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C H A P T E R

Firms in Competitive Markets

Microeconomics P R I N C I P L E S O F

N. Gregory Mankiw

Premium PowerPoint Slides

by Ron Cronovich

14

In this chapter,

look for the answers to these questions:

 What is a perfectly competitive market?

 What is marginal revenue? How is it related to total and average revenue?

 How does a competitive firm determine the quantity that maximizes profits?

 When might a competitive firm shut down in the short run? Exit the market in the long run?

 What does the market supply curve look like in the short run? In the long run?

1

FIRMS IN COMPETITIVE MARKETS 2

Introduction: A Scenario

 Three years after graduating, you run your own

business.

 You must decide how much to produce, what price

to charge, how many workers to hire, etc.

 What factors should affect these decisions?

 Your costs (studied in preceding chapter)

 How much competition you face

 We begin by studying the behavior of firms in

perfectly competitive markets.

FIRMS IN COMPETITIVE MARKETS 3

Characteristics of Perfect Competition

1. Many buyers and many sellers.

2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

 Because of 1 & 2, each buyer and seller is a

“price taker” – takes the price as given.

FIRMS IN COMPETITIVE MARKETS 4

The Revenue of a Competitive Firm

 Total revenue (TR)

 Average revenue (AR)

 Marginal revenue (MR):

The change in TR from

selling one more unit.

∆TR

∆Q MR =

TR = P x Q

TR

Q AR = = P

A C T I V E L E A R N I N G 1

Calculating TR, AR, MR

5

Fill in the empty spaces of the table.

$50$105

$40$104

$103

$102

$10$101

n/a$100

TRPQ MRAR

$10

A C T I V E L E A R N I N G 1

Answers

6

Fill in the empty spaces of the table.

$50$105

$40$104

$103

$10

$10

$10

$10$102

$10$101

n/a

$30

$20

$10

$0$100

TR = P x QPQ ∆TR

∆Q MR =

TR

Q AR =

$10

$10

$10

$10

$10

Notice that

MR = P

FIRMS IN COMPETITIVE MARKETS 7

MR = P for a Competitive Firm

 A competitive firm can keep increasing its output

without affecting the market price.

 So, each one-unit increase in Q causes revenue

to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

FIRMS IN COMPETITIVE MARKETS 8

Profit Maximization

 What Q maximizes the firm’s profit?

 To find the answer, “think at the margin.”

If increase Q by one unit,

revenue rises by MR,

cost rises by MC.

 If MR > MC, then increase Q to raise profit.

 If MR < MC, then reduce Q to raise profit.

FIRMS IN COMPETITIVE MARKETS 9

Profit Maximization

505

404

303

202

101

45

33

23

15

9

$5$00

Profit = MR – MC

MCMRProfitTCTRQAt any Q with

MR > MC,

increasing Q

raises profit.

5

7

7

5

1

–$5

10

10

10

10

–2

0

2

4

$6

12

10

8

6

$4$10

(continued from earlier exercise)

At any Q with

MR < MC,

reducing Q

raises profit.

FIRMS IN COMPETITIVE MARKETS 10

P1 MR

MC and the Firm’s Supply Decision

At Qa, MC < MR.

So, increase Q

to raise profit.

At Qb, MC > MR.

So, reduce Q

to raise profit.

At Q1, MC = MR.

Changing Q

would lower profit. Q

Costs

MC

Q1Qa Qb

Rule: MR = MC at the profit-maximizing Q.

FIRMS IN COMPETITIVE MARKETS 11

P1 MR

P2 MR2

MC and the Firm’s Supply Decision

If price rises to P2,

then the profit-

maximizing quantity

rises to Q2.

The MC curve

determines the

firm’s Q at any price.

Hence,

Q

Costs

MC

Q1 Q2

the MC curve is the

firm’s supply curve.

FIRMS IN COMPETITIVE MARKETS 12

Shutdown vs. Exit

 Shutdown:

A short-run decision not to produce anything

because of market conditions.

 Exit:

A long-run decision to leave the market.

 A key difference:

 If shut down in SR, must still pay FC.

 If exit in LR, zero costs.

FIRMS IN COMPETITIVE MARKETS 13

A Firm’s Short-run Decision to Shut Down

 Cost of shutting down: revenue loss = TR

 Benefit of shutting down: cost savings = VC

(firm must still pay FC)

 So, shut down if TR < VC

 Divide both sides by Q: TR/Q < VC/Q

 So, firm’s decision rule is:

Shut down if P < AVC

FIRMS IN COMPETITIVE MARKETS 14

The firm’s SR

supply curve is

the portion of

its MC curve

above AVC.

Q

Costs

A Competitive Firm’s SR Supply Curve

MC

ATC

AVC

If P > AVC, then

firm produces Q

where P = MC.

If P < AVC, then

firm shuts down

(produces Q = 0).

FIRMS IN COMPETITIVE MARKETS 15

The Irrelevance of Sunk Costs

 Sunk cost: a cost that has already been

committed and cannot be recovered

 Sunk costs should be irrelevant to decisions;

you must pay them regardless of your choice.

 FC is a sunk cost: The firm must pay its fixed

costs whether it produces or shuts down.

 So, FC should not matter in the decision to shut

down.

FIRMS IN COMPETITIVE MARKETS 16

A Firm’s Long-Run Decision to Exit

 Cost of exiting the market: revenue loss = TR

 Benefit of exiting the market: cost savings = TC

(zero FC in the long run)

 So, firm exits if TR < TC

 Divide both sides by Q to write the firm’s

decision rule as:

Exit if P < ATC

FIRMS IN COMPETITIVE MARKETS 17

A New Firm’s Decision to Enter Market

 In the long run, a new firm will enter the market if

it is profitable to do so: if TR > TC.

 Divide both sides by Q to express the firm’s

entry decision as:

Enter if P > ATC

FIRMS IN COMPETITIVE MARKETS 18

The firm’s

LR supply curve

is the portion of

its MC curve

above LRATC.

Q

Costs

The Competitive Firm’s Supply Curve

MC

LRATC

A C T I V E L E A R N I N G 2

Identifying a firm’s profit

19

Determine

this firm’s

total profit.

Identify the

area on the

graph that

represents

the firm’s

profit.

Q

Costs, P

MC

ATC

P = $10 MR

50

$6

A competitive firm

A C T I V E L E A R N I N G 2

Answers

20

profit

Q

Costs, P

MC

ATC

P = $10 MR

50

$6

A competitive firm

Profit per unit

= P – ATC

= $10 – 6

= $4

Total profit

= (P – ATC) x Q

= $4 x 50

= $200

A C T I V E L E A R N I N G 3

Identifying a firm’s loss

21

Determine

this firm’s

total loss,

assuming

AVC < $3.

Identify the

area on the

graph that

represents

the firm’s

loss. Q

Costs, P

MC

ATC

A competitive firm

$5

P = $3 MR

30

A C T I V E L E A R N I N G 3

Answers

22

loss MRP = $3

Q

Costs, P

MC

ATC

A competitive firm

loss per unit = $2

Total loss

= (ATC – P) x Q

= $2 x 30

= $60

$5

30

FIRMS IN COMPETITIVE MARKETS 23

Market Supply: Assumptions

1) All existing firms and potential entrants have

identical costs.

2) Each firm’s costs do not change as other firms

enter or exit the market.

3) The number of firms in the market is

 fixed in the short run

(due to fixed costs)

 variable in the long run

(due to free entry and exit)

FIRMS IN COMPETITIVE MARKETS 24

The SR Market Supply Curve

 As long as P ≥ AVC, each firm will produce its

profit-maximizing quantity, where MR = MC.

 Recall from Chapter 4:

At each price, the market quantity supplied is

the sum of quantities supplied by all firms.

FIRMS IN COMPETITIVE MARKETS 25

The SR Market Supply Curve

MC

P2

Market

Q

P

(market)

One firm

Q

P

(firm)

S

P3

Example: 1000 identical firms

At each P, market Qs = 1000 x (one firm’s Qs)

AVC P2

P3

30

P1

2010

P1

30,00010,000 20,000

FIRMS IN COMPETITIVE MARKETS 26

Entry & Exit in the Long Run

 In the LR, the number of firms can change due to

entry & exit.

 If existing firms earn positive economic profit,

 new firms enter, SR market supply shifts right.

 P falls, reducing profits and slowing entry.

 If existing firms incur losses,

 some firms exit, SR market supply shifts left.

 P rises, reducing remaining firms’ losses.

FIRMS IN COMPETITIVE MARKETS 27

The Zero-Profit Condition

 Long-run equilibrium:

The process of entry or exit is complete –

remaining firms earn zero economic profit.

 Zero economic profit occurs when P = ATC.

 Since firms produce where P = MR = MC,

the zero-profit condition is P = MC = ATC.

 Recall that MC intersects ATC at minimum ATC.

 Hence, in the long run, P = minimum ATC.

FIRMS IN COMPETITIVE MARKETS 28

Why Do Firms Stay in Business if Profit = 0?

 Recall, economic profit is revenue minus all costs

– including implicit costs, like the opportunity cost

of the owner’s time and money.

 In the zero-profit equilibrium,

 firms earn enough revenue to cover these costs

 accounting profit is positive

FIRMS IN COMPETITIVE MARKETS 29

The LR Market Supply Curve

MC

Market

Q

P

(market)

One firm

Q

P

(firm)

In the long run,

the typical firm

earns zero profit.

LRATC

long-run supply

P =

min.

ATC

The LR market supply

curve is horizontal at

P = minimum ATC.

FIRMS IN COMPETITIVE MARKETS 30

S1

Profit

D1

P1 long-run supply

D2

SR & LR Effects of an Increase in Demand

MC

ATC

P1

Market

Q

P

(market)

One firm

Q

P

(firm)

P2P2

Q1 Q2

S2

Q3

A firm begins in

long-run eq’m…

…but then an increase

in demand raises P,……leading to SR

profits for the firm.

Over time, profits induce entry,

shifting S to the right, reducing P…

…driving profits to zero

and restoring long-run eq’m.

A

B

C

FIRMS IN COMPETITIVE MARKETS 31

Why the LR Supply Curve Might Slope Upward

 The LR market supply curve is horizontal if

1) all firms have identical costs, and

2) costs do not change as other firms enter or

exit the market.

 If either of these assumptions is not true,

then LR supply curve slopes upward.

FIRMS IN COMPETITIVE MARKETS 32

1) Firms Have Different Costs

 As P rises, firms with lower costs enter the market

before those with higher costs.

 Further increases in P make it worthwhile

for higher-cost firms to enter the market,

which increases market quantity supplied.

 Hence, LR market supply curve slopes upward.

 At any P,

 For the marginal firm,

P = minimum ATC and profit = 0.

 For lower-cost firms, profit > 0.

FIRMS IN COMPETITIVE MARKETS 33

2) Costs Rise as Firms Enter the Market

 In some industries, the supply of a key input is

limited (e.g., amount of land suitable for farming

is fixed).

 The entry of new firms increases demand for this

input, causing its price to rise.

 This increases all firms’ costs.

 Hence, an increase in P is required to increase

the market quantity supplied, so the supply curve

is upward-sloping.

FIRMS IN COMPETITIVE MARKETS 34

CONCLUSION: The Efficiency of a Competitive Market

 Profit-maximization: MC = MR

 Perfect competition: P = MR

 So, in the competitive eq’m: P = MC

 Recall, MC is cost of producing the marginal unit.

P is value to buyers of the marginal unit.

 So, the competitive eq’m is efficient, maximizes

total surplus.

 In the next chapter, monopoly: pricing &

production decisions, deadweight loss, regulation.

CHAPTER SUMMARY

 For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.

 If P > AVC, a firm maximizes profit by producing

the quantity where MR = MC. If P < AVC, a firm

will shut down in the short run.

 If P < ATC, a firm will exit in the long run.

 In the short run, entry is not possible, and an

increase in demand increases firms’ profits.

 With free entry and exit, profits = 0 in the long run,

and P = minimum ATC. 35