Chapter 14
A competitive market has two characteristics:
1. There are many buyers and many sellers in the market. 2. The goods offered by the various sellers are largely the same 3. Firms can freely enter or exit the market As a result of these conditions, the actions of any single buyer or seller in the market have a negligible impact on the market price.
Because revenue varies substantially from season to season,
A firm must decided when to open and when to close. The firm should be open for business only during those times of year when its revenue > variable cost.
Exit
A long-run decision to leave the market.
Shutdown
A short-run decision not to produce anything during a specific period of time because of current market conditions.
The short-run and long-run decisions differ
Because most firms cannot avoid their fixed costs in the short run but can do so in the long run. That is, a firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market does not have to pay any costs at all, fixed or variable.
An Increase in Demand in the Short Run and Long Run: The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost. Panel (b) shows what happens in the short run when demand rises from to . The equilibrium goes from point A to point B, price rises from to , and the quantity sold in the market rises from to:
Because price now exceeds average total cost, each firm now makes a profit, which over time encourages new firms to enter the market. This entry shifts the short-run supply curve to the right from to , as shown in panel (c). In the new long-run equilibrium, point C, price has returned to but the quantity sold has increased to . Profits are again zero, and price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand.
In the long-run equilibrium of a competitive market with free entry and exit,
Firms must be operating at their efficient scale.
At the end of the above process of entry and exit,
Firms that remain in the market must be making zero economic profit
What does average revenue tell us?
How much revenue a firm receives for the typical unit sold. It is total revenue (P x Q) divided by the quantity (Q). Therefore, for all types of firms, average revenue equals the price of the good.
Notice that if firms have different costs, some firms earn profit even in the long run.
In this case, the price in the market reflects the average total cost of the marginal firm.
When looking at the shaded rectangle, the height of the rectangle is ____________; The width of the rectangle is ____________
P - ATC; Q Thus the area of the rectangle is (P-ATC)xQ If the firm is not making enough revenue on each unit to cover its ATC, it would choose to exit the market in the long-run.
The firm should enter if:
P > ATC In the long run, the firm produces on the MC curve if P > ATC, but exits if P < ATC
Entry and exit can cause the long-run market supply curve to be
Perfectly elastic
The process of entry and exit ends only when_________
Price and ATC are driven to equality
The competitive firm's short-run supply curve is:
The portion of its MC curve that lies above AVC.
Because a competitive firm is a price taker,
The price line is horizontal as the price of the firm's output is the same regardless of the quantity that the firm decides to produce. For a competitive firm, the firm's price equals both its average revenue (AR) and its marginal revenue (MR)
Because firms can enter and exit in the long run but not in the short run,
The response of a market to a change in demand depends on the time horizon
The firms exits the market if:
The revenue it would get from producing is less than its total costs.
The profit-maximizing quantity Qmax is found__________
Where the horizontal line representing the price intersects the marginal-cost curve.
As long as MR > MC,
increasing the quantity produced raises profit. However, when MR < MC, then the firm should decrease production of the good to increase profit. If the firm were to reduce production by 1 unit, the costs saved would exceed the revenue lost. But if MR > MC, then the firm should increase their production of the good to increase profit. If the firm were to raise production by 1 unit, the additional revenue would exceed the additional cost.
Total revenue is proportional to_______
the amount of output
The firm shuts down if:
-The revenue that it would earn from producing is less than its variable costs of production. -TR < VC -P<AVC
Regardless of whether the firm begins with production at a low level or at a high level, the firm will eventually adjust production until the quantity produced reaches Qmax. This analysis yields three genera rules for profit maximization:
1. If MR > MC, the firm should increase its output. 2. If MR < MC, the firm should decrease its output 3. At the profit-maximizing level of output, MR and MC are exactly equal.
General lessons of this chapter:
1. If firms are competitive and profit maximizing, the price of a good equals the marginal cost of making that good. 2. If firms can freely enter and exit the market, the price also equals the lowest possible average total cost of production. 3. When you buy a good from a firm in a competitive market, you can be assured that the price you pay is close to the cost of producing that good.
There are two reasons that the long-run market supply curve might slope upward:
1. Some resources used in production may be available only in limited quantities, as an increase in demand for farm products cannot induce an increase in quantity supplied without also inducing a rise in farmers' costs, which in turn means a rise in price. 2. Firms may have different costs. Costs vary in part because some people work faster than others and in part because some people have better alternative uses of their time than others. For any given price, those with lower costs are more likely to enter than those with higher costs. To increase the quantity of goods supplied, additional entrants must be encouraged to enter the market. Because these new entrants have higher costs, the price must rise to make entry profitable for them. Thus, for these two reasons, a higher price may be necessary to induce a larger quantity supplied, in which case the long-run supply curve is upward sloping rather than horizontal.
Summary of the chapter:
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 firm's average revenue and its marginal revenue. To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm's marginal-cost curve is its supply curve. In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. In a market with free entry and exit, profit is driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.
Also in the zero-profit equilibrium,
Economic profit is zero, but accounting profit is positive.
If a firm shuts down:
It loses all its revenue from the sale of its product. At the same time, it saves the variable costs of making its product (but must still pay the fixed costs).
If the firm produces anything,
It produces the quantity at which MC= good's price, which the firm takes as given. Yet if the price is less than AVC at that quantity, the firm is better off shutting down temporarily and not producing anything.
Also because a competitive firm is a price taker,
Its marginal revenue equals the market price. For any given price, the competitive firm's profit-maximizing quantity of output is found by looking at the intersection of the price with the marginal-cost curve.
Some equations to note:
Marginal Revenue (MR=∆TR/∆Q), Marginal Cost (MC=∆TC/∆Q), Change in Profit (MR-MC), Profit=TR-TC
Buyers and sellers in competitive markets_______________
Must accept the price the market determines and, therefore, are said to be price takers.
In the long run, firms will enter or exit the market until profit is zero. As a result,
Price equals the minimum of ATC. At this price, profit is zero. Any price above this level would generate profit, leading to entry and an increase in the total quantity supplied. Any price below this level would generate losses, leading to exit and a decrease in the total quantity supplied. Eventually, the number of firms in the market adjusts so that price equals the minimum of average total cost, and there are enough firms to satisfy all the demand at this price.
If price < ATC,
Profit is negative, which encourages some firms to exit.
If price > ATC,
Profit is positive, which encourages new firms to enter
When making the short-run decision of whether to shut down for a season, the fixed cost of land is said to be a________________
Sunk Cost. But when making the long-run decision of whether to exit the market, the cost of land is not sunk. A cost is a sunk cost when it has already been committed and cannot be recovered.
The firms should exit if:
TR < TC P < ATC
What is marginal revenue?
The change in total revenue from the sale of each additional unit of output. Total revenue is P x Q, and P is fixed for a competitive firm. Therefore, when Q rises by 1 unit, total revenue rises by P dollars. For competitive firms, marginal revenue equals the price of the good.
Marginal firm
The firm that would exit the market if the price were any lower. The marginal firm earns zero profit, but firms with lower costs earn positive profit. Entry does not eliminate this profit because would-be entrants have higher costs than firms already in the market. Higher-cost firms will enter only if the price rises, making the market profitable for them.
In the zero-profit equilibrium,
The firm's revenue must compensate the owners for all opportunity costs.
When the demand for the good increases,
The long-run result is an increase in the number of firms and in the total quantity supplied, without any change in the price.
Because firms can enter and exit more easily in the long run than in the short run,
The long-run supply curve is typically more elastic than the short-run supply curve.
Because the firm's marginal-cost curve determines the quantity of the good the firm is willing to supply at any price,
The marginal-cost curve is also the competitive firm's supply curve.
If firms already in the market are profitable,
Then new firms will have an incentive to enter the market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down prices and profits.
If firms in the market are making losses,
Then some existing firms will exit the market. Their exit will reduce the number of firms, decrease the quantity of the good supplied , and drive up prices and profits.
A firm can end up producing the profit-maximizing quantity if:
They think at the margin and make incremental adjustments to the level of production.