ECONOMICS/CHAPTER 14:FIRMS IN COMPETITIVE MARKETS-NOTES
A simple example of profit maximization
***profit is maximize when it chooses to produce either 4 or 5 gallons of milk,for a profit of $7 Another way to look at for fit maximizing quantity is by comparing the marginal revenue and the marginal cost from each unit produced. The fifth and sixth column compute marginal revenue and marginal cost from the changes in total revenue and total cost, and the last column shows the change in profit for each additional gallon produced. ***The first gallon has a marginal revenue of $6 and a marginal cost of $2;hence, producing that gallon increases profit by $4 (from $-3 to $1). The second gallon produced has a marginal revenue of $6 and a marginal cost of $3, so that gallon increases profit by $3(from $1 to $4). ***AS LONG AS MARGINAL REVENUE EXCEEDS MARGINAL COST, INCREASING THE QUANTITY PRODUCED RAISES PROFIT. Once the farm reached 5 gallons the situation changed. The 6th gallon would have a marginal revenue of $; and a marginal cost of $7, so producing it would reduce profit by $1 (from $7 to $6). !!!!!RATIONAL PEOPLE THINK AT THE MARGIN!!!! AS LONG AS MARGINAL REVENUE IS GREATER THAN MARGINAL COST, YOU SHOULD INCREASE PRODUCTION BEAUSE IT MAKES MORE $$$$$.
3 General rules for profit maximization
1. If marginal revenue is greater than marginal cost, the firm should increase its output 2.if marginal cost is greater than marginal revenue, the firm should decrease its output 3. At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal **these rule apply to any type of firm
Why the long run supply curve might slope upward
1. That some resources used in production may be available only in limited quantities. Example: consider the market for farm products. Anyone can choose to buy land and start a farm, but the quantity of land is limited. As more people became farmers, the price of farmland is bid up, which raises the costs of all farmers in the market Thus, and 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. The result is long run market supply curve that is upward sloping, even which free entry into farming. 2. That firms may have different costs. Example, consider the market for painters. Anyone can enter the market for painting services, but not everyone has the same 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 tuna those with higher costs. To increase the quantity of painting services 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, the long-run market supply curve for painting services slopes upward even with free entry into the market. Thus, for these two reasons, a higher price may be necessary to induce a larger quantity supplied, in which are the long-run supply curve is upward sloping rather than horizontal.
What is a competitive market
A competitive market sometimes called a perfectly 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. ***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. Each buyer and seller takes the market price as given. An example is the price of milk. Each dairy farmer has limited control over the price because many other sellers are offering milk that is essentially identical. Each seller can sell all he wants at the going price, he has little reason to charge less, and if he charges more buyers will go elsewhere. ***buyers and sellers in competitive markets must accept the price the market determines and, therefore, are said to be price takers. 3. Firms can freely enter or exit the market. (This third condition is sometime thought to characterize perfectly competitive markets)
The revenue of a competitive firm. (When you look at the chart, the last two columns answer these questions: 1. How much revenue does the farm receive for they typical gallon of milk? 2. how much additional revenue does the farm receive if it increases production milk by 1 gallon? The fourth column shows average revenue, which is total revenue from the third column divided by the amount of output from the first column)
A firm in a competitive market, tries to maximize profit (total revenue-total cost). Example... Vaca Farm produces a quantity of milk Q, and sells each unit at the market price, P. FARM'S TOTAL REVENUE=PxQ Another example... If a gallows of milk sells for $6 and the farm sells 1,000 gallons $6 x 1000 gallons= $6,000 (Since the farm is small to the word market for milk, it takes the price as given by the market conditions. This means, in particular, that the price of milk does not depend on the number of gallons that the farm produces and sells)
The firm's long-run decision to exit or enter a market
A firm's long-run decision to exit a market is similar to its shutdown decision. If the firm exits, it will again lose all revenue from the sales of its product but now it will save not only its variable costs of production but also its fixed costs. Thus, the firm exits the market if the revenue it would get from producing is less than its total costs. FORMULA: EXIT if TR<TC (TR is total revenue, TC is total cost) The firm exits if total revenue is less than total cost. By dividing both sides of this inequality by Q, we can write it as: EXIT if TR/Q<TC/Q We can simplify this further by nothing that TR/Q is average revenue, which equals the price P, and TC/Q is average total cost, ATC. Therefore, the firm's exit rule is FINAL EXIT FORMULA: EXIT IF P<ATC That is, a firm chooses to exit if the price of its good is less than the average total cost of production.
Average revenue (LOOK AT PICTURE)
Average revenue is total revenue divided by the quantity. AVERAGE REVENUE=P x Q/Q ***Therefore, for all types of firms, average revenue equals the price of the good.
Average revenue
Average revenue=total/output.
FIRM SHUTS DOWN IF TOTAL REVENUE IS LESS THAN VARIABLE COST. ( breaking down the formula more)
By dividing both sides of their inequality by the quantity Q, we can writ it as: SHUT DOWN IF TR/Q < VC/Q Left side of the inequality, TR/Q, is total revenue P xQ divided by Q, which is average revenue, most simply expressed as the good's price. Right side of the inequality, VC/Q, is average variable cost, AVC. Therefore, the firm's shutdown rule can be restated as Final Shut down formula if P<AVC ***a firm chooses to shut down if the price of the good is less than the average variable cost of production.
Profit maximization and the competitive firm's supply curve
Formula: the goal is to maximize profit=total revenue-total cost. Competitive firm maximizes profit and how that decision determines its supply curve.
FORMULA FOR STARTING A FIRM (The rule for entry is exactly the opposite of the rule for exit)
He will enter the market if starting a firm would be profitable, which occurs if the price of the good exceeds the average total cost of production the entry rule is FORMULA: Enter if P>ATC
Market power
If a firm can influence the market price of the good it sell it is said to have market power. Example, the local water company.
Marginal revenue
It is a change in total revenue from selling an additional output.
Marginal cost as the competitive firm;s supply curve
Look at explainations
The long run market supply with entry and exit
Profit=(P-ATC)xQ **if price is above average total cost, profit is positive, encourages firms to enter **if price is less than average total cost, profit is negative, encourages firms to exit ***note-competitive firms maximize profits by choosing a quantity at which price equals marginal cost.
FORMULA FOR FIRMS TO MAKE A DECISION TO SHUT DOWN (step 1)
Shut down =TR<VC (TR is total revenue, VC is variable cost)
Spilt milk and other sunk costs
Sunk cost= a cost when it has already been committed and cannot be recovered. Because nothing can be done about sunk costs you should ignore them when making decisions.
Examples of Acronyms
TC means total cost TR means total revenue MR means marginal revenue MC means marginal cost MR-MC=change in profit Q means quantity
How to read the graph of PROFIT AS THE AREA BETWEEN PRICE AND AVERAGE TOTAL COST
The height of the rectangle is ATC-P, and the width is Q. The area is (ATC-P)xQ, which is the firm's loss. Because a firm in this situation is not making enough revenue on each unit to cover its average total cost, it would choose to exit the market in the long run.
The supply curve in a competitive market
There are two cases to consider: 1. A market with a fixed number of firms 2. A market in which the number of firms can change as old firms exit the market and new firms enter Short period-often difficult for firms to enter and exit, so the assumption of a fixed number of firms is appropriate Long period- the number of firms can adjust to changing market conditions.
Conclusion: behind the supply curve LOOK AT VEDIO AT THE END
This discussion was on the behavior of profit-maximizing firms that supply goods in perfectly competitive markets.***rational people think at the margin. Marginal analysis has given us a theory of the supply curve in a competitive market. You have learned that 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. In particular, if firms are competitive and profit maximizing, the price of a good equals the marginal cost of making that good. Also if firms can freely enter and exit the market the price also equals the lowest possible average total cost of production.
A shift in demand in the short and long run
This explains how markets respond to changes in demand. 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 Example: Suppose the market for milk begins in a long run equilibrium. Firms are earning zero profit, so price equals the minimum of average total cost. Panel (a) in Figure 8 shows this situation. The long run equilibrium is point A, the quantity sold in the market is Q1, and the price is P1.
Marginal revenue
This is the change in total revenue from the sale of each additional unit of output. The table 1, marginal revenue equals $6, the price of a gallon of milk. Only in a competitive firm, total revenue is P xQ (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.
The firm's short-run decision to shut down
This is when the firm decides to shut down and not produce anything at all. It could either be temporary or permanent. A SHUTDOWN refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. An EXIT refers to a long-run decision to leave the market. ***short run and long run differ because firms cannot avoid their fixed costs in the short ru but can do so in the long run. That is a firm that shuts down temporarily still has to pay its fixed costs that is a firm that exits the market does not have to pay any costs at all, fixed or variable. Example a farmer who decides to not plant one season it is considered a sunk but if he sell the land it is considered making a long run decision and the cost of land is not sunk. Consider a firm's shutdown decision....if the firm shuts down it loses all revenue from the sale of its product. At the same time, it saves the variable costs of making its product (but must pay the fives costs). Thus, the firm shuts down if the revenue that it would earn from producing is less than its variable cost of production.
Why do competitive firms stay in business if they make zero profit?
Understand the zero-profit condition more fully, recall that profits equals total revenue minus total cost and that total cost includes all opportunity costs of the firm. In particular, total cost includes the time and money that the firm owners devote to the business. In the zero-profit equilibrium, the firm's profit equilibrium, the firm's revenue must compensate the owners for these opportunity costs. ***read last paragraph as an example ****keep in mind accountants and economists measure costs differently. Accountants keep track of explicit costs but into implicit costs. That is, they measure costs that require an outflow of money from the firm, but they do not include the opportunity costs of production that do not involve an outflow of money.As a result, in the zero-profit equilibrium, economic profit is zero, but accounting profit is positive. Our farmer's accountant, for instance, would conclude that the farmer earned an accounting profit of $80,000, which is enough to keep the farmer in business.
The marginal-cost and the Firm's supply decisions
You need to consider the cost curves. Cost curves has 3 features: 1. MC (marginal-cost curve) is upward sloping 2. ATC (average-total-cost curve) is U shaped ***the MC (marginal-cost curve) crosses the ATC (average-total-cost curve) at the minimum of the average total cost. 3. P (market price) is a horizontal line It is horizontal because a competitive firm is a price taker: The price of the firm's output is the same regardless of the quantity the firm decides to produce. !!!!!!Keep in mind COMPETITIVE FIRM= AVERAGE REVENUE(AR)-IT'S MARGINAL REVENUE (MR).
