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Firms in Competitive

Markets

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WHAT IS A COMPETITIVE MARKET?


A perfectly competitive market has the following
characteristics:
There are many buyers and sellers in the market.
The goods offered by the various sellers are largely the
same.
Firms can freely enter or exit the market.

An Example.
Which of the following drinks is best described by
the characteristics of a competitive market:
1.
2.
3.
4.

Tap water
Bottled water
Cola
Beer

WHAT IS A COMPETITIVE MARKET?


Because of its characteristics, the perfectly
competitive market has the following outcomes:
The actions of any single buyer or seller in the market
have a negligible impact on the market price.
Each buyer and seller takes the market price as given.

A competitive market has many buyers and sellers


trading identical products so that each buyer and
seller is a price taker.
Buyers and sellers must accept the price determined by
the market.

The Revenue of a Competitive Firm


Total revenue for a firm is the selling price times the
quantity sold.
TR = (P Q)
If a firm is a price taker, then its total revenue is
proportional to the amount of output.

How can a perfectly competitive firm change its


total revenue?
In perfect competition, firms can only change their level
of total revenue by varying their level of output
because they have no ability to change the price.

Average revenue in perfect competition


Average revenue tells us how much revenue a firm
receives for the typical unit sold.
Average revenue is total revenue divided by the quantity
sold.
Average revenue equals the price of the good.

Average Revenue

Total revenue

Quantity

Price Quantity
Quantity

= Price

Marginal Revenue of a Competitive Firm

Marginal revenue is the change in total revenue


from an additional unit sold.
MR =TR/ Q

For competitive firms, marginal revenue equals the


price of the good.
Average revenue is always equal to price.
But marginal revenue is equal to price only for firms
which operate in perfectly competitive markets.

Question
When a competitive firm doubles the amount
it sells, what happens to the price of its output
and its total revenue?
The price remains the same
=> total revenue doubles.

Total, Average, and Marginal Revenue for a Competitive


Firm

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WHAT IS THE GOAL OF A COMPETITIVE


FIRM?

The goal of a competitive firm is to maximize


profit.
This means that the firm will want to produce the
quantity that maximizes the difference between
total revenue and total cost.
Profit = TR - TC

Table 2 Profit Maximization: A Numerical Example

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AN ALTERNATIVE EXAMPLE
Pollys Ping Pong Balls is a firm that operates in a competitive market.
The ping pong balls sell for $3 per package.
Fill in the following table and find the profit maximizing level of output:

Recall the geometry of cost curves.


Costs

MC

Cost curves have


special features that are
important for our
analysis.
1.

ATC
AVC

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2.
3.

The marginal-cost curve


is upward sloping.
The average-total cost
curve is u-shaped.
The marginal-cost curve
crosses the averagetotal-cost curve at the
minimum of average
total cost.

Quantity

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Figure 1 Profit Maximization for a Competitive Firm

Costs
and
Revenue

The firm maximizes


profit by producing
the quantity at which
marginal cost equals
marginal revenue.

MC

MC2

P = MR1 = MR2

P = AR = MR

MC1

Q1

QMAX

Q2

Quantity

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PROFIT MAXIMIZATION AND THE


COMPETITIVE FIRMS SUPPLY CURVE

Profit maximization occurs at the quantity


where marginal revenue equals marginal cost.
When MR > MC a firm should increase Q
When MR < MC a firm should decrease Q
When MR = MC

=>Profit is maximized.

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An Example: A Profitable Opportunity?

As a recent graduate of Georgia Tech you have landed a job as a VP


for strategic business development at Universal Clones, Inc. You are
responsible for the entire companyon weekends.
Your costs are shown below.
Quantity
Average Total Cost
500
200
501
201
Your current level of production is 500 units. All 500 units have been
ordered by your regular customers.
You receive a call from a new customer who wants to buy 1 unit of
your product. This means you would have to increase production to
501 units. Your new customer offers you $450 to sell the extra unit.
a. Should you accept this offer?
b. What is the net change in the firms profit?

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An Example: A Profitable Opportunity?


Marginal cost can be easily calculated as the change in total
costs.
Quantity
Average Total Cost
Total Cost = Q ATC
500
200
100,000
501
201
100,701

Marginal cost in this example is $701.


$100,701 $100,000 = $701
This is much higher than the marginal revenue of $450.

The offer should not be accepted.


It would result in a $251 loss in profits.

So what does this example tell us?


It shows the importance of marginal cost in decision making.
It shows average costs can be misleading.

Marginal Cost as the Competitive Firms Supply Curve


Price

P2

This section of the


firms MC curve is
also the firms supply
curve.

MC

ATC

P1
AVC

Q1

Q2

Quantity

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The Firms Short-Run Decision to Shut Down


A shutdown refers to a short-run decision not to
produce anything during a specific period of time
because of current market conditions.
Exit refers to a long-run decision to leave the
market.
The firm considers its sunk costs when deciding to
exit, but ignores them when deciding whether to
shut down.
Sunk costs are costs that have already been committed
and cannot be recovered.

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The Firms Short-Run Decision to Shut Down


The firm shuts down if the revenue it gets from
producing is less than the variable cost of
production.
Shut down if TR < VC
Since TR = P Q and VC = AVC Q we have:
Shut down if P Q < AVC Q

or
Shut down if P < AVC
Otherwise a firm makes a loss on every unit of output.

The Competitive Firms Short Run Supply Curve

Costs
If P > ATC, the firm
will continue to
produce at a profit.

Firms short-run
supply curve

MC

ATC
If P > AVC, firm will
continue to produce
in the short run.

AVC

Firm
shuts
down if
P < AVC
0

Quantity

The Competitive Firms Short Run Supply Curve


The portion of the marginal-cost curve that lies above average
variable cost is the competitive firms short-run supply curve.
Costs
MC
Firms short-run
supply curve
ATC
AVC

Quantity

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The Firms Long-Run Decision to Exit or


Enter a Market
In the long run, the firm exits if the revenue it
would get from producing is less than its total cost.
Exit if TR < TC
Exit if P Q < ATC Q
Exit if P < ATC

A firm will enter the industry if such an action


would be profitable.
Enter if TR > TC
Enter if P Q > ATC Q
Enter if P > ATC

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The Competitive Firms Long-Run Supply Curve

Costs
Firms long-run
supply curve

Firm
enters if
P > ATC

MC = long-run S

ATC

Firm
exits if
P < ATC

Quantity

Figure 4 The Competitive Firms Long-Run Supply Curve

The competitive firms long-run supply curve is the portion


of its marginal-cost curve that lies above average total cost.
Costs
MC
Firms long-run
supply curve
ATC

Quantity

THE SUPPLY CURVES IN A


COMPETITIVE MARKET
Recap the main concepts:
Short-Run Supply Curve
The portion of its marginal cost curve that lies above
average variable cost.

Long-Run Supply Curve


The marginal cost curve above the minimum point of
its average total cost curve.

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An Example
Bobs lawn-mowing service is a profit-maximizing, competitive firm.
Bob mows lawns for $27 each.
His total cost each day is $280, of which $30 is a fixed cost.
He mows 10 lawns a day.
What can you say about Bobs short-run decision (to shut down his firm
or not) and his long-run decision (to exit from the lawn mowing business
or not)?
Bobs average total cost is $280/10 = $28,
Since $28 is greater than the price ($27), he will exit the industry in
the long run.
The fixed cost is $30, the average variable cost is ($280 - $30)/10 =
$25,
Since $25 is less than price ($27), Bob wont shut down in the short
run.

Profit as the Area between Price and Average Total Cost


1.
2.
3.

Recall that Profit = TR - TC.


Because TR = P Q and TC = ATC Q, we can rewrite this equation:
Profit = (P ATC) Q.
Using this equation, we can measure the profit (or the loss) at the firm's profit- maximizing
level of output (or loss-minimizing level of output).
Price
MC

ATC

Profit
P
ATC

P = AR = MR

(profit-maximizing quantity)
0

Quantity

Loss as the Area between Price and Average Total Cost


(b) A Firm with Losses
Price

MC

ATC

ATC
P

P = AR = MR
Loss

Q
(loss-minimizing quantity)

Quantity

THE SUPPLY CURVE IN A


COMPETITIVE MARKET
Market supply equals the sum of the quantities
supplied by the individual firms in the market.
The Short Run Supply:
Market supply with a fixed number of firms
For any given price, each firm supplies a quantity of
output so that its marginal cost equals price.
The market supply curve reflects the individual firms
marginal cost curves.

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Market Supply with a Fixed Number of Firms


Assume that there are 1,000 identical firms in the market.
(a) Individual Firm Supply

(b) Market Supply


Price

Price

MC

Supply

$2.00

$2.00

1.00

1.00

100

200

Quantity (firm)

100,000

200,000 Quantity (market)

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The Long Run: Market Supply with Entry and Exit


1.If firms in an industry are earning profit, this will attract new
firms.
The supply of the product will increase (the supply curve will shift
to the right).
The price of the product will fall and profit will decline.

2.If firms in an industry are incurring losses, firms will exit.


The supply of the product will decrease (the supply curve will shift
to the left).
The price of the product will rise and losses will decline.

3.At the end of this process of entry or exit, firms that remain
in the market must be making zero economic profit.

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The Long Run: Market Supply with Entry and Exit

1.Because Profit = TR TC, profit will only be zero


when: TR = TC.
a. Because TR = P Q and TC = ATC Q, we can rewrite
this as: P = ATC.
b.Therefore, the process of entry or exit ends only when
price and average total cost become equal.

2.This implies that the long-run equilibrium of a


competitive market must have firms operating at their
efficient scale.

Market Supply with Entry and Exit


In the long run, price equals the minimum of average total cost.
The long-run market supply curve is horizontal at this price.
(a) Firms Zero-Profit Condition

(b) Market Supply


Price

Price

MC
ATC
P = minimum
ATC

Supply

Quantity (firm)

Quantity (market)

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Why Do Competitive Firms Stay in Business


If They Make Zero Profit?
Profit is equal to total revenue minus total cost.
To an economist, total cost includes all of the
opportunity costs of the firm.
If a firm is earning zero profit,

=> the firm's revenues are compensating the firm's


owners for the time and money that they have
spent on keep their businesses going.

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A Shift in Demand in the Short Run and


Long Run

Firms can enter and exit a market in the long


run but not in the short run,

The market adjustment to changes in demand


depends on the time horizon.

An Increase in Demand in the Short Run and Long Run

Assume that the market is in the long-run equilibrium.


=>Firms are earning zero profit and price equals the minimum of
average total cost.

Firm

Market
Price

Price

MC

ATC

Short-run supply, S1
A

P1

Long-run
supply

P1

Demand, D1
0

Quantity (firm)

Q1

Quantity (market)

An Increase in Demand in the Short Run and Long Run


(b) Short-Run Response
Market

Firm
Price

Price

Profit

MC

ATC

P2

P2

P1

P1

S1

A
D2

Long-run
supply

D1
0

Quantity (firm)

Q1

Q2

Quantity (market)

If the demand for the product increases, this will lead to an


increase in the price of the good.
Firms will respond to the increase in price by producing
more in the short run.
Because price is now greater than average total cost, firms
are earning profit.

An Increase in Demand in the Short Run and Long Run


(c) Long-Run Response
Market

Firm
Price

Price

MC

ATC

P2

S1
S2
C

P1

Long-run
supply

P1
D2
D1

Quantity (firm)

Q1

Q2

Q3 Quantity (market)

The profit will attract new firms into the industry, shifting the supply
curve to the right.
This will lower price until it falls back to the minimum of average
total cost and firms are once again earning zero economic profit.

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An Example
WSJ: Since peaking in 1976, per capita beef
consumption in the United States has fallen by 28.6
percent and size of the U.S. cattle herd has shrunk to
a 30 year low.
What are the short run and the long-run effects of
the decline of the demand for beef?

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Short Run Effect


The shift of the industry demand curve from D1 to D2 reduces the quantity from Q1
to Q2 and reduces the price from P1 to P2.
This affects the firm, reducing its quantity from q1 to q2.
Before the decline in the price, the firm was making zero profits; afterwards, profits
are negative, as average total cost exceeds price.

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Long Run Effect


Since firms were losing money in the short run, some firms leave the industry.
The supply curve shifts from S1 to S3.
The shift of the supply curve is just enough to increase the price back to its original
level, P1.
As a result, industry output falls still further, to Q3.
For firms that remain in the industry, the rise in the price to P1 returns them to
their original situation, producing quantity q1 and earning zero profits.

Why the Long-Run Supply Curve is Upward Sloped?

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Earlier we assumed that all potential entrants faced the same costs as
existing firms,

Average total cost of each firm was unaffected by the entry of new
firms into the industry.
The long-run supply of the industry will be a horizontal line at
minimum average total cost.
But, there are two possible reasons why this may not be the case.
If a resource is limited in quantity, entry of firms will increase the price of this
resource, raising the average total cost of production.
Farmland

If firms have different costs, then it is likely that those with the lowest costs will
enter the industry first.
If the demand for the product increases, the firms that would enter will likely have
higher costs than those firms already in the market.
The marginal firm is the firm that would exit the market if the price were any lower.

In this situation, the long-run supply curve of the industry will be


upward sloping.
No matter what the shape of the long-run supply curve, it is generally more
elastic than the short-run supply curve of the industry (due to the fact that firms
can enter or exit in the long run).