Perfectly Competitive Market - Micro Economics

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Chapter 14Chapter 14Chapter 14Chapter 14

Firms inFirms inCompetitiveCompetitive

MarketsMarkets

Firms inFirms inCompetitiveCompetitive

MarketsMarkets

© 2002 by Nelson, a division of Thomson Canada Limited © 2002 by Nelson, a division of Thomson Canada Limited © 2002 by Nelson, a division of Thomson Canada Limited © 2002 by Nelson, a division of Thomson Canada Limited



Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14:

� Learn what characteristics make a marketcompetitive.

� Examine how competitive firms decidehow much output to produce.

� Examine how competitive firms decidewhen to shut down productiontemporarily.

� Examine how competitive firms decide

whether to exit or entry the market.� See how firm behaviour determines a

market¶s short-run and long-run supplycurves.

� Learn what characteristics make a marketcompetitive.

� Examine how competitive firms decidehow much output to produce.

� Examine how competitive firms decidewhen to shut down productiontemporarily.

� Examine how competitive firms decide

whether to exit or entry the market.� See how firm behaviour determines a

market¶s short-run and long-run supplycurves.

In this chapter you will«In this chapter you will«




� A perfectly competitive market hasthe following characteristics:

± There are many buyers and sellers

in the market. ± The goods offered by the various

sellers are largely the same.

± Firms can freely enter or exit themarket.

� A perfectly competitive market hasthe following characteristics:

± There are many buyers and sellers

in the market. ± The goods offered by the various

sellers are largely the same.

± Firms can freely enter or exit themarket.

WHAT IS A COMPETITIVEWHAT IS A COMPETITIVEMARKETMARKET




� A competitive market has manybuyers and sellers trading identicalproducts so that each buyer and

seller is a price taker. ± Buyers and sellers must accept the

price determined by the market.

� A competitive market has manybuyers and sellers trading identicalproducts so that each buyer and

seller is a price taker. ± Buyers and sellers must accept the

price determined by the market.

WHAT IS A COMPETITIVEWHAT IS A COMPETITIVEMARKETMARKET




� Total revenue for a firm is the selling

price times the quantity sold .

TR = (P TR = (P vv Q)Q)

� Total revenue is proportional to theamount of output.

� Average revenue tells us how muchrevenue a firm receives for the typical unitsold.

� Average revenue is total revenue dividedby the quantity sold.

� Total revenue for a firm is the selling

price times the quantity sold .

TR = (P TR = (P vv Q)Q)

� Total revenue is proportional to theamount of output.

� Average revenue tells us how muchrevenue a firm receives for the typical unitsold.

� Average revenue is total revenue dividedby the quantity sold.

The Revenue of a CompetitiveThe Revenue of a CompetitiveFirmFirm




� In perfect competition, average revenueequals the price of the good.

� In perfect competition, average revenueequals the price of the good.


Average Revenue = Total revenueQuantity

Price Quantity

Quantity

Price

!

v

!




� Marginal revenue is the change intotal revenue from an additional unitsold.

� For competitive firms, marginalrevenue equals the price of the good.

� Marginal revenue is the change intotal revenue from an additional unitsold.

� For competitive firms, marginalrevenue equals the price of the good.


MR =MR =((TR/ TR/ ((QQ




Table 14Table 14--1: Total, Average, and Marginal1: Total, Average, and MarginalRevenue for a Competitive FirmRevenue for a Competitive Firm

664868

664267

663666

663065

662464

661863

$ 661262

$ 6$ 6$ 61

(MR = ¨TR/¨ Q )( AR = TR/ Q )(TR = P x Q )(P )(Q )

MarginalRevenue

AverageRevenue

TotalRevenuePrice

Quantity(in litres)




� The goal of a competitive firm is tomaximize profit, which equals totalrevenue minus total cost.

� This means that the firm will want toproduce the quantity that maximizesthe difference between total revenue

and total cost .

� The goal of a competitive firm is tomaximize profit, which equals totalrevenue minus total cost.

� This means that the firm will want toproduce the quantity that maximizesthe difference between total revenue

and total cost .

PROFIT MAXIMIZATION AND THEPROFIT MAXIMIZATION AND THECOMPETITIVE FIRM¶S SUPPLY CURVECOMPETITIVE FIRM¶S SUPPLY CURVE




Table 14Table 14--2: Profit Maximization: A Numerical2: Profit Maximization: A NumericalExampleExample

(MR - MC )

Changein Profit

- 3

- 2

- 1

0

1

96147488

86438427

76630366

66

723305

56717244

246612183

33648122

$ 4$ 2$ 6

1561

- $ 3$ 3$ 00

(MC =

¨TC/¨ Q )(MR = ¨TR/¨ Q )(TR - TC )(TC )(TR )(Q )

MarginalCost

MarginalRevenueProfitTotal Cost

TotalRevenue

Quantity(in litres)




� Profit maximization occurs at thequantity where marginal revenue

equals marginal cost .

� When MR > MC increase Q

� When MR < MC decrease Q

�� WhenWhen MR = MC MR = MC Profit is maximizedProfit is maximized..

� Profit maximization occurs at thequantity where marginal revenue

equals marginal cost .

� When MR > MC increase Q

� When MR < MC decrease Q

�� WhenWhen MR = MC MR = MC Profit is maximizedProfit is maximized..

PROFIT MAXIMIZATION AND THEPROFIT MAXIMIZATION AND THECOMPETITIVE FIRM¶S SUPPLY CURVECOMPETITIVE FIRM¶S SUPPLY CURVE




Costsand

Revenue

Quantity0

MC 1

Q1

The firm maximizes

profit by producingthe quantity at which

marginal cost equals

marginal revenue.

MC

AVC

Q MAX

MC 2

Q 2

P = MR 1 = MR 2 P = AR = MR

ATC

Figure 14Figure 14--1: Profit Maximization for a1: Profit Maximization for aCompetitive FirmCompetitive Firm




Price

Quantity0

MC

AVC

ATC

P 2

Q2

This section of thefirm¶s MC curve isalso the firm¶s supplycurve.

Q1

P 1

Figure 14Figure 14--2: Marginal Cost and the Firm¶s2: Marginal Cost and the Firm¶sSupply CurveSupply Curve




� A shutdown refers to a short-rundecision not to produce anythingduring a specific period of timebecause of current marketconditions.

� Exit refers to a long-run decision to

leave the market.

� A shutdown refers to a short-rundecision not to produce anythingduring a specific period of timebecause of current marketconditions.

� Exit refers to a long-run decision to

leave the market.

A Firm¶s ShortA Firm¶s Short--Run DecisionsRun Decisions




� The firm considers its sunk costs

when deciding to exit, but ignoresthem when deciding whether to shutdown.

±S unk costs are costs that havealready been committed and

cannot be recovered.

� The firm considers its sunk costs

when deciding to exit, but ignoresthem when deciding whether to shutdown.

±S unk costs are costs that havealready been committed and

cannot be recovered.





� The firm shuts down if the revenue itgets from producing is less than thevariable cost of production.

± Shut down if TR < VC

± Shut down if TR/ Q < VC/ Q

± Shut down if P < A

VC

� The firm shuts down if the revenue itgets from producing is less than thevariable cost of production.

± Shut down if TR < VC

± Shut down if TR/ Q < VC/ Q

± Shut down if P < A

VC





Price

Quantity0

MC

AVC

ATC

Firm¶s short-runsupply curve

Firm shutsdown if P < AVC

Figure 14Figure 14--3: The Competitive Firm¶s Short3: The Competitive Firm¶s Short--Run Supply CurveRun Supply Curve

If AVC < P < ATC , firm willproduce in theS-R but at aloss.

If ATC < P thefirm will

produce at aprofit.




� The portion of the marginal-cost curvethat lies above average variable cost is thecompetitive firm¶s short-run supply curve.

� The portion of the marginal-cost curvethat lies above average variable cost is thecompetitive firm¶s short-run supply curve.





� In the long run, the firm exits if the revenue itwould get from producing is less than its totalcost.

± Exit if TR < TC

± Exit if TR/ Q < TC/ Q

± Exit if P < ATC

� A firm will enter the industry if such an actionwould be profitable.

± Enter if TR > TC ± Enter if TR/ Q > TC/ Q

± Enter if P > ATC

� In the long run, the firm exits if the revenue itwould get from producing is less than its totalcost.

± Exit if TR < TC

± Exit if TR/ Q < TC/ Q

± Exit if P < ATC

� A firm will enter the industry if such an actionwould be profitable.

± Enter if TR > TC ± Enter if TR/ Q > TC/ Q

± Enter if P > ATC

A Firm¶s LongA Firm¶s Long--Run Decision toRun Decision toEnter or ExitEnter or Exit




Price

Quantity0

MC

AVC

ATC

Firm¶slong-runsupply curve

Firm shutsdown if P < ATC

Figure 14Figure 14--4: The Competitive Firm¶s Long4: The Competitive Firm¶s Long--Run Supply CurveRun Supply Curve




� Short-Run Supply Curve

± The portion of its marginal cost

curve that lies above averagevariable cost.

� Long-Run Supply Curve

± The marginal cost curve above theminimum point of its average totalcost curve.

� Short-Run Supply Curve

± The portion of its marginal cost

curve that lies above averagevariable cost.

� Long-Run Supply Curve

± The marginal cost curve above theminimum point of its average totalcost curve.

THE SUPPLY CURVE INTHE SUPPLY CURVE INCOMPETITIVE MARKETSCOMPETITIVE MARKETS




(a)A Firm with Profits (b)A Firm with Losses

Price

Quantity

0

MC

P = AR = MR

Profit

P

ATC

QQuantity

0

MC

P = AR = MR Loss

P

ATC

Q

Price

Figure 14Figure 14--5: Profit as the Area between Price5: Profit as the Area between Priceand Average Total Costand Average Total Cost




� Market supply equals the sum of thequantities supplied by the individualfirms in the market.

� Market supply equals the sum of thequantities supplied by the individualfirms in the market.

THE SUPPLY CURVE INTHE SUPPLY CURVE INCOMPETITIVE MARKETSCOMPETITIVE MARKETS




� For any given price, each firmsupplies a quantity of output so thatits marginal cost equals price.

� The market supply curve reflects theindividual firms¶ marginal costcurves.

� For any given price, each firmsupplies a quantity of output so thatits marginal cost equals price.

� The market supply curve reflects theindividual firms¶ marginal costcurves.

The Short Run: Market SupplyThe Short Run: Market Supplywith a Fixed Number of Firmswith a Fixed Number of Firms




(a) Individual Firm Supply (b) Market Supply

Price

Quantity (firm)

0

MC

100

Quantity (market)

0

Price

$1.00

$2.00

200

MC

100 000

$1.00

$2.00

200 000

Figure 14Figure 14--6: Market Supply with a Fixed6: Market Supply with a FixedNumber of FirmsNumber of Firms




� Firms will enter or exit themarket until profit is driven to

zero.� In the long run, price equals the

minimum of average total cost.

� The long-run market supplycurve is horizontal at this price.

� Firms will enter or exit themarket until profit is driven to

zero.� In the long run, price equals the

minimum of average total cost.

� The long-run market supplycurve is horizontal at this price.

The Long Run: Market Supply withThe Long Run: Market Supply withEntry and ExitEntry and Exit




(a) Firm¶s Zero-Profit Condition (b) Market Supply

Price

Quantity (firm)0

MC

Quantity (market)0

Price

P =minimum

ATC

Supply

Figure 14Figure 14--7: Market Supply with Entry and7: Market Supply with Entry andExitExit




� At the end of the process of entry and exit,firms that remain must be making zeroeconomic profit.

� The process of entry and exit ends onlywhen price and average total cost aredriven to equality.

� Long-run equilibrium must have firmsoperating at their efficient scale.

� At the end of the process of entry and exit,firms that remain must be making zeroeconomic profit.

� The process of entry and exit ends onlywhen price and average total cost aredriven to equality.

� Long-run equilibrium must have firmsoperating at their efficient scale.

The Long Run: Market Supply withThe Long Run: Market Supply withEntry and ExitEntry and Exit




� Profit equals total revenue minustotal cost.

� Total cost includes all theopportunity costs of the firm.

� In the zero-profit equilibrium, thefirm¶s revenue compensates theowners for the time and money theyexpend to keep the business going.

� Profit equals total revenue minustotal cost.

� Total cost includes all theopportunity costs of the firm.

� In the zero-profit equilibrium, thefirm¶s revenue compensates theowners for the time and money theyexpend to keep the business going.

Why Stay in Business if You MakeWhy Stay in Business if You MakeZero Profit?Zero Profit?




� An increase in demand raises priceand quantity in the short run.

� Firms earn profits because price nowexceeds average total cost.

� An increase in demand raises priceand quantity in the short run.

� Firms earn profits because price nowexceeds average total cost.

Why Stay in Business if You MakeWhy Stay in Business if You MakeZero Profit?Zero Profit?




(a) Initial Condition

Price

Quantity (firm)0

Quantity (market)0

Price

MC

P 1 P

Short-run Supply, D1

Demand, D1

Long-runSupply

P 1 A

Q1

Firm Market

Figure 14Figure 14--8: An Increase in Demand in the8: An Increase in Demand in theShort Run and the Long Run.Short Run and the Long Run.




(b) Short-Run Response

Price

Quantity (firm)0

Quantity (market)0

Price

MC

P 1

Short-run Supply, S1

D1

Long-runSupply

P 1 A

Q1

Firm Market

P 2 P 2

D2

Profit

B

Q2





(c) Long-Run Response

Price

Quantity (firm)0

Quantity (market)0

Price

P 1

S 1

D1

Long-runSupply

P 1 A

Q1

Market

P 2

D2

B

Q2

MC

Firm

S 2

P 1 Long-runSupply

P 1C

Q3





� Some resources used in production maybe available only in limited quantities.

� Firms may have different costs

� Marginal Firm

± The marginal firm is the firm that wouldexit the market if the price were any

lower.

� Some resources used in production maybe available only in limited quantities.

� Firms may have different costs

� Marginal Firm

± The marginal firm is the firm that wouldexit the market if the price were any

lower.

Why the Long Run Supply CurveWhy the Long Run Supply CurveMight Slope UpwardMight Slope Upward




SummarySummary

� Because a competitive firm is a pricetaker, its revenue is proportional to theamount of output it produces.

� The price of the good equals both thefirm¶s average revenue and its marginalrevenue.

� To maximize profit, a firm chooses the

quantity of output such that marginalrevenue equals marginal cost.

� Because a competitive firm is a pricetaker, its revenue is proportional to theamount of output it produces.

� The price of the good equals both thefirm¶s average revenue and its marginalrevenue.

� To maximize profit, a firm chooses the

quantity of output such that marginalrevenue equals marginal cost.




SummarySummary

� This is also the quantity at which priceequals marginal cost.

� Therefore, the firm¶s marginal cost curveis its supply curve.

� In the short run, when a firm cannotrecover its fixed costs, the firm willchoose to shut down temporarily if the

price of the good is less than averagevariable cost.

� This is also the quantity at which priceequals marginal cost.

� Therefore, the firm¶s marginal cost curveis its supply curve.

� In the short run, when a firm cannotrecover its fixed costs, the firm willchoose to shut down temporarily if the

price of the good is less than averagevariable cost.




SummarySummary

� In the long run, when the firm can recover both fixed and variable costs, it willchoose to exit if the price is less thanaverage total cost.

� In a market with free entry and exit, profitsare driven to zero in the long run and allfirms produce at the efficient scale.

� Changes in demand have different effectsover different time horizons.

� In the long run, when the firm can recover both fixed and variable costs, it willchoose to exit if the price is less thanaverage total cost.

� In a market with free entry and exit, profitsare driven to zero in the long run and allfirms produce at the efficient scale.

� Changes in demand have different effectsover different time horizons.




SummarySummary

� In the long run, the number of firmsadjusts to drive the market back to thezero-profit equilibrium.

� In the long run, the number of firmsadjusts to drive the market back to thezero-profit equilibrium.




The EndThe End

Perfectly Competitive Market - Micro Economics

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