Firms in Competative Markets

Long Run Average Cost and Economies of Scale

• Long Run Average Cost (LRAC):

  • Represents the per unit cost of production when all inputs are variable.

  • Three stages:

  1. Decreasing Costs: When costs are going down as production increases.

     • Known as Economies of Scale:

       • Defined as the cost advantage that arises with increased output due to the scale of operations, leading to a decrease in per-unit costs.

       • Example: Companies that produce more achieve lower costs per unit through operational efficiencies.

  2. Constant Costs: The flat part of the curve.

     • Known as Constant Returns to Scale:

       • Defined as a situation where increasing inputs does not change the output level.

       • Firms increase production but costs remain unchanged proportionally.

  3. Increasing Costs:

     • After a certain point, further increases in production lead to rising costs per unit.

     • This indicates Diseconomies of Scale:

       • Defined as a situation where the cost per unit increases as production scales up, often due to inefficiencies.

Understanding Profit

• Profit: The financial gain obtained when the revenue exceeds the costs associated with producing goods or services.

  • Formula for Profit Calculation:

    • Profit = Total Revenue (TR) - Total Cost (TC)

Types of Firms in Economics

• Firms categorized into four market structures based on competition levels:

  1. Perfect Competition:

     • Characteristics:

     • Many buyers and sellers.

     • No single buyer or seller can influence the market price (price takers).

     • Selling identical products (e.g., commodities like soybeans).

     • Free entry and exit of firms in the market.

       • Firms can enter the market without high barriers (e.g., no regulatory barriers).

       • If profits exist, new firms will enter until profits are driven to zero.

       • If losses occur, firms will exit until losses are eliminated.

  2. Monopoly:

     • One firm dominates the market.

     • High barriers to entry prevent other firms from entering.

     • Price maker: the monopolist sets the price for the market.

  3. Oligopoly:

     • Few firms control the market.

     • Firms may collude to set prices or may compete against each other.

     • Price movements can affect other competitors significantly.

  4. Monopolistic Competition:

     • Many firms, but each firm sells a product that is differentiated from others.

     • Example: Different styles of restaurants (e.g., Mexican vs. French) compete in the same market.

Questions Addressed in Perfect Competition

• In a perfectly competitive market, firms face three primary questions:

  1. Should I enter the market?

  2. How much should I produce?

  3. Should I stay or exit the market?

Definition of Perfect Competition

• Key characteristics that define a perfectly competitive market include:

  • Many Buyers and Sellers: Each firm is a price taker, meaning they accept the market price dictated by supply and demand.

  • Identical Products: All firms in this market produce a homogeneous product.

  • Free Entry and Exit: Firms can enter and exit the industry without significant barriers or regulatory restrictions.

Revenue in Perfect Competition

• Total Revenue (TR): Calculated as Price (P) multiplied by Quantity sold (Q):

  • TR = P imes Q

• Average Revenue (AR): Defined as total revenue divided by Quantity:

  • AR = rac{TR}{Q}

• Marginal Revenue (MR): Change in total revenue resulting from the sale of one additional unit:

  • MR = rac{ ext{Change in } TR}{ ext{Change in } Q}

  • In perfect competition: AR = MR = P since the revenue per unit remains constant.

Example Calculation: Emory's Orchard

• Apportioned apples into bushels, priced at $20 per bushel:

  • Revenue Calculations:

    • TR = Price × Q:

    • For 1 bushel: TR = $20

    • For 2 bushels: TR = $40

    • AR = TR/Q:

    • For the 1st bushel: AR = $20

    • For the 2nd bushel: AR = $20

  • Understanding AR and MR: For a perfectly competitive firm, both Average Revenue and Marginal Revenue remain constant due to the set market price:

Market Demand and Supply in Perfect Competition

• The firm’s demand curve is horizontal, signifying perfectly elastic demand.

  • Firms cannot change market price without losing all customers, confirming their price-taker status.

Profit Maximization Strategy

• To maximize profit, firms focus on the Quantity (Q) where MR equals Marginal Cost (MC):

  • Continue increasing production as long as MR > MC

  • Stop when MR < MC to avoid losses.

  • Profit defined as maximized when the difference between TR and TC is the largest:

  • Profit Positioning:

    • Achieved equilibrium occurs when: MR = MC

Marginal Cost Equation

• Marginal Cost (MC): Defined as the change in total cost that arises from producing one more unit of a product:

  • MC = rac{ ext{Change in TC}}{ ext{Change in Q}}

  • Example:

    • If total cost increases from $6 to $14 with production of an additional bushel, MC = 14 - 6 = 8.

Conclusion of Chapter 12

• This chapter encompassed cost functions and fundamental cost terms essential to determine optimal operational output and pricing strategies for firms in perfectly competitive markets.