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Therefore, every buyer and every seller takes the market price as given.
Everybody is a price taker
Price takers
A firm in a perfectly competitive market cannot stay in business if its price is higher than what the other firms are charging No firm would be able to raise the market price by reducing production and attempting to create a shortage. Conversely, there is no danger that a firm would drive the market price down by producing too much. Therefore, no firm would want to charge a price lower than what the others are charging. In short, each firm takes the prevailing market price as a givenlike the weatherand charges that price.
Total Revenue of a Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR = P Q
We saw this in Chapters 5 and 13
Marginal Revenue of a Competitive Firm Marginal Revenue is the increase () in total revenue when an additional unit is sold. MR = TR / Q
The Revenue of a Competitive Firm In perfect competition, marginal revenue equals price: P = MR. We saw earlier that P = AR Therefore, for all firms in perfect competition, P = AR = MR
Market
Demand, P = AR = MR
Demand, P = AR 0
Quantity (firm)
Quantity (market)
The market price is P. No matter what amount Jones and Peters produces, the market price will not change. Therefore, J&P will be able to sell any feasible output if it charges the price P.
The market demand curve is negatively sloped, as usual. That is, the market price, which is the lowest prevailing price, is inversely related to the quantity 10 demanded.
Supply
We have just seen the demand curves for a firm and for the entire industry Next, we need to work out what the supply curves look like
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All fixed costs are sunk costs in the short run but not in the long run The number of firms in an industry is fixed in the short run but not in the long run
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 13
The Firms Short-Run Decision to Shut Down A firm will shut down (temporarily) if its variable costs exceed its total revenue, no matter what quantity it produces Its fixed costs do not matter! This is because
Fixed costs are sunk costs in the short run
sunk costs are defined as costs that will have to be paid even if the firm shuts down.
Therefore, FC cannot affect a firms decision on whether to stay open or shut down
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 15
Sunk Costs
Sunk costs will have to be paid even when a firm is in a temporary shutdown.
Examples:
If the firm signs a long-term contract with its landlord, the rent will have to be paid even when the firm is temporarily shut down. Some maintenance costs will have to be incurred even when the firm is shut down. The firm may be under contract to provide customer service to past customers even after it shuts down.
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The Firms Short-Run Decision to Shut Down A firm shuts down if total revenue is less than variable cost, no matter what quantity the firm produces. That is, A firm shuts down if
TR < VC, no matter what Q is, or TR/Q < VC/Q, no matter what Q is, or P < AVC, no matter what Q is.
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AVC
PH
Minimum AVC PL 0 The firm shuts down because P < Minimum AVC
Minimum AVC
Quantity
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Is it possible to figure out the profitmaximizing output from just the MR and MC numbers?
The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.
MC
MC2
ATC
P = MR1 = MR2 AVC Therefore, P = AR = MR = MC is the fingerprint of perfect competition P = AR = MR
MC1
CHAPTER 14
Q1
QMAX
Q2
Quantity
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PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS SUPPLY CURVE Profit maximization occurs at the quantity where marginal revenue equals marginal cost.
This is a crucial principle in understanding the behavior of firms
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PROFIT MAXIMIZATION AND THE COMPETITIVE FIRMS SUPPLY CURVE When MR > MC increase Q When MR < MC decrease Q When MR = MC Profit is maximized; stick with this Q.
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Supply
P2
P1
Q1
Q2
Quantity
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MC
P2
ATC
P1
AVC
Q1
Q2
Quantity
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ATC If P > AVC, firm will continue to produce in the short run.
AVC
Quantity
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The Short Run: Market Supply with a Fixed Number of Firms The market supply curve is the horizontal sum of the individual firms short run supply curves.
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MC
Supply
$2.00
$2.00
1.00
1.00
100
200
Quantity (firm)
100,000
MC
Supply
$2.00
$2.00
1.00
1.00 DemandH
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Price = Minimum ATC; profit = zero; demand has no effect on price, and no effect on the quantity produced by a firm; demand does affect the quantity produced by the industry, and the number of firms in the industry
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The Firms Long-Run Decision to Exit or Enter a Market In the long run, the firm exits if it sees that its total revenue would be less than its total cost no matter what quantity (Q) it might produce That is, a firm exits if
TR < TC, no matter what Q is. TR/Q < TC/Q , no matter what Q is. P < ATC , no matter what Q is.
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The Firms Long-Run Decision to Exit or Enter a Market A new firm will enter the industry if it can expect to be profitable. That is, a new firm will enter if
TR > TC for some value of Q TR/Q > TC/Q for some value of Q P > ATC for some value of Q
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PL 0
Quantity
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ATC
0
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Quantity
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ATC
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Long-Run Equilibrium
Price Price
ATC
Market Demand
$1.50
Quantity (firm)
6,000 Quantity (industry) P = AR = MR = MC = ATC is the fingerprint of perfect competition in the long run.
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This is it, as far as long-run equilibrium is concerned! How many firms are there in long-run equilibrium? What would happen if demand moves left (decreases)? What could cause prices to increase?
A Firms Profit
Profit equals total revenue minus total costs.
Profit = TR TC Profit/Q = TR/Q TC/Q Profit = (TR/Q TC/Q) Q Profit = (P ATC) Q
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Figure 5 Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits Price MC Profit P ATC
ATC
P = AR = MR
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Figure 5 Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses Price
MC
ATC
ATC P Loss P = AR = MR
Quantity
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The Long Run: Market Supply with Entry and Exit Firms will enter or exit the market until profit is driven to zero. Price equals the minimum of average total cost. The long-run market supply curve is a horizontal line at this price.
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Quantity (firm)
Quantity (market)
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Why Do Competitive Firms Stay in Business If They Make Zero Profit? Profit = TR TC Total cost = explicit cost + implicit cost. Profit = 0 implies TR = explicit cost + implicit cost In the zero-profit equilibrium, the firm earns enough revenue to compensate the owners for the time and money they spend to keep the business going. So, dont feel sorry for the owners!
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Economic profit Accounting profit Implicit costs Total opportunity costs Explicit costs Explicit costs
Revenue
Revenue
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Application
We will now work through what happens when the demand for a product increases.
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New firms enter Market supply increases (shifts right) Price decreases; gradually returns to minimum ATC Profits decrease; gradually return to zero So, the long-run effect of an increase in demand is as follows: the price is unchanged, each firms output is unchanged, the number of firms increases, industry output increases. 46
MC
ATC A P1
P1
q1
Quantity (firm)
Q1
Quantity (market)
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Price
Price
Profit P2 P1
MC
ATC P2 A P1
S1
D2 D1 0 q1 q2 Quantity (firm) 0 Q1 Q2
Long-run supply
Quantity (market)
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MC P1
ATC P2 A P1
S1 S2 C D2 D1 Long-run supply
q1
Quantity (firm)
Q1
Q2
Q3 Quantity (market)
An increase in demand leads to an increase in price in the short run. But this price increase will not last. New firms will enter and push the price back to P1, the minimum ATC. Each firms output will return to q1. The only long-run effect 49 of demand will be to increase the number of firms.
Any Questions?
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Summary
Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firms average revenue and its marginal revenue.
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Summary
To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost. This is also the quantity at which price equals marginal cost. Therefore, the firms marginal cost curve is its supply curve.
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Summary
In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.
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Summary
In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale. Changes in demand have different effects over different time horizons. In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 54