Firms and Competitive Markets
Competitive Market
• Properties
– Many buyers and sellers
– Trading identical products
– Each buyer and seller a price taker
– Free entry/exit of the market
• Goal is to maximize profit
– ∏ = TR - TC
• Total Revenue
– Price time quantity: TR = P x Q
• Average Revenue
– Total Revenue divided by quantity sold
• Marginal Revenue
– Change in revenue from additional unit sold
• For competitive firms
– Average Revenue = P
– Marginal Revenue = P
Profit Max
• Profit Maximization
– Produce at the quantity that maximizes the
difference between TR and TC
– Compare marginal revenue with marginal cost
• If MR > MC increase production
• If MR < MC decrease production
• If MR = MC profit maximized
Profit Max Decision
Costs
and
Revenue
Producing here
MC > MR so don’t
MC
ATC
MC = MR so profit
maxed
AVC
P = MR
= AR
Producing here
MC < MR so
produce more
Q*
Quantity
• Marginal Cost Curve (MC) determines the
quantity a firm would be willing to supply at a
given price
• Therefore it is the firms supply curve
MC Curve as Supply Curve
Costs
and
Revenue
MC
ATC
P2
AVC
P1
Q1
Q2
Quantity
Shut down and Exit
• Shut Down
– Short Run decision not to produce
– Still have to pay fixed costs though
• Exit (don’t Enter)
– Long Run decision
– No costs
Short Run Decision
• Focus on
– Total Revenue
– Variable costs (fixed costs are fixed, so ignore)
• Decision
– Shut down if TR < VC ( or MR/AR < AVC )
• Competitive Firms Short Run Supply Curve
– MC curve above the AVC curve
Short Run Supply Curve
Costs
ATC
In short run firms produce on
the MC curve if P > AVC
MC
AVC
Quantity
In short run firms shut down if P < AVC
Long Run Decision
• Exit Market if:
– TR < TC
– Or P < ATC
• Enter Market if:
– TR > TC
– Or P > ATC
• Competitive Firms Long Run Supply Curve
– Portion of the MC curve above the ATC curve
Long Run Supply Curve
Costs
ATC
MC
In long run firms produce
on MC curve if P > ATC
Firms exit market if
P<ATC
Quantity
Profit
• If P > ATC
– Positive profits
– ∏ = TR – TC = (P – ATC) x Q
• If P < ATC
– Negative profits (losses)
– Loss = TC – TR = (ATC – P) x Q
Firm with Profits
Firm with Losses
AVC
AVC
MC
MC
Profit
P
Loss
AVC
AVC
P
Profit Maximizing Q
Q*
Q*
Cost Minimizing Q
Market Supply Curve
• In short run # of firms fixed
• Each firm supplies where P = MC
• Each firms supply curve is the MC curve above
their AVC curve (otherwise 0)
• For market supply just add up horizontally
S1
S2
+
S - Market
=
• In long run # of firms not fixed
– Free entry/exit
• If P > ATC
– Profits are positive
– Firms enter market
• If P < ATC
– Firms taking losses
– Firms exit the market
• This means all firms (assuming identical cost
curves) will produce at MC = ATC (efficient pt)
– So MKT supply curve will be horizontal at that
point (perfectly elastic)
Long Run Market Supply
Multiple Firms with identical cost
curves
Add up supply at MC = ATC level for
each to get Market Supply
Price
Price
ATC
MC
P=
Min ATC
Supply
Quantity
Quantity
Some Caveats
P
P
Actual Supply would be more like
this, with holes and dots denoting
when different firms enter. That is it
would not be a smooth line.
And perhaps it could still slope up if
by increasing market size they bid
up the cost of inputs. This would
cause latte entering firms to have
higher cost curves.
Or some firms could just be
better at it, thus having lower
cost curves. But either way LR
flatter than SR.
Q
Q
•
•
•
•
So why stay in business if making zero profit?
Profit = Total Revenue – Total Costs
Total Costs include opportunity costs
Zero Profit Equilibrium
– Zero economic profit
– Positive accounting profit
Shift in Demand and LR and SR supply
response
• Market in long run eq.
– P = ATC
– Zero economic profit
• Increase in demand
– Demand shifts out
– Short Run
• Higher quantity, higher price
• P > ATC
• Positive economic profit
•
•
•
•
•
•
Because of positive profits
Firms enter in the long run
SR supply curve shifts right
Price falls back to low point on ATC
Quantity increases (because of more firms)
Back to efficient scale
Initial State of Equilibrium
Market
Firm
P
P
D
SR
Supply
ATC
MC
P’
LR Supply
Q’
Q
Q
Demand Shifts, + Profits
Market
Firm
P
P
D
Price
increases
SR
Supply
ATC
MC
Which leads to
+ profits
P’’
LR Supply
Q
Q
Supply Shifts, 0 Profits
Market
P
Firm
SR
Supply
D
Profits
induce
firms to
enter
market
P’’’
P
ATC
MC
Restoring Long Run
Equilibrium, but
with more firms
Price falls back
Q
Q