Ch 14: Firms in Competitive MarketsFriday, November 14, 201410:14 PM -If a firm can influence the market price of a the good it sells, it is said to have market power.- A market supply curve is tightly linked to firms' costs of productionWhat is a Competitive Market?-The Meaning of CompetitionoCompetitive Market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price takeroThe actions of any single buyer or seller in the market have a negligible impact on the market price. oBuyers and sellers in competitive markets must accept the price the market determines and, therefore are said to be price takersoAnother condition sometimes brought to characterize perfectly competitive markets is that firms can freely enter and exit the market. -The Revenue of a Competitive FirmoA firm in a competitive market tries to maximize profit. oConsider the Vaca Family Dairy FarmoThey produce a quantity of milk, Q, and sell each unit at the market price, P. The farm's total revenue is P*QoSince the Vaca family is price takers, the total revenue is proportional to the amount of output. oHow much revenue does the farm receive for the typical gallon of milk?oHow much additional revenue does the farm receive it increases production of milk by 1 gallon?oAverage revenue: total revenue divided by the quantity sold -Total revenue (P*Q) divided by the quantity (Q)-For all firms, average revenue equals the price of the goodoMarginal revenue: the change in total revenue from an additional unit sold-This result illustrates a lesson that applies only to competitive firms: total revenue is P*Q and P is fixed for a competitive firm. -For competitive firms, marginal revenue equals the price of the good.Profit Maximization and the Competitive Firm's Supply Curve-A Simple Example of Profit MaximizationoRemember: rational people think at the marginoIf marginal revenue is greater than marginal cost, the Vacas should increase the production of milk because it will put more money in their pockets (marginal revenue) than it takes out (marginal cost)oIf marginal revenue is less than marginal cost, the Vacas should decrease production. oIf the Vacas think at the margin and make incremental adjustments to the level of production, they are naturally led to produce the profit-maximizing quantity-The Marginal-Cost Curve and the Firm's Supply DecisionoThe MC curve is sloping upward, the ATC curve is u-shaped, the MC curve crosses the ATC curve at the minimum of average total cost. There is a horizontal line at the market price(P) because the firm is a price taker.oThe firm's price equals both its average revenue (AR) and its marginal revenue (MR)oIf marginal revenue is greater than marginal cost, the firm should increase its outputoIf marginal cost is greater than marginal revenue, the firm should decrease its outputoAt the profit-maximizing level of output, marginal revenue and marginal cost are exactly equaloBecause the firm's marginal cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal cost cure is also the competitive firm's supply curve. -The Firm's Short-Run Decision to Shut DownoA shutdown refers to a short run decision not to produce anything during a specific period of time because of current market conditions-The firm shuts down if the total revenue (TR) that it would earn from producing is less than its variable costs (VC) of production-Shutdown if TR < VC-Shutdown if TR/Q < VC/Q-Shutdown if P < AVC-When choosing to produce, the firm compares the price it receives for the typical unit to the average variable cost that it must incur to produce the typical unit. Ifthe price doesn't cover the average variable cost, the firm is better off stopping production altogether. The firm still loses money (because it has to pay fixed costs), but it would lose even more money by staying open. oAn exit refers to a long run decision to leave the market. oA firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits the market doesn't have to pay any costs at all, fixed or variable.-Spilt Milk and Other Sunk CostsoSunk cost: a cost that has already been committed and cannot be recovered-Because nothing can be done about sunk costs, you can ignore them when making decisions about various aspects of life, including business strategy. oWe assume that the firm cannot recover its fixed costs by temporarily stopping production. That is, regardless of the quantity of output supplied (even if it is zero), the firmstill has to pay its fixed costs. As a result, the fixed costs are sunk in the short run, and the firm can ignore them when deciding how much to produce. -Case Study: Near-Empty Restaurants and Off-Season Miniature GolfoMany restaurant's costs - the rent, kitchen equipment, tables, plates, silverware, etc. - are fixed costs. Shutting down the restaurant during lunch would not reduce these costs. In other words, these costs are sunk in the short run. When deciding whether or not to serve lunch, only variable costs - the price of additional food and the wages of the extra staff - are relevant. The owner shuts down the restaurant at lunchtime only if the revenue from the few lunchtime customers fails to cover the restaurant's variable costs. oFixed costs - costs of buying the land and building the course - are irrelevant in making the decision of whether a mini golf course should stay open during certain seasons. The minigolf course should be open for business only during those times of year when its revenue exceeds its variable costs. -The Firm's Long-Run Decision to Exit or Enter a MarketoThe firm exits the market if the total revenue (TR) it would get from producing is less than its total costs (TC). -Exit if TR < TC-Exit if TR/Q < TC/Q-Exit if P < ATCoThe criterion for entry is exactly opposite of the criterion for exit-Enter if P > ATCoThe competitive firm's long-run supply curve is the portion of its marginal cost curve thatlies above the average total cost-Measuring Profit in Our Graph for the Competitive FirmoRecall that Profit equals total revenue (TR) minus total cost (TC)-Profit = TR - TC-Profit = (TR/Q - TC/Q) * Q-Note that TR/Q is average revenue, which is the price, P, and TC/Q is average total cost, ATC:Profit = (P - ATC) * Q Costs1. In the short run, the firm produces on the MC curve if P >AVCMCATCAVCShort Run Decision2. …but shuts down if P <AVC