Competitive Markets

Market Structure

  • How much should firms produce?
    • Firms consider market demand and the behavior of other firms.
    • Firm behavior depends on the market structure.
  • Market Structure:
    • Number of firms in the market.
    • Ease of entry and exit for firms.
    • Ability of firms to differentiate their products.

Price Taking

  • Competitive market structure: many firms, identical products, easy entry/exit.
  • A market is competitive if each firm is a price taker.
    • Price taker: A firm that cannot significantly affect the market price.
    • Price taker firms face a horizontal demand curve at the market price.

Why the Firm’s Demand Curve Is Horizontal

  • Perfectly competitive markets have five characteristics that force firms to be price takers:
    • Many small buyers and sellers.
    • All firms produce identical products.
    • Buyers and sellers have full information.
    • Negligible transaction costs.
    • Free entry and exit.

Deviations from Perfect Competition

  • Many markets are highly competitive even if they don't meet all perfect competition characteristics.
  • Competition: Markets where no buyer or seller can significantly affect the market price, even if not perfectly competitive.

Why We Study Perfect Competition

  • Many markets can be reasonably described as competitive (e.g., agriculture, stock exchanges).
  • Perfectly competitive markets have desirable properties and are used as a benchmark.

Profit

  • Economic profit: Revenue minus economic cost.
    • If profit is negative, the firm makes a loss.
    • Economic cost includes explicit and implicit costs.
  • Economists assume firms maximize profits: π=R−C\pi = R - C; if \pi < 0, the firm makes a loss.

Two Decisions for Maximizing Profit

  • The firm’s profit function is: π(q)=R(q)−C(q)\pi(q) = R(q) - C(q).
  • To maximize profit, firms must answer two questions:
    • Output decision: What output level maximizes profit or minimizes loss?
    • Shutdown decision: Is it more profitable to produce or shut down?

Maximizing Profit

  • Firms maximize profit where the vertical distance between Total Cost (TC) and Revenue is greatest.
  • The optimal quantity q∗q^* is where profit is maximized.

Output Decision Rules

  • Output Rule 1: Set output where profit is maximized.
  • Output Rule 2: Set output where marginal profit is zero.
  • Output Rule 3: Set output where marginal revenue equals marginal cost: MR(q)=MC(q)MR(q) = MC(q).

Output Decision Rules (Continued)

  • Marginal revenue (MR): Change in revenue from selling one more unit: MR=ΔRΔqMR = \frac{\Delta R}{\Delta q}.
  • Marginal profit: Change in profit from selling one more unit: Marginal profit(q) = MR(q) − MC(q).

Shutdown Decision Rule

  • Shutdown Rule 1: Shut down only if it reduces the loss.
  • Example: Revenue (R) = $2,000, Variable Cost (VC) = $1,000, Fixed Cost (FC) = $3,000.
    • Profit = $2,000 - $1,000 - $3,000 = -$2,000 (loss).
    • If the firm shuts down, the loss would be -$3,000 (FC), so it's better to operate.
    • FC includes rent/lease of machines/premises.

Shutdown Decision Rule (Continued)

  • Shutdown Rule 2: Shut down only if revenue is less than avoidable cost.
    • Avoidable costs vary with production; some fixed costs are avoidable.
  • Both shutdown rules hold for all firms in the short run and long run.
  • In the long run, all costs are avoidable; shut down if facing any loss.

Short-Run Output Decision

  • Because a competitive firm’s marginal revenue equals the market price:
  • A profit-maximizing competitive firm produces where marginal cost equals the market price: MR=pMR = p, MC(q)=pMC(q) = p.

How a Competitive Firm Maximizes Profit

  • Profit is maximized when Marginal Revenue (MR), which equals the market price, equals Marginal Cost (MC).
  • Example shows profit maximization at a specific quantity where MR = MC.

Short-Run Shutdown Decision

  • The firm shuts down if it can reduce its loss by doing so. It will shut down only if its revenue is less than its avoidable variable cost:
    • R(q) = pq < VC(q)
    • In average terms: p < AVC(q)
  • A competitive firm shuts down if the market price is less than its short-run average variable cost at the profit-maximizing quantity.

The Short-Run Shutdown Decision

  • Graphical representation showing shutdown point where price falls below minimum Average Variable Cost (AVC).
  • Area A represents loss when producing, Area B represents loss when shutting down.

Supply Curves: Short-Run Firm Supply Curve

  • If the price falls below the firm’s minimum average variable cost, the firm shuts down.
  • The competitive firm’s short-run supply curve is its marginal cost curve above its minimum average variable cost.

Supply Curves: Short-Run Market Supply Curve

  • In the short run, the number of firms in a market (n) is fixed.
  • If all firms are identical, the market supply at any price is n times the supply of an individual firm.

Supply Curves: Short-Run Market Supply with Identical Firms

  • As the number of identical firms grows very large, the market supply curve approaches a horizontal line at the minimum point of the AVC curve.
  • The more identical firms, the flatter (more elastic) the short-run market supply curve.

Short-Run Market Supply with Two Different Lime Firms

  • Illustrates market supply with two firms having different cost structures.
  • The market supply curve is the horizontal sum of individual supply curves.
  • When both firms produce, the market supply curve is flatter.

Short-Run Competitive Equilibrium in the Lime Market

  • Graphical representation of firm and market equilibrium.
  • Shows how individual firm decisions combine to form market supply and demand.

Long-Run Competitive Profit Maximization

  • The firm chooses the quantity that maximizes its profit using the same rules as in the short run.
  • The firm picks the quantity that maximizes long-run profit, the difference between revenue and long-run cost.
  • Equivalently, it operates where long-run marginal profit is zero and where marginal revenue equals long-run marginal cost.

Long-Run Competitive Profit Maximization (2 of 2)

  • After determining the output level (q∗q^*) that maximizes its profit or minimizes its loss, the firm decides whether to produce or shut down.
  • The firm shuts down if its revenue is less than its avoidable or variable cost.
  • In the long run, the firm shuts down (exits) if it would make an economic loss by operating since all costs are variable.

Long-Run Firm Supply Curve

  • A firm’s long-run supply curve is its long-run marginal cost curve above the minimum of its long-run average cost curve.
  • The firm is free to choose its capital in the long run, so the firm’s long-run supply curve may differ substantially from its short-run supply curve.

The Short-Run and Long-Run Supply Curves

  • Graphical representation showing the relationship between short-run and long-run cost and supply curves.
  • Illustrates adjustments firms make in the long run compared to the short run.

Long-Run Market Supply Curve

  • The competitive market supply curve is the horizontal sum of the supply curves of the individual firms in both the short run and the long run.
  • In the long run, firms can enter or leave the market.
  • Thus, before we can obtain the long-run market supply curve, we need to determine how many firms are in the market at each possible market price.

Entry and Exit

  • In a market with free entry and exit:
    • A firm enters the market if it can make a long-run profit: \pi > 0.
    • A firm exits the market to avoid a long-run loss: \pi < 0.
    • If firms in a market are making zero long-run profit, they are indifferent between staying in the market and exiting.

Long-Run Market Supply with Identical Firms and Free Entry

  • The long-run market supply curve is flat at the minimum long-run average cost if
    • firms can freely enter and exit the market
    • an unlimited number of firms have identical costs
    • and input prices are constant.

Long-Run Firm and Market Supply with Identical Vegetable Oil Firms

  • Graphical representation showing long-run firm and market supply curves when firms are identical.
  • Market supply is perfectly elastic at the minimum LRAC.

Long-Run Market Supply with Limited Entry

  • First, if the number of firms in a market is limited in the long run, the market supply curve slopes upward.
  • The number of firms is limited if the government restricts the number, if firms need a scarce resource, or if entry is costly.

Long-Run Market Supply When Firms’ Cost Functions Differ

  • A second reason why some long-run market supply curves slope upward is that firms differ.
  • Firms with relatively low minimum long-run average costs are willing to enter the market at lower prices than others, resulting in an upward-sloping long-run market supply curve.
  • Many markets have a number of low-cost firms and other higher-cost firms.

Application: Upward-Sloping Long-Run Supply Curve for Cotton

  • Illustrates how the long-run supply curve can slope upward due to differences in production costs among countries.
  • Countries with lower production costs (e.g., Nicaragua) enter the market at lower prices.

Long-Run Market Supply When Input Prices Vary with Output

  • A third reason why market supply curves may slope is non-constant input prices.
  • In markets in which factor prices rise when output increases, the long-run supply curve slopes upward even if firms have identical costs and can freely enter and exit.

Long-Run Firm and Market Supply in an Increasing-Cost Market

  • Graphical representation showing how increasing input prices affect long-run firm and market supply.
  • Increased production leads to higher input costs, shifting cost curves upward and resulting in an upward-sloping market supply curve.