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.

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• 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.