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Principles of Economics, Ninth Edition N. Gregory Mankiw

PowerPoint Slides prepared by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. Gregory Mankiw Principles Of Economics Ninth Edition

Chapter 14

Firms in Competitive Markets

What is a Competitive Market, Part 1

Competitive market

Perfectly competitive market

Market with many buyers and sellers

Trading identical products

Each buyer and seller is a price taker

Firms can freely enter or exit the market

What is a Competitive Market, Part 2

Firm in a competitive market

Tries to maximize profit

Profit

Total revenue minus total cost

Total revenue, TR = P ˣ Q

Price times quantity

Proportional to the amount of output

What is a Competitive Market, Part 3

Average revenue, AR = TR / Q

Total revenue divided by the quantity sold

Marginal revenue, MR = ∆TR / ∆Q

Change in total revenue from an additional unit sold

For competitive firms

AR = P

MR = P

Table 1 Total, Average, and Marginal Revenue for a Competitive Firm

Profit Maximization, Part 1

Maximize profit

Produce quantity where total revenue minus total cost is greatest

Compare marginal revenue with marginal cost

If MR > MC: increase production

If MR < MC: decrease production

Maximize profit where MR = MC

Table 2 Profit Maximization: A Numerical Example

Profit Maximization, Part 2

The marginal-cost curve and the firm’s supply decision

MC curve is upward sloping

ATC curve is U-shaped

MC curve crosses the ATC curve at the minimum of ATC curve

The price line is horizontal: P = AR = MR

Figure 1 Profit Maximization for a Competitive Firm

Profit Maximization, Part 3

Rules for profit maximization:

If MR > MC, firm should increase output

If MC > MR, firm should decrease output

If MR = MC, profit-maximizing level of output

Marginal-cost curve

Determines the quantity of the good the firm is willing to supply at any price

Is the supply curve

Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve

Profit Maximization, Part 4

Shutdown

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

Exit

Long-run decision to leave the market

Firm doesn’t have to pay any costs

Profit Maximization, Part 5

The firm’s short-run decision to shut down

TR = total revenue

VC = variable costs

Firm’s decision:

Shut down if TR < VC (or P < AVC)

Competitive firm’s short-run supply curve

The portion of its marginal-cost curve

That lies above average variable cost

Figure 3 The Competitive Firm’s Short-Run Supply Curve

Profit Maximization, Part 6

Sunk cost

A cost that has already been committed and cannot be recovered

Should be ignored when making decisions

“Don’t cry over spilt milk”

“Let bygones be bygones”

In the short run, fixed costs are sunk costs

Near-empty Restaurants & Off-season Miniature Golf, Part 1

Restaurant – stay open for lunch?

Fixed costs: not relevant; are sunk costs in short run

Variable costs, VC: relevant

Shut down if revenue from lunch < VC

Stay open if revenue from lunch > VC

Staying open can be profitable, even with many tables empty.

Near-empty Restaurants & Off-season Miniature Golf, Part 2

Operator of a miniature-golf course

Ignore fixed costs

Shut down if

Revenue < variable costs

Stay open if

Revenue > variable costs

Profit Maximization, Part 7

Firm’s long-run decision

Exit the market if

Total revenue < total costs; TR < TC (same as: P < ATC)

Enter the market if

Total revenue > total costs; TR > TC (same as: P > ATC)

Competitive firm’s long-run supply curve

The portion of its marginal-cost curve that lies above average total cost

Figure 4 The Competitive Firm’s Long-Run Supply Curve

Profit Maximization, Part 8

Measuring profit

If P > ATC

Profit = TR – TC = (P – ATC) ˣ Q

If P < ATC

Loss = TC - TR = (ATC – P) ˣ Q

= Negative profit

Figure 5 Profit as the Area between Price and Average Total Cost

Supply Curve, Part 1

Short run: market supply with a fixed number of firms

Short run: number of firms is fixed

Each firm supplies quantity where P = MC

For P > AVC: supply curve is MC curve

Market supply

Add up quantity supplied by each firm

Figure 6 Short-Run Market Supply

Supply Curve, Part 2

Long run

Firms can enter and exit the market

If P > ATC, firms make positive profit

New firms enter the market

If P < ATC, firms make negative profit

Firms exit the market

Supply Curve, Part 3

Long run

Process of entry and exit ends when

Firms still in market make zero economic profit (P = ATC)

Because MC = ATC: Efficient scale

Long run supply curve is perfectly elastic

Horizontal at minimum ATC

Figure 7 Long-Run Market Supply

Supply Curve, Part 4

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

Profit = total revenue – total cost

Total cost includes all opportunity costs

Zero-profit equilibrium

Economic profit is zero

Accounting profit is positive

“We’re a nonprofit organization - we don’t intend to be, but we are!”

Supply Curve, Part 5

Market in long run equilibrium

P = minimum ATC

Zero economic profit

Increase in demand

Demand curve shifts outward

Short run

Higher quantity

Higher price: P > ATC, positive economic profit

Supply Curve, Part 6

Positive economic profit in short run

Long run – firms enter the market

Short run supply curve – shifts right

Price – decreases back to minimum ATC

Quantity – increases

Because there are more firms in the market

Efficient scale

Figure 8 An Increase in Demand in the Short Run and Long Run (a)

Figure 8 An Increase in Demand in the Short Run and Long Run (b)

Figure 8 An Increase in Demand in the Short Run and Long Run (c)

Supply Curve, Part 7

Long-run supply curve might slope upward

Some resource used in production may be available only in limited quantities

Increase in quantity supplied – increase in costs – increase in price

Firms may have different costs

Some firms earn profit even in the long run

Long-run supply curve

More elastic than short-run supply curve