chpt14 business econ

Firms in Competitive Markets

Introduction

The chapter by Andres Hervas-Drane discusses the dynamics of firms operating within competitive markets, emphasizing critical concepts such as marginal revenue, total revenue, average revenue, profit maximization, and the implications of market entry and exit.

Key Questions

• What is marginal revenue?

• How does it relate to total and average revenue?

• What properties does it exhibit in a perfectly competitive market?

• How do competitive firms determine the quantity to maximize profits?

• What are the effects of free market entry and exit on long-run outcomes?

Revenue of a Competitive Firm

• Total Revenue (TR): The total income generated from selling goods and services.

• Average Revenue (AR): Revenue per unit sold, calculated as TR divided by quantity sold.

• Marginal Revenue (MR): The additional revenue gained from selling one more unit; mathematically, MR = ΔTR/ΔQ.

• Competitive firms operate as price-takers, meaning they accept the market price (P) as given without influencing it through their output decisions.

Revenue Relationships

Given the price (P) remains constant for firms in competitive markets, the relationships can be summarized:

• TR increases as output (Q) increases: TR = P x Q

• Average Revenue: AR = TR/Q = P

• Marginal Revenue equals Price: MR = P

Marginal Revenue Calculation Example

A detailed example illustrates how total revenue, average revenue, and marginal revenue function in a competitive setup at various levels of output.

Profit Maximization

To ascertain the optimal output level (Q) for profit maximization, firms must analyze marginal changes. If a unit increase in Q leads to MR > MC (Marginal Cost), firms should increase Q to enhance profit. Conversely, if MR < MC, firms should reduce Q to increase profit.

Profit Maximization Strategy for Competitive Firms

The process involves understanding the relationship between MR and MC to determine the optimal quantity. At the profit-maximizing quantity, firms set MR = MC.

Supply Decision of Firms

Illustrated through a graph, the point where MR equals MC determines the profitable quantity for competitive firms. These dynamics enable firms to operate efficiently in the market.

Characteristics of Perfect Competition

• Market Structure:

  • Many buyers and sellers: Ensures that no single buyer or seller can control market prices.

  • Homogeneous goods: Products offered are largely uniform, compelling buyers to base decisions solely on price.

  • Freedom of entry and exit: New firms can enter the market if profits are high; firms may exit if losses are incurred.

• Long-Run Equilibrium:After market adjustments occur, remaining firms earn zero economic profits; in equilibrium, price equals minimum average total cost (ATC). Firms continue their operations because they can cover all costs, including implicit ones, leading to positive accounting profits despite zero economic profit.

Case Study: Restaurant Industry Dynamics

The high turnover in restaurants illustrates competitive markets where new entrants frequently emerge while older firms exit. Only a few succeed long-term, reflecting intense competition and low average profitability.

Summary of Key Points

Marginal revenue for a firm represents the increase in total revenue from supplying an extra unit. In a perfectly competitive market, MR equals AR equals price (P). Firms maximize profit by equating marginal revenue with marginal cost (MR = MC). Economic profits will trend towards zero in the long run due to free market entry and exit.