2007 Thomson South-Western

Outline
What is a competitive market? Short-run profit maximization Minimizing short-run losses The competitive firms supply curve and industry short-run supply curves Perfect competition in long-run Perfect competition and efficiency Summary

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Market structure
Many of firms decisions depend on the structure of the market in which it operates. Market structure describes the important features of a market such as:

number of suppliers/producers product degree of uniformity do firms in the market produce identical products or differentiated products? Ease of entry into market can new firms enter easily or are they blocked by barriers? forms of competition among firms do firms compete only through prices or use advertising & product differences?
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WHAT IS A COMPETITIVE MARKET?

1. Many buyers & sellers 2. Each buys & sells only a small fraction of the total amount exchanged in the market

3. Produce homogenous product (close substitute)

4. Buyers & sellers are fully informed about the price & availability of resources and products

5. Firms & resources are freely mobile can easily enter and leave the industry 6. Individual firm of producers do not have influence on price
- price is determined by market DD and SS the perfectly competitive firm is a price taker must accept the market price but free to produce whatever quantity
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Market equilibrium & Firms Demand Curve in Perfect Competition

Price Market equilibrium Price Firms demand

$5

$5

1,000

Q of wheat

10

15

Q of wheat

Market price of wheat =$5 is determined by intersection of the market DD and SS curve. Once market P is established , producers can sell all they wants at the market P Perfectly competitive firm so small how much the firm produce has no effect on the market price
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Short-run Profit Maximization

Profit = Total revenue (TR) Total cost (TC) Total revenue for a firm is the selling price times the quantity sold. TR = (P Q) Total revenue is proportional to the amount of output.
Average revenue (AR) tells how much revenue a firm receives for the typical unit sold.

AR = TR / Q
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The Revenue of a Competitive Firm

In perfect competition, AR= Price

Total revenue Average Revenue = Quantity Price Quantity Quantity

AR Price
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The Revenue of a Competitive Firm

Marginal revenue is the change in total revenue from an additional unit sold.

MR =TR/Q
For competitive firms, MR=Price Thus in perfect competition,

P=AR=MR
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Table 1 Total, Average, and Marginal Revenue for a Competitive Firm

Q
1 gallon 2 3 4 5

Price
$6 6 6 6 6

6 7 8

6 6 6

TR = (PXQ) $6 12 18 24 30 36 42 48

AR = TR/Q $6 6 6 6 6 6 6 6

MR= TR/ Q
6 6 6 6

6 6 6

Price = Average Revenue = Marginal Revenue

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PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS SUPPLY CURVE

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. Firm maximizes economic profit when TR > TC by the greatest amount
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The Marginal Cost-Curve and the Firms Supply Decision Golden rule of profit maximization: MR = MC which holds for all market structure For perfectly competitive firm, demand curve = P = MR = AR Firm will expand output as long as MR > MC & stop expanding output before MC > MR When MR > MC, increase Q When MR < MC, decrease Q When MR = MC, profit is maximized.
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Profit Maximization: A Numerical Example (Price = $6)

Q TR = (PXQ) $0 6 12 18 24 30 36 42 48 TC Profit MR MC (TR-TC) (TR/ Q) (TC/ Q) -$3 1 4 6 7 7 6 4 1 $6 6 6 6 6 6 6 6 $2 3 4 5 6 7 8 9 $4 3 2 1 0 -1 -2 -3
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Change in Profit (MR-MC)

0 gallon 1 2 3 4 5 6 7 8

$3 5 8 12 17 23 30 38 47

Short-Run Profit Maximization (TR TC)

Total dollars TC TR

$30 $23

Maximum economic profit = $7

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Short-Run Profit Maximization (MR= MC)

Dollars per unit MC ATC $6 $5 PROFIT A d=MR=AR

1. MC curve intersection with MR at point A where Q=5

2. Output < 5, MR > MC, so can increase profit by increasing output 3. Output beyond 5, MC > MR, firm can increase profit by reducing output

4. Economic profit = rectangle = TR ($6 X 5 ) ATC ($5 X 5) = $5

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Profit Maximization for a Competitive Firm

Costs and Revenue

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

Suppose the market price is P. MC If the firm produces Q2, marginal cost is MC2. ATC P = AR = MR AVC

MC2

P = MR1= MR2

MC1

If the firm produces Q1, marginal cost is MC1.

Q1

QMAX

Q2

Quantity
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Minimizing Short-Run Losses

Sometimes the price that the firm is required to take will be so low that no rate of output will gives profit Faced with losses, firm has 2 options: 1. It can produce at a loss or 2. Temporarily shut down In SR firm faces 2 types of cost : FC & VC A firm that shut down in the SR must still pay FC The decision to shut down or proceed depends on whether revenue could cover VC As long firms revenue cover VC (or price covers AVC) & some portion of FC a firm will produce and not shut down
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 The firm shuts down if the revenue it gets from producing is less than the variable cost of production. Shut down if TR < VC Shut down if TR/Q < VC/Q Shut down if P < AVC

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Minimizing Losses
Q 0 1 MR or P $3 TR $0 3 TC $15.0 19.75 MC $4.75 ATC $19.75 AVC $4.75 Profit or loss -$15 -16.75

2
3 4 5 6 7 8 9 10

$3
$3 $3 $3 $3 $3 $3 $3 $3

6
9 12 15 18 21 24 27 30

23.50
26.50 29.00 31.00 32.50 33.75 35.25 37.25 40.00

3.75
3.00 2.50 2.00 1.50 1.25 1.50 2.00 2.75

11.75
8.83 7.25 6.20 5.42 4.82 4.41 4.14 4.00

4.25
3.83 3.50 3.20 2.92 2.68 2.53 2.47 2.50

-17.50
-17.50 -17.00 -16.00 -14.50 -12.75 -11.25 -10.25 -10.00

11
12 13 14

$3
$3 $3 $3

33
36 39 42

43.25
48.00 54.50 64.00

3.25
4.75 6.50 9.50

3.93
4.00 4.19 4.57

2.57
2.75 3.04 3.50

-10.25
-12.00 -15.50 -22.00

15

$3

45

77.50

13.50

5.17

4.17

-32.50

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Minimizing Short-Run Losses

Total dollars TC Dollars per unit MC

TR
$40 $30 $4 $3 $2.50 LOSS A

ATC AVC d=MR=AR

minimum economic loss=$10

10 1. TR lies below TC

10 1. P > AVC (MC=MR) .

2. Vertical distance measures the loss 3. Loss minimized at Q=10

2. Firm will produce rather than shut-down even though firm experiencing loss. Q=10.
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The Firm and Industry Short-Run Supply Curves

As long as P covers AVC, firm will supply the quantity resulting from the intersection of its upward-sloping MC curve and its MR or demand curve The portion of the firms MC curve that intersects and rises above the lowest point on its AVC curve becomes short-run firm SS curve The quantity supplied is determined by the intersection of the firms MC curve and its demand or MR curve.
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Figure 2 Marginal Cost as the Competitive Firms Supply Curve

Price So, this section of the firms MC curve is also the firms supply curve.

As P increases, the firm will select its level of output along the MC curve. MC

P2

ATC P1 AVC

Q1

Q2

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Figure 3 The Competitive Firms Short-Run Supply Curve Costs If P > ATC, the firm will continue to produce at a profit. If P > AVC, firm will continue to produce in the short run. Firm shuts down if P< AVC 0 Firms short-run supply curve MC

ATC

AVC

Quantity
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Aggregating individual supply to form market supply

Sa

Sb

Sc

Sa + Sb +Sc = S

P P

P P 10 20 10 20

P P

P P

10 20

30

60

1. At price < P, no output supplied 2. At P, each firm supplies 10 units: market supply = 30 units 3. At P, each firm supplies 20 units: market supply = 60 units 4. SR industry supply curve is horizontal sum of all firms SR supply curves : horizontal summation of the firm level MC curves
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Relationship between SR profit maximization & Market equilibrium

Firm MC=s ATC $5 A PROFIT d $5 Industry or market MC=s

$4

AVC
D

12

12,000

1. Market P=$5 and assume there are 1,000 producers, market supply = 12,000. At this price each firm produce 12 unit 2. Each producer earns an economic profit of $12 (TR-TC= $60 - $48)
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Profit as the Area between Price and Average Total Cost (a) A Firm with Profits
Price MC ATC

Profit
P

ATC

P = AR = MR

Quantity Q (profit-maximizing quantity) 2007 Thomson South-Western

Profit as the Area between Price and Average Total Cost

(b) A Firm with Losses
Price

MC

ATC

ATC P Loss P = AR = MR

Q (loss-minimizing quantity)

Quantity
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3 Possible Profit Outcomes in the Short Run

P and Cost MC ATC $20 AR=MR $25 $20 profit P and Cost MC ATC AR=MR

8 a. Normal profit (P=ATC) P and Cost MC ATC $20 $17 loss AR=MR

b. Economic Profit (P>ATC)

c. Economic loss (P<ATC) 7 Q

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Perfect Competition in Long Run

In the long run: Firms have time to enter & exit Can adjust their scale of operations No distinction between FC and VC because all inputs are variable in the LR SR economic profit will encourage new firms to enter the market in the LR May encourage some existing firms to expand their scale of operations Industry supply curve shifts rightward in the LR driving down the price This process continues as long as economic profit is greater than zero There is zero economic profit in the LR
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 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 TR/Q < TC/Q Exit if P < ATC A firm will enter the industry if such an action would be profitable. Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC
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Long run equilibrium for the firm and the industry

Firm MC ATC LRAC p Industry or market S

p D

1. In the LR market SS adjust as firms enter or leave 2. This continues until market SS intersect the market DD at a P=lowest point on each firms LRAC at point E. (P=ATC) efficient scale 3. At point E, MC, SRAC and LRAC are all equal.
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Figure 4 The Competitive Firms Long-Run Supply Curve

Costs Firm long-run s supply curve MC = long-run S Firm enters if P > ATC

ATC

Firm exits if P < ATC

Quantity
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Figure 7 Long-Run Market Supply

(a) Firms Zero-Profit Condition
Price

(b) Market Supply Price

MC ATC
P = minimum ATC SS

Quantity (firm)

Quantity (market)

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The Long Run: Market Supply with Entry and Exit

At the end of the process of entry and exit, firms that remain must be making zero economic profit. The process of entry and exit ends only when price and average total cost are driven to equality. Long-run equilibrium must have firms operating at their efficient scale.

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A Shift in Demand in the Short Run and Long Run

An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost.

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Figure 8 An Increase in Demand in the Short Run and Long Run

(a) Initial Condition Price Market
Short run supply, S1 A Long run supply D1

Price

Firm

MC ATC P 1

P 1

Q1

Quantity (market)

Quantity (firm) With firms earn zero profit.

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A market begins in long run equilibrium.

Long run adjustment to an increase demand

Firm MC p p profit d ATC LRAC d P p a c D1 D q q Q Q1 Q2 Q3 b Industry or market S S1

1. Initial market equilibrium at a : firms supplies q & earns normal profit 2. Suppose DD (D to D1), in short run market P to p ; firms output (q) 3. Economic profit attract new , supply (S to S1) . 4. New equilibrium at point c & price return to initial level 5. Firms demand curve shift back down from d to d.
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Long run adjustment to an decrease demand

Firm MC ATC LRAC d d p P Industry or market S1 S

p p

E
loss

c a b D D1

Q3

Q2

Q1

1. Initial LR market equilibrium at a and firms equilibrium at E 2. Suppose DD (D to D1), in short run market P to p ; firms demand fall from d to d ; output to q. Market output falls to Q2. 3. Economic loss many firms exit - supply (S to S1) . 4. P back to p, new equilibrium at point c 5. Market output reduced to Q3 & firms only earns normal profit as demand shift back to d.
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Perfect Competition and Efficiency

There are two concepts of efficiency used to judge market performance
- productive efficiency (producer surplus) - allocative efficiency (consumer surplus)

Perfect competition guarantees both allocative and productive efficiency in the long run Efficiency allocation of resources where marginal benefit = marginal cost (MB=MC)
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Productive efficiency Productivity efficiency occurs when the firm produces at the minimum point on its long-run average cost curve (LRAC) the market price equals the minimum average total cost (P=ATC) The entry & exit of firms and any adjustment in the scale of each firm ensure that each firm produces at the minimum point on its LRAC curve
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Allocative Efficiency Occurs when firms produce the output that is most valued by consumers The demand curve reflects the marginal value that consumers attach to each unit.
-the market price is the amount of money that people are willing & able to pay for the final unit they consume

In both the SR & LR, the equilibrium price in perfect competition = marginal cost of supplying the last unit sold (P=MC)
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Consumer surplus (the connection between demand and marginal benefit)

$5 $4 $3 $2 $1

Consumer surplus

DD= MB

Marginal benefit is the value of one more unit of a good MB = the maximum price that consumer are willing to pay for another unit of good DD curve = MB curve Consumer surplus = difference between value of a good & market price When consumer buy less than it is worth they receive consumer surplus Represented by area below DD curve but above market clearing price

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Producer surplus (the connection between supply and marginal cost)

SS = MC

Producer surplus

$15

10
5

When firms sells something more than it costs to produce the firms obtains a producer surplus Represented by area above supply curve and below market clearing price

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Consumer surplus and Producer surplus

Dollars per unit

Maximizing The social welfare Consumer surplus

SS= MC

P*

Producer surplus

DD= MB

When market equilibrium reached at point E, productive efficiency & allocative efficiency occurs. the combination of P* and Q* maximizes the sum of consumer surplus & producer surplus.

Q*

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Summary
Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firms average revenue and its marginal revenue. To maximize profit, a firm chooses the quantity of output such that MR=MC This is also the quantity at which P=MC Therefore, the firms marginal cost curve is its supply curve.
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Summary
In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the P < AVC. In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the P < ATC. In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale.
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Summary
Changes in demand have different effects over different time horizons. In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.

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