14
FIRMS IN COMPETITIVE
MARKETS
CHAPTER OUTLINE:
I.
What Is a Competitive Market?
A.
B.
The Meaning of Competition
1.
Definition of competitive market: a market with many buyers and sellers trading
identical products so that each buyer and seller is a price taker.
2.
There are three characteristics of a competitive market (sometimes called a
perfectly competitive market).
a.
There are many buyers and sellers.
b.
The goods offered by the sellers are largely the same.
c.
Firms can freely enter or exit the market.
The Revenue of a Competitive Firm
1.
Total revenue from the sale of output is equal to price times quantity.
TR = P × Q
2.
Average revenue
a.
Definition of average revenue: total revenue divided by the quantity sold.
AR = TR / Q
b.
3.
For all firms, average revenue equals the price of the good.
Marginal revenue
a.
Definition of marginal revenue: the change in total revenue from
an additional unit sold.
MR = ΔTR / ΔQ
b.
For competitive firms, marginal revenue equals the price of the good.
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Chapter 14/Firms in Competitive Markets
II.
Profit Maximization and the Competitive Firm's Supply Curve
A.
A Simple Example of Profit Maximization: The Smith Dairy Farm
1.
B.
2
The profit-maximizing quantity can also be found by comparing marginal revenue
and marginal cost.
a.
If marginal revenue is greater than marginal cost, increasing output will
raise profit.
b.
If marginal revenue is less than marginal cost, decreasing output will
raise profit.
c.
Profit-maximization occurs where marginal revenue is equal to marginal
cost.
The Marginal-Cost Curve and the Firm's Supply Decision
1.
For a competitive firm, the firm’s price equals both its average revenue and its
marginal revenue, which can be shown by a horizontal line.
2.
At the profit-maximizing level of output, marginal revenue is equal to marginal
cost.
3.
Because the firm's marginal cost curve determines how much the firm is willing
to supply at any price, it is the competitive firm's supply curve.
Chapter 14/Firms in Competitive Markets
C.
The Firm's Short-Run Decision to Shut Down
1.
There is a difference between a temporary shutdown of a firm and an exit from
the market.
a.
A shutdown refers to the short-run decision not to produce anything
during a specified period of time because of current market conditions.
b.
Exit refers to a long-run decision to leave the market.
2.
If a firm shuts down, it will earn no revenue and will have only fixed costs (no
variable costs).
3.
A firm will shut down if the revenue that it would get from producing is less than
its variable costs of production:
Shut down if TR < VC.
4.
That is, a firm chooses to shut down if the price of the good is less than the
average variable cost of production.
Shut down if P < AVC.
5.
A competitive firm’s short-run profit-maximizing strategy:
If:
P ≥ AVC
P < AVC
The Firm Will:
Produce output level where MR = MC
Shut down and produce zero output
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Chapter 14/Firms in Competitive Markets
D.
6.
The competitive firm's short-run supply curve is the portion of its marginal cost
curve that lies above average variable cost.
7.
Spilt Milk and Other Sunk Costs
a.
Definition of sunk cost: a cost that has been committed and cannot be
recovered.
b.
A firm’s fixed costs are sunk in the short run, and the firm should ignore
these costs when making supply decisions.
The Firm's Long-Run Decision to Exit or Enter a Market
1.
A firm exits the market if the revenue that it would earn from producing is less
than its total costs:
Exit if TR < TC.
2.
That is, a firm chooses to exit if the price of the good is less than the average
total cost of production.
Exit if P < ATC.
3.
A firm will enter the market if the price exceeds the average total cost.
Enter if P > ATC.
4.
A competitive firm’s long-run profit-maximizing strategy:
If:
P > ATC
P = ATC
P < ATC
4
The Firm Will:
Enter because economic profits are earned
Not enter or exit because economic profits are zero
Exit because economic losses are incurred
Chapter 14/Firms in Competitive Markets
5.
E.
The competitive firm's long-run supply curve is the portion of its marginal cost
curve that lies above average total cost.
Measuring Profit in Our Graph for the Competitive Firm
1.
Profit = TR − TC
= ( P − ATC ) × Q
2.
Using this equation, we can measure the amount of profit (or loss) at the firm's
profit-maximizing level of output (or loss-minimizing level of output).
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Chapter 14/Firms in Competitive Markets
III.
The Supply Curve in a Competitive Market
A.
B.
The Short Run: Market Supply with a Fixed Number of Firms
1.
Each firm's short-run supply curve is its marginal cost curve above average
variable cost.
2.
To get the market supply curve, we add the quantity supplied by each firm in the
market at every given price.
The Long Run: Market Supply with Entry and Exit
1.
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At the end of the process of entry or exit, firms that remain in the market must
be making zero economic profit.
a.
If firms in an industry are earning profits, new firms will enter the
market. This entry will increase the supply of the product, and drive
down prices and profits.
b.
If firms in an industry are incurring losses, some exiting firms will exit
the market. Their exit will reduce the supply of the product, and drive up
prices and profits.
2.
The process of entry or exit ends only when price and average total cost become
equal.
3.
The long-run equilibrium of a competitive market with free entry and exit must
have firms operating at their efficient scale.
Chapter 14/Firms in Competitive Markets
C.
D.
4.
The long-run market supply curve is horizontal at the price consistent with zero
profit-the minimum of average total cost.
5.
Why do competitive firms stay in business if they make zero profit?
a.
To an economist, total cost includes all of the opportunity costs of the
firm.
b.
In the zero-profit equilibrium, economic profit is zero, but accounting
profit is positive.
A Shift in Demand in the Short Run and Long Run
1.
Assume that the market begins in long-run equilibrium. This means that firms
are earning zero profit and price equals the minimum of average total cost.
2.
If the demand for the product increases, this will lead to an increase in the price
of the good. In the new short-run equilibrium, the firms are making positive
profit, which over time encourage new firms to enter the market.
3.
This entry shifts the short-run supply curve to the right. In the new long-run
equilibrium, the price is driven back to the minimum of average total cost, profits
are again zero, but the number of firms and the total quantity supplied rise.
Why the Long-Run Supply Curve Might Slope Upward
1.
There are two possible reasons why the long-run supply curve might slope
upward.
a.
If some resource used in production is limited in quantity, entry of firms
will increase the price of this resource, raising the average total cost of
production.
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Chapter 14/Firms in Competitive Markets
b.
2.
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If firms have different costs, then it is likely that those with the lowest
costs will enter the industry first. Because new entrants have higher
costs, the price must rise to make entry profitable for them.
The long-run supply curve of an industry is generally more elastic than the shortrun supply curve of the industry.