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Firms in Competitive Markets

Competitive Markets Overview

  • Competitive markets involve firms that are price takers, meaning they accept the market price as given, without influence.

Characteristics of Perfect Competition

  • Many Buyers and Sellers: Ensures no single firm can influence the market price.

  • Identical Goods: Products offered by different firms are largely the same, leading to interchangeability.

  • Free Entry and Exit: Firms can enter or exit the market easily, influencing supply.

Revenue Definitions

  • Total Revenue (TR): Total income from sales.

    • Formula: TR=P\cdot Q where P = price and Q = quantity.

  • Average Revenue (AR): Revenue generated per unit sold.

    • Formula: AR=\frac{TR}{Q}{}{}=P (In perfect competition, AR equals price).

  • Marginal Revenue (MR): Change in TR from selling one more unit.

    • Formula: MR=\frac{\Delta TR}{\Delta Q} or MR = P in competitive markets.

  • Demand Curve: In a competitive market, the demand curve faced by an individual firm is perfectly elastic, meaning that it can sell any quantity of output at the market price but nothing at a higher price (demand is a horizontal line - very elastic)

  • each one-unit increase in quantity (Q) causes revenue to rise by PRICE (P) so MR = P

Profit Maximization

  • To maximize profit, firms must consider marginal changes:

    • Increase Output: If MR > MC (Marginal Cost), increase quantity.

    • Decrease Output: If MR < MC , reduce quantity.

  • The profit-maximizing condition occurs where:

    • MR = MC

Shutdown vs Exit

  • Shutdown (Short-run): A decision not to produce, but still responsible for fixed costs (FC).

    • Condition to shut down: If TR < VC (variable costs).

    • Alternatively, if price P < AVC (Average Variable Costs), shut down.

    • "The firm’s SR supply curve is the portion of its MC curve above AVC."

  • Exit (Long-run): A decision to leave the market, with no longer incurring fixed costs.

    • Condition to exit: If TR < TC (Total Costs).

    • Alternatively, if price P < ATC (Average Total Costs), exit the market.

  • Enter: A new firm’s decision to enter the market if profitable to do so.

    • Condition to enter: If TR > TC

    • Alternatively, if price P > ATC (Average Total Costs), enter the market

Short-Run and Long-Run Market Supply Curves

  • Short-Run Supply Curve: The portion of the Marginal Cost (MC) curve above the Average Variable Cost (AVC) curve.

    • If P > AVC , firms produce where P = MC . If P < AVC , firms shut down (produce zero).

  • Long-Run Supply Curve: Reflects changes in the number of firms; it may slope upward if firms have different costs or if costs rise with entry.

  • Long-Run Equilibrium: Achieved when there's no incentive for firms to enter or exit, resulting in zero economic profits (P = ATC).

Market Dynamics and Zero-Profit Conditions

  • Entry and Exit Thresholds:

    • Positive economic profit attracts new firms, shifting the supply curve right and reducing prices.

    • Losses lead firms to exit, shifting the supply curve left and increasing prices.

  • Zero-Profit Condition: Firms make no economic profit when:

    • P = ATC and P = MC , ensuring maximum efficiency in resource allocation.

Conclusion: Efficiency of Competitive Markets

  • In perfect competition, firms optimize output where:

    • P = MR = MC

  • The equilibrium in a competitive market ensures total surplus is maximized, reflecting efficiency in consumer and producer welfare.