Chapter 14 Firms in Competitive Markets

What is a Competitive Market?

• Characteristics: – Many buyers & sellers– Goods offered are largely the same– Firms can freely enter &/or exit the market– Buyers & sellers are price takers

Revenue of a Competitive Firm

• Total Revenue = Price x Quantity (remember these types of firms can’t change

price, so they have to change Q)• Average Revenue = TR/Quantity• Marginal Revenue = Change in TR/Change in Q

• For perfectly competitive firms, AR & MR are equal to the price

Profit Maximization

• If MR > MC, increasing output raises profit• If MR < MC, decreasing output raises profit

• Therefore, profit maximization is where MR = MC

Profit Maximization

• Since MR = Market Price for perfectly competitive firms, it looks like…

Profit Maximization

• Since MC determines Q, it becomes the competitive firm’s supply curve

Short-Run Decision to Shut Down

• Shutdown vs. Exit- If you temporarily shut down, you still pay

fixed costs• You shut down if TR < VC or similarly, P < AVC

• Competitive Firm’s short-run supply curve is portion of MC curve above AVC

Short-Run Decision to Shut Down

Sunk Costs

• Cost has already been committed and cannot be recovered – ignore them in decisionmaking

• Cases: Near Empty Restaurants & Off-Season Miniature Golf

Firm’s Long-Run Decision to Exit or Enter a Market

• Firm will exit market if revenue it would get from producing is less than its total costs(exit if P < ATC)

• Firm will enter market if P > ATC• Firm’s long-run supply curve is the portion of

its MC curve that lies above ATC

Measuring Profit

• Profit = (P – ATC) x Q

Short Run: Fixed # of Firms

• As long as P > AVC, each firm’s MC curve is its supply curve

• Market is just a sum of the Q for each indiv. firm

Long Run: Entry & Exit

• Firms will enter or exit based on incentives (are existing firms profitable?)

• At the end of the process, firms that remain in the market must be making zero economic profit

• This happens when P = ATC or TR = TC

SO…

Long-Run Equilibrium

• If firms maximize profit at P = MC and P = ATC to make economic profits equal zero then…

The level of production will be at the efficient scale where MC = ATC

Why stay in business with Zero Profit?

• Zero profit includes opportunity costs, so to stay in business, firm’s revenues must be compensating owner for opp. costs

Shift in Demand in Short & Long Run

• Side by Side Analysis• If market is in long-run equilibrium, firms earn

zero profit and P = min. of ATC• If demand increases, price increases and firms

will produce more in short run… so, P is now greater than ATC and firms are earning profit

• Profit attracts new firms and supply curve shifts to right, lowering price and returning us to zero economic profit

Side by Side Analysis

Why Long-Run Supply Curve Might Slope Upward

• Normally, we assume all entrants to market face same costs and ATC was unaffected by entry of others, so long-run Supply curve of industry is horizontal line at minimum of ATC

Why Long-Run Supply Curve Might Slope Upward

• 2 possible reasons why this might not be the case:

1. If a resource is limited in quantity, entry will increase price of resource and raise ATC

2. If firms have different costs, it’s likely those with lowest costs enter industry first. If demand then increases, firms that would enter will likely have higher costs