14
The Big Picture
Firms in Competitive Markets
•
•
PRINCIPLES OF
ECONOMICS
Chapter 13: The cost of production
Now, we will look at firm’s revenue
– But revenue depends on market structure
1.
2.
3.
4.
FOURTH EDITION
N. G R E G O R Y M A N K I W
Premium PowerPoint® Slides
by Ron Cronovich
2008 update
Modified by Joseph Tao-yi Wang
Competitive market (this chapter)
Monopoly (chapter 15)
Oligopoly (chapter 16)
Monopolistic Composition (chapter 17)
– Are there other types of markets? Yes, not now
© 2008 South-Western, a part of Cengage Learning, all rights reserved
Introduction: A Scenario
In this chapter, look for the answers to
these questions:
What is a perfectly competitive market?
Three years after graduating, you run your own
business.
You must decide how much to produce, what price
What is marginal revenue? How is it related to
to charge, how many workers to hire, etc.
total and average revenue?
What factors should affect these decisions?
How does a competitive firm determine the
• Your costs (studied in preceding chapter)
• How much competition you face
quantity that maximizes profits?
When might a competitive firm shut down in the
We begin by studying the behavior of firms in
short run? Exit the market in the long run?
perfectly competitive markets.
What does the market supply curve look like in the
short run? In the long run?
CHAPTER 14
FIRMS IN COMPETITIVE MARKETS
2
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3
FIRMS IN COMPETITIVE MARKETS
The Revenue of a Competitive Firm
Characteristics of Perfect Competition
Total revenue (TR)
TR = P x Q
This
This is
is typically
typically resulted
resulted from:
from:
Average revenue (AR)
AR =
TR
=P
Q
1.
1. The
The goods
goods offered
offered for
for sale
sale are
are largely
largely the
the same.
same.
Marginal Revenue (MR):
MR =
∆TR
∆Q
Perfect
Perfect Competition:
Competition: There
There are
are Perfect
Perfect Substitutes
Substitutes
(if
(if don’t
don’t buy
buy from
from you,
you, can
can buy
buy from
from her
her instead)
instead)
The change in TR from
selling one more unit.
2.
2. Many
Many buyers
buyers and
and many
many sellers
sellers (how
(how many?)
many?)
3.
3. Firms
Firms can
can freely
freely enter
enter or
or exit
exit the
the market.
market.
Because of 1 & 2, each buyer and seller is a
“price taker” – takes the price as given.
CHAPTER 14
FIRMS IN COMPETITIVE MARKETS
4
CHAPTER 14
FIRMS IN COMPETITIVE MARKETS
5
ACTIVE LEARNING
Exercise
1:
ACTIVE LEARNING
Answers
Fill in the empty spaces of the table.
Q
P
0
$10
1
$10
2
TR
1:
Fill in the empty spaces of the table.
TR
Q
P
TR = P x Q
n.a.
0
$10
$0
n.a.
$10
1
$10
$10
$10
$10
2
$10
$20
3
$10
3
$10
$30
$10
4
$10
$40
4
$10
$40
$10
5
$10
$50
5
$10
$50
$10
AR
MR
AR =
Q
MR =
∆TR
∆Q
$10
Notice
Notice that
that$10
MR
MR == P
P
$10
$10
$10
$10
$10
6
7
MR = P for a Competitive Firm
Profit Maximization
A competitive firm can keep increasing its output
without affecting the market price.
So, each one-unit increase in Q causes revenue
“Think at the margin.”
to rise by P, i.e., MR = P.
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
MR
MR == P
P is
is only
only true
true for
for
firms
firms in
in competitive
competitive markets.
markets.
CHAPTER 14
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.
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FIRMS IN COMPETITIVE MARKETS
CHAPTER 14
9
FIRMS IN COMPETITIVE MARKETS
Profit Maximization
MC and the Firm’s Supply Decision
(continued from earlier exercise)
Rule: MR = MC at the profit-maximizing Q.
At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.
CHAPTER 14
What Q maximizes the firm’s profit?
To find the answer,
∆Profit =
Profit MR MC
MR – MC
Q
TR
TC
0
$0
$5
–$5
1
10
9
1
2
20
15
5
3
30
23
7
4
40
33
7
5
50
45
5
FIRMS IN COMPETITIVE MARKETS
At Qa, MC < MR.
So, increase Q
to raise profit.
$10 $4
$6
At Qb, MC > MR.
10
6
4
10
8
2
So, reduce Q
to raise profit.
10
10
0
At Q1, MC = MR.
10
12
–2
Changing Q
would lower profit.
10
CHAPTER 14
Costs
MC
MR
P1
Qa Q1 Qb
FIRMS IN COMPETITIVE MARKETS
Q
11
MC and the Firm’s Supply Decision
Shutdown vs. Exit
Shutdown:
If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
The MC curve
determines the
firm’s Q at any price.
A short-run decision not to produce anything
because of market conditions.
Costs
MC
P2
MR2
P1
MR
Hence,
the MC curve is the
firm’s supply curve.
Q1
CHAPTER 14
Q2
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.
Q
FIRMS IN COMPETITIVE MARKETS
12
A Firm’s Short-run Decision to Shut Down
• Cost of shutting down:
• 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:
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FIRMS IN COMPETITIVE MARKETS
A Competitive Firm’s SR Supply Curve
MC
ATC
AVC
If P < AVC, then
firm shuts down
(produces Q = 0).
Shut down if P < AVC
FIRMS IN COMPETITIVE MARKETS
CHAPTER 14
The firm’s SR
Costs
supply curve is
the portion of
its MC curve
If P > AVC, then
above AVC.
firm produces Q
where P = MC.
revenue loss = TR
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Exit:
14
The Irrelevance of Sunk Costs
CHAPTER 14
FIRMS IN COMPETITIVE MARKETS
Q
15
A Firm’s Long-Run Decision to Exit
• Cost of exiting the market:
Sunk cost: a cost that has already been
committed and cannot be recovered
revenue loss = TR
• Benefit of exiting the market:
Sunk costs should be irrelevant to decisions;
cost savings = TC
(zero FC in the long run)
you must pay them regardless of your choice.
FC is a sunk cost: The firm must pay its fixed
So, firm exits if TR < TC.
Divide both sides by Q to write the firm’s
costs whether it produces or shuts down.
So, FC should not matter in the decision to shut
decision rule as:
down.
Exit if P < ATC
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A New Firm’s Decision to Enter Market
The Competitive Firm’s Supply Curve
In the long run, a new firm will enter the market if
The firm’s
LR supply curve
is the portion of
its MC curve
above LRATC.
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
Costs
MC
LRATC
Q
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FIRMS IN COMPETITIVE MARKETS
2 A:
Identifying a firm’
firm’s profit
ACTIVE LEARNING
CHAPTER 14
ACTIVE LEARNING
Identify the
area on the
graph that
represents
the firm’s
profit.
2 A:
Answers
A competitive firm
Determine
this firm’s
total profit.
19
FIRMS IN COMPETITIVE MARKETS
A competitive firm
Costs, P
Costs, P
MC
profit per unit
= P – ATC
= $10 – 6
= $4
MR
ATC
P = $10
MC
MR
ATC
P = $10
profit
$6
$6
Total profit
= (P – ATC) x Q
= $4 x 50
= $200
Q
50
Q
50
20
2 B:
Identifying a firm’
firm’s loss
ACTIVE LEARNING
21
ACTIVE LEARNING
A competitive firm
Determine
this firm’s
total loss,
assuming
AVC < $3.
Identify the
area on the
graph that
represents
the firm’s
loss.
2 B:
Answers
A competitive firm
Costs, P
Costs, P
MC
MC
Total loss
= (ATC – P) x Q
= $2 x 30
= $60
ATC
$5
ATC
$5
P = $3
MR
30
P = $3
Q
loss
loss per unit = $2
MR
30
22
Q
23
The SR Market Supply Curve
Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
As long as P ≥ AVC, each firm will produce its
2) Each firm’s costs do not change as other firms
enter or exit the market.
Recall from Chapter 4:
profit-maximizing quantity, where MR = MC.
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.
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)
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FIRMS IN COMPETITIVE MARKETS
The SR Market Supply Curve
P
entry & exit.
If existing firms earn positive economic profit,
Market
• New firms enter, SR market supply shifts right.
• P falls, reducing profits and slowing entry.
S
P3
P3
P2
P2
AVC
P1
If existing firms incur losses,
P1
10 20 30
Q
(firm)
Q
(market)
10,000
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25
In the LR, the number of firms can change due to
At each P, market Qs = 1000 x (one firm’s Qs)
One firm
MC
FIRMS IN COMPETITIVE MARKETS
Entry & Exit in the Long Run
Example: 1000 identical firms.
P
CHAPTER 14
• some firms exit, SR market supply shifts left.
• P rises, reducing remaining firms’ losses.
20,000 30,000
FIRMS IN COMPETITIVE MARKETS
26
The Zero-Profit Condition
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FIRMS IN COMPETITIVE MARKETS
27
Why Do Firms Stay in Business if Profit = 0?
Long-run equilibrium:
Recall, economic profit is revenue minus all
The process of entry or exit is complete –
remaining firms earn zero economic profit.
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
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.
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29
SR & LR Effects of an Increase in Demand
The LR Market Supply Curve
A firm begins in
…but then an increase
profits
to zero
…leading
to…driving
SR
Over time,
profits
induce
entry,
in
demand
raises
P,…
long-run eq’m…
andfirm.
restoring
long-run
eq’m.
profits for the
shifting
S to the
right, reducing P…
The LR market supply
curve is horizontal at
P = minimum ATC.
In the long run,
the typical firm
earns zero profit.
One firm
P
P
P=
min.
ATC
One firm
MC
P
Market
Profit
LRATC
long-run
supply
Q
(firm)
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30
A
P1
long-run
supply
D1
Q
(firm)
CHAPTER 14
C
Q1 Q2
Q3
D2
Q
(market)
31
FIRMS IN COMPETITIVE MARKETS
1) Firms Have Different Costs
As P rises, firms with lower costs enter the market
The LR market supply curve is horizontal if
before those with higher costs.
1) all firms have identical costs, and
Further increases in P make it worthwhile
2) costs do not change as other firms enter or
exit the market.
for higher-cost firms to enter the market,
which increases market quantity supplied.
If either of these assumptions is not true,
Hence, LR market supply curve slopes upward.
then LR supply curve slopes upward.
FIRMS IN COMPETITIVE MARKETS
S2
B
P2
P2
P1
Why the LR Supply Curve Might Slope Upward
CHAPTER 14
S1
ATC
Q
(market)
FIRMS IN COMPETITIVE MARKETS
Market
P
MC
At any P,
32
•
For the marginal firm,
P = minimum ATC and profit = 0.
•
For lower-cost firms, profit > 0.
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33
FIRMS IN COMPETITIVE MARKETS
CONCLUSION: The Efficiency of a
Competitive Market
2) Costs Rise as Firms Enter the Market
In some industries, the supply of a key input is
limited (e.g., there’s a fixed amount of land
suitable for farming).
The entry of new firms increases demand for this
input, causing its price to rise.
Profit-maximization:
Perfect competition:
So, in the competitive eq’m:
MC = MR
P = MR
P = MC
Recall, MC is cost of producing the marginal unit.
This increases all firms’ costs.
Hence, an increase in P is required to increase
P is value to buyers of the marginal unit.
So, the competitive eq’m is efficient, maximizes
the market quantity supplied, so the supply curve
is upward-sloping.
total surplus.
In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.
CHAPTER 14
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CHAPTER 14
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35
Perfect Competition
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
– Firms enter if P > ATC; exit if P < ATC
increase in demand increases firms’ profits.
• Homework: Mankiw, Ch.14, pp. 308-309,
Problem 3, 5, 9, 11, 12.
With free entry and exit, profits = 0 in the long run,
and P = minimum ATC.
CHAPTER 14
FIRMS IN COMPETITIVE MARKETS
Products are Perfect Substitutes
Result: Price Taking
P = MR = MC
SR: Will operate if P > AVC (FC is sunk)
LR: Will operate at P = ATC
36