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Firms in Competitive Markets

Survey of ECON

Robert L. Sexton

Chapter 7

Chapter 7 Sections

– A Perfectly Competitive Market

– An Individual Price Taker’s Demand Curve

– Profit Maximization

– Short-Run Profits and Losses

– Long-Run Equilibrium

– Long-Run Supply

A Perfectly Competitive Market

Section 1

SECTION 1 QUESTIONS

A Perfectly Competitive Market

Many Buyers and Sellers

In a perfectly competitive market, there are many buyers and sellers.
Because each firm is so small in relation to the industry, its production decisions have no impact on the market.
For this reason, perfectly competitive firms are called price takers.

Consumers believe that all firms in perfectly competitive markets sell identical or homogeneous products.
For example, in the wheat market we are assuming that it is not possible to determine any significant and consistent qualitative differences in the wheat produced by different farmers.

Identical (Homogeneous) Products

Product markets characterized by perfect competition have no significant barriers to entry or exit.
This means that it is fairly easy for entrepreneurs to become suppliers of the product or, if they are already producers, to stop supplying the product.

Easy Entry and Exit

Barriers to entry are modest, so large numbers of firms can enter the business if they so desire.
Because of easy market entry and exit, perfectly competitive markets generally consist of a large number of small suppliers.

Easy Entry and Exit

Highly organized markets for securities and agricultural commodities are the best examples of perfectly competitive markets.

Perfectly Competitive Markets: Examples

While the assumptions for perfect competition may seem a bit unrealistic, the model is useful.
Many markets resemble perfect competition: firms face very elastic demand curves and relatively easy entry and exit.
It gives us a standard of comparison.

Easy Entry and Exit

Section 1

An Individual Price Taker’s Demand Curve

Section 2

SECTION 2 QUESTIONS

An Individual Price Taker’s Demand Curve

Perfectly competitive firms are price takers, selling at the market-determined price.
An individual seller cannot sell at any price higher than the current market price because buyers could purchase the same good from someone else at the market price.
A seller would not charge a lower price when he could sell all he wants at the market price.

An Individual Firm’s
Demand Curve

In a perfectly competitive market, an individual seller can change his output and it will not alter the market price.
Each producer provides such a small fraction of the total supply that a change in the amount he or she offers does not have a noticeable effect on market price.

In a perfectly competitive market, then, an individual firm can sell as much as it wishes to place on the market at the prevailing price.
The demand, as seen by the seller, is perfectly elastic at the market price.

An Individual Firm’s
Demand Curve

A perfectly competitive seller won't charge more than the market price because no one will buy at higher prices, and will not charge less because the seller can sell all she wants at the market price.
Thus, the demand curve is horizontal at the market price over the entire range of output that she could possibly produce.

An Individual Firm’s
Demand Curve

Exhibit 7.1: Market and Individual Firm Demand Curves in a Perfectly Competitive Market

The position or height of each firm’s demand curve varies with every change in the market price.
Sellers are provided with current information about market demand and supply conditions as a result of price changes.

A Change in Market Price and the Firm’s Demand Curve

The perfectly competitive model does not assume any knowledge on the part of individual buyers and sellers about market demand and supplythey only have to know the price of the good they sell.

A Change in Market Price and the Firm’s Demand Curve

Exhibit 7.2: Market Prices and the Position of a Firm’s Demand Curve

Section 2

Profit Maximization

Section 3

SECTION 3 QUESTIONS

Profit Maximization

The firm’s objective is to maximize profits.
It wants to produce the amount that maximizes the difference between its total revenues and total costs.

Total revenue for a perfectly competitive firm equals the market price of the good (P) times the quantity (q) of units sold.

Total Revenue

TR = P × q

TOTAL REVENUE (TR)

the product price times the quantity sold

Average Revenue and Marginal Revenue

AVERAGE REVENUE (AR)

the total revenue divided by the number of units sold

MR = ΔTR ÷ Δq

MARGINAL REVENUE (MR)

the increase in total revenue resulting from a one-unit increase in sales

AR = TR ÷ q

= (P × q) ÷ q

In a perfectly competitive market, additional units of output can be sold without reducing the market price.
Therefore, marginal revenue is constant and equal to the market price, which is also the average revenue.

Average Revenue and Marginal Revenue

In perfect competition, marginal revenue, average revenue, and price are all equal:

P = MR = AR

Average Revenue, Marginal Revenue, and Price

Exhibit 7.3: Revenues for a Perfectly Competitive Firm

In all types of market environments, the firm will maximize its profits at the level of output that maximizes the difference between total revenue and total cost, which is at the same output level at which marginal revenue equals marginal cost.

How Do Firms Maximize Profits?

Equating Marginal Revenue and Marginal Cost

The importance of equating marginal revenue and marginal costs for maximizing profits is straightforward.

As long as the marginal revenue derived from expanded output exceeds the marginal cost of that output, the expansion of output creates additional profits.
However, expansion of output when the marginal cost of production exceeds marginal revenue will lead to losses on the additional output, decreasing profits.

Equating Marginal Revenue and Marginal Cost

The profit-maximizing output rule says a firm should always produce where its
MR = MC.

The Profit-Maximizing Level of Output

Exhibit 7.4: Finding the Profit-Maximizing Level of Output

As long as marginal revenue exceeds marginal cost, producing and selling those units add more to revenues than to costs; in other words, they add to profits.
However, once the production is expanded beyond four units of output, the costs are less than the marginal revenues, and profits begin to fall.

The Profit-Maximizing Level of Output

Exhibit 7.5: Cost and Revenue Calculations for a Perfectly Competitive Firm

Section 3

Short-Run Profits and Losses

Section 4

SECTION 4 QUESTIONS

Short-Run Profits and Losses

Producing at the profit-maximizing output level does not mean that a firm is actually generating profits.
It merely means that a firm is maximizing its profit opportunity at a given price level.
A firm could be:
Earning profits
Generating losses
Breaking even

Three easy steps to determine economic profits, economic losses, or zero economic profits:

Where MR equals MC proceed down to horizontal axis to find q*, the profit-maximizing output level.

At q*, go straight up to demand curve, then to price axis to find the market price, P*. Now you can find TR at the profit-maximizing output level because TR = P x q.

The Three-Step Method

The last step is to find total costs. Go straight up from q* to the short-run average total cost (SRATC) curve; this will give you the average cost per unit. If we multiply average total costs by the output level, we can find the total costs TC = ATC x q.

The Three-Step Method

If TR > TC at the profit-maximizing output level, the firm is generating economic profits.
If TR < TC, the firm is generating economic losses.
If TR = TC, the firm is earning zero economic profits,
Covering both implicit and explicit costs, economists sometimes call zero economic profit a normal rate of return.

The Three-Step Method

Exhibit 7.6: Short-Run Profits, Losses, and Zero Economic Profits

Alternatively, to find total economic profits we can take the product price at P* and subtract the ATC at q*. This will give us per-unit profit. If we multiply this by output, we will arrive at total economic profit. Or (P* - ATC) × q* = total economic profit.
Economists sometimes call the zero economic profit a normal rate of return.
That is, the owners are doing as well as they could elsewhere, in that they are getting the normal rate of return on the resources they invested in the firm.

The Three-Step Method

A firm generating an economic loss faces a tough choice.
Should it continue to produce or shut down its operation?
To make this decision, we need to consider average variable costs.

Evaluating Economic Losses in the Short Run

If a firm cannot generate enough revenues to cover its variable costs, then it will have larger losses if it operates than if it shuts down (losses in that case = fixed costs).
Thus, a firm will not produce at all unless the price is greater than its average variable costs.

Evaluating Economic Losses in the Short Run

At price levels greater than or equal to average variable costs, a firm may continue to operate in the short run even if average total costs—variable and fixed costs—are not completely covered.
Because fixed costs continue whether the firm produces or not, it is better to earn enough to cover a portion of these costs than to earn nothing at all.

Operating at a Loss

When price is less than average total costs but more than average variable costs, the firm produces in the short run, but at a loss.
To shut down would make this firm worse off because it can cover at least some of its fixed costs with the excess of revenue over its variable costs.

Operating at a Loss

Exhibit 7.7: Short-Run Losses: Price above AVC but below ATC

When the price a firm is able to obtain for its product is below its average variable costs at all ranges of output, it is unable to cover even its variable costs in the short run.
Since it is losing even more than the fixed costs it would lose if it shut down, it is more logical for the firm to cease operations.

The Decision to Shut Down

Exhibit 7.8: Short-Run Losses: Price below AVC

At all prices above minimum AVC, a firm produces in the short run, even if ATC is not completely covered.
At all prices below the minimum AVC, the firm shuts down.
Therefore, the short-run supply curve of an individual competitive seller is identical to that portion of the MC curve that lies above the minimum of the AVC curve.

The Short-Run Supply Curve

As a cost relation, the MC curve above minimum AVC shows the marginal cost of producing any given output.
As a supply curve, the MC curve above minimum AVC shows the equilibrium output that the firm will supply at various prices in the short run.

The Short-Run Supply Curve

Beyond the point of lowest AVC, the MC of successively larger outputs are progressively greater, so the firm will supply larger amounts only at higher prices.

The Short-Run Supply Curve

Exhibit 7.9: The Firm’s Short-Run Supply Curve

The short-run market supply curve
is the summation of all the individual firms’ supply curves (that is, the portion of the firms’ MC above AVC) in the market.
Because the short run is too brief for new firms to enter the market, the market supply curve is the summation of existing firms.

Deriving the Short-Run
Market Supply Curve

Exhibit 7.10: Deriving the Short-Run Market Supply Curve

Section 4

Long-Run Equilibrium

Section 5

SECTION 5 QUESTIONS

Long-Run Equilibrium

If perfectly competitive producers make economic profits:
Resources devoted to that lucrative business increase.
More firms enter the industry and existing firms expand, shifting the market supply curve to the right over time.
The impact of increasing supply, other things equal, is to reduce the equilibrium price.

As entry into the profitable industry pushes down the market price, producers will move from making a profit (P > ATC) to zero economic profits (P = ATC).
In long‑run equilibrium, perfectly competitive firms make zero economic profits, earning a normal return on the use of their capital.

Long-Run Equilibrium

Zero economic profits is an equilibrium or stable situation because any positive economic (above‑normal) profits signal resources into the industry, beating down prices and thus revenues to the firm.

Long-Run Equilibrium

Economic losses signal resources to leave the industry, causing supply reductions that lead to increased prices and higher firm revenues to the remaining firms.
Only at zero economic profits is there no tendency for firms to either enter or leave the business.

Long-Run Equilibrium

Exhibit 7.11: Profits Disappear with Entry

Exhibit 7.12: Losses Disappear with Exit

The long‑run competitive equilibrium for a perfectly competitive firm can be graphically illustrated.
Where MC = MR, short-run and long-run average total costs are also equal.
The ATC curves touch the MC and MR (demand) curves at the equilibrium output point.

The Long‑Run Equilibrium for the Competitive Firm

Because the MR curve is also the AR curve, average revenues and average total costs are equal at the equilibrium point.

The Long‑Run Equilibrium for the Competitive Firm

The long-run equilibrium output in perfect competition occurs at the lowest point on the ATC curve, so the equilibrium condition in the long run in perfect competition is for firms to produce at that output that minimizes per-unit total costs.

The Long‑Run Equilibrium for the Competitive Firm

Exhibit 7.13: The Long-Run Competitive Equilibrium

Section 5

Long-Run Supply

Section 6

SECTION 6 QUESTIONS

Long-Run Supply

When the output of an entire industry changes, the likelihood is greater that changes in costs will occur.
The three possible types of industries seen when considering long-run supply are:
Constant-costs
Increasing-costs
Decreasing-cost
The shape of the long-run supply curve depends on the extent to which input costs change when there is entry or exit of firms in the industry.

In a constant-cost industry, the prices of inputs do not change as output is expanded. The industry does not use inputs in sufficient quantities to affect input prices.

A Constant-Cost Industry

Because the industry is one of constant costs, industry expansion does not alter firms’ cost curves, and the industry long-run supply curve is horizontal.

A Constant-Cost Industry

The short-run higher profits from an increase in demand attracts entry until long-run equilibrium is again reached.
The long‑run equilibrium price is at the same level that prevailed before demand increased.
The only long‑run effect of the increase in demand is an increase in industry output.

A Constant-Cost Industry

Exhibit 7.14: Demand Increase in a Constant-Cost Industry

In an increasing-cost industry, the cost curves of the individual firms rise as the total output of the industry increases.

An Increasing-Cost Industry

When an industry utilizes a large portion of an input, input prices will rise when the industry uses more of that input as it expands output, which will shift firms’ cost curves upward.

An Increasing-Cost Industry

For example, if a construction boom occurs in a fully employed economy, would it be more costly to obtain additional resources such as workers and raw materials?
Yes, as an increasing-cost industry, the industry can only produce more output if it gets a higher price, because the firm’s costs of production rise as output expands.

An Increasing-Cost Industry: Example

As new firms enter and output expands, the increase in demand for inputs causes the price of inputs to rise—the cost curves of all construction firms shift upward as the industry expands.
The industry can produce more output, but only at a higher price, enough to compensate the firm for the higher input costs.
In an increasing-cost industry, the long-run supply curve is upward sloping.

An Increasing-Cost Industry

A firm experiences lower cost as an industry expands. The new long-run market equilibrium has more output at a lower price—that is, the long-run supply curve for a decreasing-cost industry is downward sloping.
This situation might occur in the computer industry.

A Decreasing-Cost Industry

The firms in the industry may be able to acquire computer chips at a lower price as the industry’s demand for computer chips rises.
The marginal and average costs of the firm fall as input prices fall because of expanded output in the industry.
In this case, the LRS curve would be negatively sloped.

A Decreasing-Cost Industry

PRODUCTIVE EFFICIENCY

requires that firms produce goods and services in the least costly way

This is where P = minimum ATC.
The output that results from equilibrium conditions of market demand and supply in perfectly competitive markets is economically efficient.

Perfect Competition and
Economic Efficiency

Once the competitive equilibrium is reached, the buyers’ marginal benefit equals the sellers’ marginal cost.
That is, in a competitive market, producers efficiently use their scarce resources (labor, machinery, and other inputs) to produce what consumers want.

Perfect Competition and
Economic Efficiency

In this sense, perfect competition achieves allocative efficiency.
Allocative efficiency is where P = MC and production will be allocated to reflect consumer preferences.

Perfect Competition and
Economic Efficiency

Exhibit 7.15: Allocative Efficiency and Perfect Competition

Section 6