sss/Principles of Microeconomics

Spring 2019 Prin iples of Mi roe onomi s T. Tung

Part XIV

Firms in a Competitive Market

A Competitive Market has the following attributes:

� There are many buyers and many sellers in the market

� The goods o�ered by the various sellers are largely the same (Essentially, there is a homogenous good in the

market)

� Buyers and sellers must a ept the pri e the market determines and are pri e takers.

� Firms an freely enter or exit the market

� Close real world examples of ompetitive markets are milk or wheat.

The Revenue of a Competitive Firm

� Firms in a ompetitive market still look to maximize pro�ts:

Pro�t = Total Revenue - Total Cost

� Sin e �rms are pri e takers in ompetitive markets, the level of output of the �rm will di tate the total revenue.

Total revenue will in rease when a greater quantity is sold.

� Similar to a �rm's ost urves, there will be two key ways to analyze revenues:

� Average Revenue: Total revenue divided by the quantity sold.

� How mu h revenue the supplier re eives for the typi al unit.

* For all �rms, average revenue equals the pri e of the good.

� Marginal Revenue: The hange in total revenue from an additional unit sold.

* For all �rms, marginal revenue equals the pri e of the good.

v

Revenue Chart for a Milk Produ er, Pri e = $6:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Pro�t Maximization and the Competitive Firm's Supply Curve:

� Firms will hoose the level of quantity that maximizes pro�ts.

� Through observation of the marginal revenue and the marginal ost, �rms an determine the optimal

level of quantity

� Whenever marginal revenue is greater than the marginal ost, the �rm should in rease the produ tion of the

good.

� However, if MR < MC the �rm should de rease produ tion.

� The following hart demonstrate the optimal level of quantity for the same milk produ er:

� The �rm maximizes pro�t at a quantity of 4 or 5 gallons of milk

The Marginal-Cost Curve and the Firm's Supply De ision

� From the previous hapter, we know that the marginal- ost urve (MC) is upward sloping and the average-

total- ost (ATC) is U-Shaped.

� The MC urve interse ts the ATC at the minimum point on the ATC

� Sin e �rms are pri e takers, the pri e (P) is represented by a horizontal line. This is the market pri e that

�rms will have to �trade� at.

� What is the quantity that maximizes pro�t?

� We an use the following �gure to determine this optimal level:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� When the quantity is below Qmax, MR > MC so the �rm an boost pro�ts by raising produ tion

� When the quantity is above Qmax, MR < MC so the �rm an boost pro�ts by de reasing produ tion

� The pro�t-maximizing quantity (Qmax) is found where the horizontal pri e line interse ts the

MC urve

� Firms will respond to an in rease in pri e by in reasing the level of produ tion. This is be ause the pri e is

the marginal revenue for the �rm. When marginal revenue in reases, the �rm should in rease produ tion to

apitalize

� Be ause the �rm's marginal- ost urve determines the quantity of the good the �rm is

willing to supply at any pri e, the marginal- ost urve is also the ompetitive �rm's supply

urve.

The Firm's Short-Run De ision to Shut Down:

� In ertain ir umstan es, �rms may de ide to shut down and not produ e anything at all

� Shutdown: Short-run de ision not to produ e anything during a spe i� period of time due to urrent

market onditions

� Exit: Refers to long-run de ision to exit the market

* During a temporary shutdown, �xed osts still need to be paid as the �rm may de ide to produ e

more in the future (Ex: Continuing to pay rent after temporarily shutting produ tion down)

* When a �rm permanently exits a market, produ tion will never ontinue & there will be no �xed

osts.

� Fixed osts determine whether it is worth it to shut down or not

� In the short run, �rms an not avoid their �xed osts

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� In the long run, �rms an avoid their �xed osts

� Fixed osts are also viewed as sunk osts as they are lost before produ tion even begins

Firms shut down if the revenue that it would earn from produ ing is less than its variable ost of

produ tion:

� Mathemati al Cal ulation:

Shutdown if T R < V C

� The �rm should shut down if total revenue is less than variable ost. We next divide both sides of the

inequality by Q:

Shutdown if

T R Q

< V C Q

� The left side of the inequality, TR/Q is total revenue P*Q divided by quantity � whi h is also average revenue

and an be expressed as the good's pri e, P

� The right side of the inequality is also average variable ost, AVC. We an rewrite the equation as:

Shutdown if P < AV C

� The ompetitive �rm's short-run supply urve is the portion of its marginal- ost urve that lies above average

variable ost

Spilled Milk and Other Sunk Costs:

� Sunk Cost: A ost that has already been ommitted and annot be re overed

� Be ause nothing an be done about sunk osts, you an ignore them when making business strategy

de isions

� Fixed/Sunk osts an not be re overed by temporarily shutting down. They an not be ignored when de iding

how mu h to produ e:

The Firm's Long-Run De ision to Exit or Enter a Market:

� Firms exit the market if the revenue it would get from produ ing is less than its total osts.

� If TR stands for total revenue, and TC stands for total ost, then the �rm's exit riterion an be written as:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

Exit if T R < T C

� We an divide both sides of the inequality by the quantity Q:

Exit if

T R Q

< T C Q

� We an simplify the expression like above:

Exit if P < AT C

� The riterion for entry is exa tly the opposite of the riterion for exit.

� The ompetitive �rm's long-run supply urve is the portion of its marginal- ost urve that lies above average

total ost:

Measuring Pro�t in Our Graph for the Competitive Firm:

Profit = T R − T C

� On e again, we divide both sides of the inequality by Q:

Profit = (T R/Q − T C/Q) ∗ Q

� Again, note that TR/Q is average revenue, whi h is the pri e, P, and TC/Q is average total ost, ATC:

Profit = (P − AT C) ∗ Q

� We an graphi ally show positive and negative pro�ts:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

The Supply Curve in Competitive Market:

� We will utilize the assumption of a �xed number of sellers in the short run and an adjusting amount in the

long run:

� When there is a �xed amount of sellers in the short run, ea h �rm supplies a quantity of output so that its

marginal ost equals the pri e.

� This an be demonstrated visually with 1,000 identi al �rms and di�erent levels of ost.

The Long Run: Market Supply with Entry and Exit:

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Spring 2019 Prin iples of Mi roe onomi s T. Tung

� In the long run, free entry and exit from the market drives produ ers to enter a market when there is a pro�t

and exit when there is a loss

� Assumption: Every �rm has the same produ tion for produ ing goods & a ess to the same markets for

buying inputs. Thus, every �rm had the same ost urves.

� Whenever P > ATC, �rms will de ide to enter the market. On the other hand, whenever P < ATC �rms will

exit the market.

� Thus, the overall result is that �rms that remain in the market must be making zero e onomi pro�t. (This

an be onsidered a stasis point).

Firm's Pro�t = (P − AT C) ∗ Q

� Competitive �rms maximize pro�ts by hoosing a quantity of produ tion where marginal revenue = marginal

ost.

� We just on�rmed that in the long run, free entry & exit for e the pri e = ATC.

� Given that marginal revenue is equal to the pri e, produ tion will have to o ur at the point where ATC

= MC.

� The only point where these two urves interse t is at the minimum of ATC.

� In the long-run equilibrium of a ompetitive market with free entry and exit, �rms must

be operating at their e� ient s ale:

Competitive �rms stay in business be ause they are making zero e onomi pro�t. E onomi pro�t

a ounts for the non ash �ow opportunity osts (foregone wages, other alternatives et .) and it is

this type of pro�t that is equal to 0 in the long run. Thus, �rms will hoose to stay in the market

be ause all opportunity osts are overed.

The following example demonstrate the impa t of a hange in the market and �rm supply urves given ertain

shifts:

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