#3 Firms in Competitive Markets

Competitive Firm Short-run Supply curve graph

Marginal cost curve determines the quantity of the good the firm is willing to supply at any price. MC curve is the firm's supply curve.

A market begins in long-run equilibrium with a firm making zero economic profit.

Market in long-run equilibrium: P = minimum ATC, firms make zero economic profit.

When P < ATC

Negative profit (loss)

In a large city, one chain of coffee shops controls a large market share because locals believe its coffee tastes better than that of its competitors.

No (is not an identical product - from consumer's pov)

Determine if this is a competitive market: Gentoo Inc. controls the copyright to a popular series of mystery novels. It is the only company with the right to legally publish books in the series in the United States.

No (not many sellers)

There are thousands of car dealerships that serve millions of consumers each year. The dealerships vary by location, offerings, and quality, allowing consumers with an array of preferences to find vehicles that match their individual needs.

No (product -cars- not considered identical products)

Suppose pretzel stands in NYC are a perfectly competitive market in long-run equilibrium. One day, the city starts imposing a $100 per month tax on each stand. How does this policy effect the number of pretzels consumed in the short-run and long-run

No change in the short-run, down in the long-run.

An industry graph has supply and demand with an equilibrium price and quantity. A individual firm has a perfectly elastic demand curve (same as price) and the price is determined by the industry equilibrium price.

No matter how much an individual person/firm sells, the price remains the same (dictated by market equilibrium price). The price line for individual firm is the same as the demand curve (P = AR = MR = Demand curve). MC curve is supply curve.

Example: Quantity of milk demanded increases due to new health properties. (long-run)

Over time, profit encourages new firms to enter the market so quantity supplied increases and the short-run supply curve shifts from S1 to S2 causing price of milk to fall. Eventually price is driven back down to min ATC, economic profits are zero, and firms stop entering the market. Hence reaches new long-run equilibrium at point C.

In the long-run equilibrium of a competitive market with identical firms, what are the relationships among price P, marginal cost MC, and average total cost ATC.

P = MC and P = ATC

In the short-run equilibrium of a competitive market with identical firms, if new firms are getting ready to enter what are the relationships among price P, marginal cost MC, and average total cost ATC.

P = MC and P > ATC

In a perfectly competitive market P, AR, and MR

P = MR = AR = Demand curve (perfectly elastic).

A firm will enter a market if

P > ATC or, TR > TC

In the short run, competitive firms will temporarily shut down production if the price falls below

P1

In the long run, some competitive firms will exit the market if the price is below

P2

In the long run, the competitive equilibrium is

P2, Q2

For competitive firms Average revenue (AR) and marginal revenue (MR)

AR = P and MR = P

Average Revenue formula (AR)

AR = TR/Q

If the price is P4, the firm will earn profits equal to the area

(P4 − P3) × Q3

Total revenue in a market is

(TR = P × Q) proportional to amount the of output.

Positive Economic profit in the short-run

-long run: firms enter the market. -Short-run: supply curve shifts right. -Price decreases back to minimum ATC. -Quantity increases (because there's more firms in the market). -Efficient scale.

Profit maximizing rules for a competitive firm (4)

1) Find Q at P = MC. 2) If P < AVC, shutdown immediately and remain out of business. 3) If AVC < P < ATC, operate in the short-run but exit in the long-run. 4) If P > ATC, stay in business.

Profit maximization rules (5)

1) MC curve slopes upwards (rises as quantity rises). 2) ATC curve is U-shaped. 3) MC curve crosses ATC curve at minimum ATC. 4) The price is a horizontal line: P = AR = MR. 5) Profit is maximized when producing at quantity when MC = MR.

2 reasons long-run market supply curves might slope upwards

1) Some resources used in production are only available in limited quantities. 2) Firms have different costs.

(7) Competitive market characteristics (also called perfectly competitive market) In-class

1) There are many buyers and sellers. 2) Identical Goods. 3) Each buyer and seller is a price taker. 4) Firms can freely enter or exit the market. 5) Perfect information. 6) No externality. 7) Zero Economic Profit

Sunk cost

A cost that has already been committed and cannot be recovered. (since nothing can be done about sunk costs, you should ignore them when making decisions about life or business strategies).

Example:

As more people demand milk at a given price, the demand curve shifts right, hence price increases and quantity increases. At this new area, P > ATC so firms enter the market and supply shifts right, hence price decreases. Price decreases back to original price where competitive firms make 0 economic profit P = ATC. Result: price remains same, but quantity of the good and the number of firms increases in market increases.

Why do competitive firms stay in business if they make zero economic profit?

Because although the economic profit is zero (TR - explicit and implicit costs); the accounting profit is positive since it doesn't include implicit costs.

Marginal Revenue explained

Change in total revenue from an additional unit sold. For competitive firms, marginal revenue equals the price of the good.

Sunk Cost Fallacy

Describes our tendency to follow through on an endeavor if we have already invested time, effort, or money, whether or not the current costs outweigh the benefits. (commitment bias: following through on what we committed despite that costs of that decision may outweigh the benefits)

Oligopoly

Few sellers; sells similar goods

Long-run characteristics of a firm

Firms can enter and exit the market. If P > ATC, firms make positive profit (and new firms enter market). If P < ATC firm makes negative profit (and firms exit the market).

In the long-run, the process of entry and exit ends when

Firms still in the market make zero economic profit (P = ATC) because MC = ATC; efficient scale.

Example: Restaurant deciding whether to stay open for lunch

Fixed cost (rent, etc) is not relevant when deciding to stay open; is a sunken cost in the short-run. Variable costs are relevant when deciding to stay open. Shutdown if TR < VC. Stay open if TR > VC.

Average Revenue explained

For all firms, average revenue equals the price of the good.

Short-run market supply curve

Has a fixed number of firms; Each firm supplies the quantity where P = MC. (for P > AVC, supply curve is the MC curve). Market supply derived from: adding up quantity supplied by each firm.

Monopolistic Competitive Market

Has only one seller; sells similar goods

The competitive firm's long-run supply curve is the portion of its MC curve that lies above the ATC curve.

In the long-run, the firm produces on the MC curve if P > ATC.

Sunk cost example

In the short-run, fixed costs are sunk costs, and a firm should ignore fixed costs when deciding how much to produce (or whether to shutdown). "don't cry over split milk"; "let bygones be bygones".

Short-run market supply graph(s) for an individual firm and a market supply (derived from quantity supplied of all firms)

In the short-run, the number of firms in a market is fixed, as a result, the market supply graph reflects the sum of the individual firm's MC curves.

Short-run response to demand increasing

Increase in demand increases price leading to short-run profits. In the short-run this creates higher quantity and higher price (P > ATC = (+) economic profit)

When a perfectly competitive firm increases the quantity it produces and sells by 10%, its marginal revenue _______ and its total revenue rises by ______.

Its marginal revenue STAYS THE SAME and its total revenue rises by EXACTY 10%. (MR = ΔTR/ΔQ)

If a profit-maximizing, competitive firm is producing a quantity at which marginal cost is between AVC and ATC, it will...

Keep producing in the short-run but exit in the long-run

Measuring profit if P < ATC

Loss = TC - TR = (ATC - P) × Q

A firm maximizes profit when

MR = MC

Profit maximizing condition in a perfectly competitive market is

MR = MC, or P = MC. (AR = MC)

Marginal Revenue formula (MR)

MR = ΔTR/ΔQ

A competitive firm's short-run supply curve is its ______ cost curve above its _______ cost curve.

Marginal cost curve above its Average variable cost curve.

Example: Some resources in production available in limited quantities

People who want to become farmers need farm land which has limited quantity but a high demand. An increase in demand cannot increase quantity supplied without increases price and hence the cost to farmers.

When P > ATC

Positive profit

Measuring profit if P > ATC

Profit = TR - TC = (P - ATC) × Q

Profit maximization for a competitive firm graph

Profit is maximized by producing the quantity where MC = MR. Note: P = AR = MR

If the price is P4, a competitive firm will maximize profits if it produces

Q3

Exit

Refers to a long-run decision to leave the market. Firm doesn't have to pay any costs.

Shutdown

Refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Firm still has to pay fixed costs.

Example: Quantity of milk demanded increases due to new health properties. (short-run)

Short-run equilibrium moves from point A to B and price rises from p1 to p2. Existing firms respond to increase in price by increasing the amount they produce. Because each firm's supply is the same as its MC curve, each firm's increase in production depends upon the MC cost curve of the firm. The new short-run equilibrium: price of milk exceeds ATC so firms make a positive profit.

Firm will exit when (3)

TR < TC or P < ATC (TR/Q < TC < Q)

Firm shuts down if (3)

TR < VC or P < AVC (TR/Q < VC/Q).

Because the firm's marginal cost curve determines the quantity of a good the firm is willing to supply at any price...

The marginal cost curve is also the firm's competitive supply curve.

Graph of firms making profit or losses

The profit or loss is the area between the price and ATC. Height of profit or loss box is (P - ATC) and width is the quantity. When P = MC, this is the value of loss-minimizing quantity or profit maximizing quantity.

In the long-run if some firms are making losses, they will exit the market which reduces the number of firms

This causes quantity supplied to fall and prices and profits to increase.

Goal of a firm in a competitive market

To maximize profit (Profit = Total revenue - total cost) (Profit = (Price -ATC) × Q)

A firm will shutdown (temporarily) if

Total Revenue it would earn from producing is less than the variable costs of production.

A firm will exit a market (permanently) if

Total revenue it would get from producing is less than its total cost of production.

Demand curve is horizontal (elastic) since individual firms take the price as given by market conditions. P = MR = AR = Demand curve.

When MR = MC (P = MC) this is the optimal quantity to produce that will maximize profit (and minimize loss). Since firms cannot choose their market price, they instead choose quantity.

Moral Hazard (another reason for market failure other than public goods and externalities)

When a buyer or seller has more information about a good than another. (Ex: a patient (consumer) knows more about their health conditions than a medical insurance agency; or if a car dealer knows more about a vehicle than a potential buyer).

Perfect information

When buyers and sellers have the same information about a good.

Long-run response to increased demand and profits.

When profits induce entry, supply increases and price falls restoring long-run equilibrium.

The competitive firm's short-run supply curve is the portion of its MC curve that lies above the AVC.

Where MC curve is above AVC curve it is the short-run supply curve.

Short-run supply and Long-run equilibrium graph.

Will be indifferent producing where MC = AVC (produce 0 or 15,000). Between AVC and ATC on MC cost curve, will produce short-run, exit long-run. MC = ATC, break even profit (long-run equilibrium = 0 economic profit). MC > ATC produce with positive profit.

There are several dozen crust makers that distribute their frozen products to hundreds of pizza shops nationwide. The shop owners source crusts from the cheapest available producer.

Yes (satisfies all assumptions)

Which of the following markets would most closely satisfy the requirements for a competitive market?

a gold bullion

Firms with higher costs will enter a market only if

prices rise, making market profitable for them to enter.

If the long-run market supply curve for a good is perfectly elastic, an increase in the demand for that good will, in the long run, cause

an increase in the number of firms in the market but no increase in the price of the good.

In the long run, some firms will exit the market if the price of the good offered for sale is less than

average total cost

When MR < MC a firm should

decrease production

If a competitive firm doubles its output, its total revenue

doubles

Demand curve for a firm with a monopoly is

downwards sloping. Monopolistic firms are price-makers (can choose their price).

For a competitive firm, marginal revenue is

equal to the price of the good sold

In the short run, the competitive firm's supply curve is the

portion of the marginal-cost curve that lies above the average-variable-cost curve.

When MR = MC

firm is at profit-maximizing level of output (production)

In the long-run equilibrium of a competitive market with free entry and exit

firms must be operating at their equilibrium scale.

At the end of this process of entry and exit...

firms that remain in the market must be making zero economic profit. (recall Profit = (P - ATC) × Q) Equation shows that a firm will have zero economic profit if price of a good equals ATC of producing the good.

A long-run supply curve is perfectly elastic with a horizontal minimum at

horizontal minimum at ATC

When MR > MC a firm should

increase production

If a competitive firm is producing a level of output where marginal revenue exceeds marginal cost, the firm could increase profits if it

increased production

The long-run market supply curve

is more elastic than the short-run market supply curve. (is not always perfectly elastic)

A competitive firm takes

its price as given by market conditions

The process of entry and exit only ends when

price and ATC are driven to equality (when P and ATC are equal).

To maximize profit

produce quantity where TR - TC is greatest.

A competitive firm maximizes profit by choosing the quantity at which

marginal cost = price

The competitive firm maximizes profit when it produces output up to the point where

marginal cost equals marginal revenue.

Example: Firms have different costs

painters may have different costs than other painters due to supplies and how fast they work. Those with lower costs are more likely to enter the market. To increase amount of paintings produced, additional entrants that enter have higher costs and hence price of paintings must increase for them to make a profit.

If all firms in a market have identical cost structures and if inputs used in the production of the good in that market are readily available, then the long-run market supply curve for that good should be

perfectly elastic

In the long run, the competitive firm's supply curve is the

portion of the marginal-cost curve that lies above the average-total-cost curve.

Because firms can enter and exit more easily in the long-run than the short-run, the long-run supply curve is typically more elastic (horizontal line) than

short-run supply curves.

MC cost curve is the _____ curve for perfectly competitive market firms.

supply curve. [when demand curve shifts for market industry graph, MC stays the same on firm graph, is unaffected] Short-run supply curve when MC is above AVC. Long-run supply curve when MC is above ATC.

If an input necessary for production is in limited supply so that an expansion of the industry raises costs for all existing firms in the market, then the long-run market supply curve for a good could be

upward sloping

A grocery store should close at night if the [important]

variable costs of staying open are greater than the total revenue due to staying open.

In long-run equilibrium in a competitive market, firms are operating at

zero economic profit; their efficient scale; the intersection of marginal cost and marginal revenue; the minimum of their ATC curves.