Econ Notes: Chapter 14Introduction: a scenarioThree years after graduating, you run your own business.You must decide how much to produce, what price to charge, how many workers to hireWhat factors should affect these decisions?Your cost (studied in preceding chapter)How much competition you faceWe begin by studying the behavior of firms in perfectly competitive markers.Characteristics of Perfect Competition1. Many buyers and many sellers2. The goods offered for sale are largely the same.Nike, ford, Starbucks, and coke are not perfectly competitiveCoffee beans, fruit, and ground beef are perfectly competitive3. Firms can freely enter or exit the marketNo barriers to entryAnyone can come into the market(4) Because of 1 & 2, each buyer and seller is a “price taker”- takes the price as given.(5) MR is equal to price(6) MR is a straight Line- Perfectly elasticWe assume the buyers and sellers have perfect informationThe price, perfectly competitive, etcThe Revenue of a Competitive FirmTotal revenue (TR) : TR = P x QAverage Revenue (AR) : AR = (TR/Q) = PMarginal Revenue (MR)*: the change in TR from selling one more unitMR = (Δ in TR) / Δ in Q)Active learning 1: look in bookNotice that MR = P***If you know that price, you don’t have to calculate marginal revenue (MR)MR = P for a Competitive FirmA perfectly competitive firm can keep increasing its output without affecting the market priceSo, each one-unit increase in Q causes revenue to rise by P, i.e, MR = PMR = P is only true for firms in perfectly competitive marketsProfit MaximizationWhat 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 MCIf MR > MC, then increase Q to raise profitIf MR < MC, then reduce Q to raise profit*** remember farmer jack example.If cost more to make it than selling it then reduce output to raise profitIf cost less to make it than selling it then raise output to make moneyProfit = TR – TC (economic problem)When MR = MC, you have maximized your profitProfit maximizing quantity is when this happensChange in profit = 0Can’t get any biggerAt any Q with MR > MC, increasing Q raises profitAt any Q with MR < MC, reducing Q raises profitMC and the Firm’s Supply DecisionLook at graph in bookMR is a straight line going across graphThis is a demand curve for a perfectly competitive firm and this is perfectly elasticMC in an increasing lineRule : MR = MC at the profit-maximizing QIf price rises to P2, then the profit-maximizing quantity rises to Q2The MC curve IS the firm’s supply curveStay Open vs. Shutdown vs. Exit (Characteristics)Stay open: a short-run decision to remain open and continue to produce when P is less than ATC but greater than AVC. Still produce where MC = MR even when making a loss.Maximize profit at MC = MR, but if loosing money then profit is minimized at MC = MRYour loose is the least (minimized)AVC are workers that still get a pay check…hope market changesShutdown: a short-run decision not to produce anything because of market conditionstemporaryExit: a long-run decision to leave the marketYou don’t come back, not temporaryCircuit CityA key difference:If shut down in SR, must still pay FC.If exit in LR, zero costs.A Firm’s Short-run Decision to Shut DownCost of shutting down: revenue loss = TRBenefit of shutting down: cost savings = VCFirm must still pay FCSo, shut down if TR < VCDivide both sides by Q: TR / Q < VC / QSo, firm’s decision rule is:Shut down if P < AVCTemporary- waiting for market to improveA Competitive Firm’s SR Supply CurveLook at graphIf P > AVC, then firm produces Q where P = MCIf P < AVC, then firm shuts down (produces Q=0)**In the short run, a perfectly competitive firms supply curve is the MC curve above AVCThe firm’s SR supply curve is the portion of its MC curve above AVCThe Irrelevance of Sunk CostsSunk cost: a cost that has already been committed and cannot be recoveredSuck costs should be irrelevant to decisions; you must pay them regardless of your choiceFC is a sunk cost: the firm must pay its fixed costs whether it produces or shuts down.Land Taxes, Car InsuranceSo, FC and AFC should not matter in the decision to shut downA Firm’s Long-run Decision to ExitCost of exiting the market: revenue loss = TRBenefit of exiting the market: cost savings = TCZero FC in the long runSo, firm exits if TR < TCIn the long run you have to pay all or your billsDivide both sides by Q to write the firm’s decision rule as:Exit if P < ATCAVC doesn’t matterA New Firm’s Decision to Enter MarketA firm can enter a perfectly competitive market only in the long runIn the long run, a new firm will enter the market if it is profitable to do so: if TR > TCThey do not exit or enter in the short runDivide both sides by Q to express the firm’s entry decision as:Enter if P > ATCThe Competitive Firm’s Supply CurveThe firm’s LR supply curve is the portion of its MC curve above LRATC (look on page 289 in book for graph)Active learning 2: identifying a firm’s profitDemand curve is equal to MR (marginal revenue)Look for where MC = MR for market maximizingLook where ATC related to MRGo down and over and that is the profitTotal profit = (P – ATC) x QActive learning 3: identifying a firm’s loseloss minimizing quantity bc ATC is above MR at this pointtotal loss = (P – ATC) x Qit is negative so you know it is a lossThe SR Market Supply CurveAs long as P >= AVC, each firm will produce its profit-maximizing quantity, where MR = MCRecall from chapter 4:At each price, the market quantity supplied is the sum of quantities supplied by all firmsExample: 1000 identical firmsat each P, market Qs = 1000 x (one firm’s Qs)Entry and Exit in the Long RunWhat happens to the Market!In the LR, the number of firms can change due to entry and exitIf existing firms earn positive economic profit,New firms enter, SR market supply shifts rightP falls, reducing profits and slowing entryif existing firms incur losses,some firms exit, SR market supply shifts left.P rises, reducing remaining firm’s lossesThe Zero-Profit ConditionLong-run equilibrium: the process of entry or exit is complete- remaining firms earn zero economic profitNo more firms enter or leave the marketZero economic profit occurs when P = ATCSince firms produce where P = MR = MC, the zero-profit condition is P = MC = ATCRecall that MC intersects ATC at minimum ATCHence, in the long run, P = minimum ATCWhy Do Firms Stay in Business