Economics 103
Lecture # 11
The Competitive Firm
The last step in completing our model is to specify a type of
market behavior on the part of firms.
We are going to start by assuming firms are competitive.
The Competitive Firm:
a. Each firm takes the price as given.
b. Each firm ignores the action of rival firms.
c. No firm engages in strategic behavior.
d. The price is set in the “market”.
Does such a firm exist?
Probably true for a wheat farm.
Or for your average
small firm.
But these assumptions are not true for large firms:
We’ll talk about
these firms later.
When a firm is a price taker, they are soooo small changes in their
output have no impact on the market price.
They can produce as much as they want, and the price never changes.
This means the demand curve they face is treated as infinitely elastic.
What is MR?
AR?
Why does MR=AR?
A firm wants to Maximize Profit.
Profit = Total Revenue – Total Costs.
A necessary condition for maximizing profits is the following :
Marginal Revenue = Marginal Costs.
Why would the firm do
better at producing 10, than
some other quantity?
-the profit max. rule
is P=MC
Is the firm making a profit at
10?
PROFIT VS RENT
If there are no SUNK costs, then profit and rent are the same
thing.
- let’s start with this assumption.
To tell if this firm is making a profit we need to measure costs on
the graph.
Method 1: The area under the MC curve measures VC.
So if there are no sunk/fixed
costs, this area would be the
profit of the firm.
We also call this rent, and seller’s
surplus.
PROFIT VS RENT
Method 2: Using the average cost curves.
This shaded area should equal
the other shaded area.
Both areas are the total revenue
minus the total costs.
This method is easier because we are dealing with rectangles,
and we can deal with the case of sunk costs not equaling
zero.
What happens when there are fixed costs? Suppose the fixed costs
equal $10.
Nothing happens to the AVC.
But the AC curve shift up by the
AFC.
Clearly the firm earns zero
profit.
What is the shaded area?
Rent: = Total Revenue – Opportunity Costs
There seems to be no end of confusion between Rents and Profits.
Why would a firm
ever stay in business if it
made a loss?
How could a firm stay in business if it
made zero profit?
Can a firm ever make an economic profit in equilibrium?
The answer is NO.
- entry or exit of firms will eliminate the profit or loss.
-if the profit is due to a “special” factor input, then the
price of this input increases until the profit is
eliminated.
In both cases the AC curve adjusts until profit is eliminated.
Can a firm make a rent in equilibrium?
Absolutely. This is the amount that could be taken
away and the firm would still stay in business.
In the early 1990’s the National Institute for Health gave out
fellowships for “life long support”.
-after 10 years they found that only 50%
of researchers were still doing research.
-these 50% were clearly earning rents.
Given the structure of costs, what is the firm’s supply curve?
The segment above the
minimum AVC curve along
the MC is the supply curve
of the firm?
Why?
Because the firm maximizes profit when it sets P=MC.
So, if we have a competitive firm, what does the market
supply look like.
This turns out to depend on how the various firms
differ.
Case 1: All firms identical, no sunk costs.
Suppose every firm was identical.
Then we would have:
The market supply
curve is just flat.
Suppose every firm was identical in everyway, except they had
different levels of fixed/sunk costs.
The marginal firm
earns zero rent.
The intra marginal firms
earn zero profit, and
positive rent.
Why would a firm be
intra marginal?
What does the marginal firm look like?
What happens if we combine the comparative advantage
ideas from before with the diminishing marginal products
of this lecture?
Each individual firm would now have different shaped
marginal costs.
The low cost firms produce first, and as price increases
higher cost firms join the market.
Once again we would have extensive and intensive
adjustments. The market supply curve would still be
upward sloping.
The bottom line:
Market supply curves are upward sloping.