • Higher quantity
      • Higher price: P > ATC leading to positive economic profit
    • Long Run:
      • Firms enter the market.
      • Short-run supply curve shifts right.
      • Price decreases back to minimum ATC.
      • Quantity increases due to more firms in the market
      • Efficient scale is achieved.