Slide 1Knowledge RecapCompetitive MarketsRevenue in Competitive MarketsProfit Maximization RuleProfit Maximization RuleProfit Maximization RuleProfit Maximization RuleProfit Maximization RuleProfit Maximization RuleProfit Maximization RuleProfit Maximization RuleShort-run Decision to Shut DownLong-run Decision to Exit MarketShort-run vs Long-run ProfitECON 203: Principles of MicroeconomicsClass 14: Firms’ Decisions in Competitive Markets1Knowledge Recap•Total Cost: the sum of Fixed and Variable Costs.–Average Total Cost (ATC) is the cost of producing a typical unit of output (Total Cost / Quantity).–Marginal Cost (MC) is the cost of producing one additional unit of output.–MC curve crosses ATC curve at its minimum (efficient scale).•Total Revenue: the amount a firm receives for sale of its output (P*Q).•Profit = Total Revenue – Total Cost•A firm’s objective is to maximize its profits.Profit = Total Revenue – Total Cost2Competitive Markets•Firms’ decisions are guided by:–Its objective (profit maximization).–Market structure (in this case, competitive market).•Characteristics of competitive markets.–Many buyers and sellers.–Same product offered by all sellers (homogenous product).–Firms can freely enter exit the market (no barriers to entry).•Given the first two, firms are price-takers.–Individual firms’ output decisions do not affect market price.–All units of output are sold at the same price (market price).•Firms can differ in their cost structures.3Revenue in Competitive Markets•Average Revenue. –Revenue received for the typical unit of output Total Revenue / Quantity–Corresponds to market price.Since TR = P*Q and AR = TR/Q  AR = P•Marginal Revenue.–Revenue received for one additional unit of output.Change in Revenue / Change in Quantity •Since all units of output are sold at market price:Average Revenue = Marginal Revenue = Price4Profit Maximization Rule•Total profit is maximized when MC = MR.–If MC< MR:•The cost of producing one more unit is less than the revenue obtained from it.•The firm can increase profits by increasing production. –If MC > MR:•The cost of producing one more unit is more than the revenue obtained from it.•The firm can increase profits by decreasing production.–When MC = MR:•The cost of producing one more unit is equal to the revenue obtained from it.•Producing one more unit will not affect the firm’s profit.5Profit Maximization Rule•Example: market for sugar (per ton).6Q P TR MR TC MC ATC Profit (TR – TC)Δ Profit0 $500 0 $2001 $500 $500 $3002 $500 $1,000 $5003 $500 $1,500 $8004 $500 $2,000 $1,2005 $500 $2,500 $1,7006 $500 $3,000 $2,300Profit Maximization Rule•Example: market for sugar (per ton).7Q P TR MR TC MC ATC Profit (TR – TC)Δ Profit0 $500 0 $500 $2001 $500 $500 $500 $3002 $500 $1,000 $500 $5003 $500 $1,500 $500 $8004 $500 $2,000 $500 $1,2005 $500 $2,500 $500 $1,7006 $500 $3,000 $500 $2,300•Example: market for sugar (per ton).Profit Maximization Rule8Q P TR MR TC MC ATC Profit (TR – TC)Δ Profit0 $500 0 $500 $2001 $500 $500 $500 $300 $100 $3002 $500 $1,000 $500 $500 $200 $2503 $500 $1,500 $500 $800 $300 $2674 $500 $2,000 $500 $1,200 $400 $3005 $500 $2,500 $500 $1,700 $500 $3406 $500 $3,000 $500 $2,300 $600 $383Profit Maximization Rule•Example: market for sugar (per ton).Profit = TR – TC = P*Q – ATC*Q = (P – ATC)*Q9Q P TR MR TC MC ATC Profit (TR – TC)Δ Profit0 $500 0 $500 $2001 $500 $500 $500 $300 $100 $3002 $500 $1,000 $500 $500 $200 $2503 $500 $1,500 $500 $800 $300 $2674 $500 $2,000 $500 $1,200 $400 $3005 $500 $2,500 $500 $1,700 $500 $3406 $500 $3,000 $500 $2,300 $600 $383Profit Maximization Rule•Example: market for sugar (per ton).Profit = TR – TC = P*Q – ATC*Q = (P – ATC)*Q10Q P TR MR TC MC ATC Profit (TR – TC)Δ Profit0 $500 0 $500 $200 -$1001 $500 $500 $500 $300 $100 $300 $200 $3002 $500 $1,000 $500 $500 $200 $250 $500 $3003 $500 $1,500 $500 $800 $300 $267 $700 $2004 $500 $2,000 $500 $1,200 $400 $300 $800 $1005 $500 $2,500 $500 $1,700 $500 $340 $800 $06 $500 $3,000 $500 $2,300 $600 $383 $700 -$100Profit Maximization Rule•Three general rules of profit maximization:– If marginal revenue is greater than marginal cost, the firm should increase its output.– If marginal cost is greater than marginal revenue, the firm should decrease its output.–At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.11Profit Maximization Rule•The firm will produce where MC = MR.–In a competitive market MR = P.–This implies that in a competitive market MC = MR = P.–At any price, firm will produce the quantity for which P = MC.–MC trails the firm’s supply curve.12Short-run Decision to Shut Down•In the short-run fixed costs are sunk costs.–Fixed costs cannot be avoided (must be paid).–If a firm shuts down, in the short run it only saves variable costs. •Decision to shut down when:–Total Revenue < Variable Cost–Total Revenue / Quantity < Variable Cost / Quantity–Price < AVC•Short-run supply curve:–Zero if P < AVC–MC if P >= AVC13Long-run Decision to Exit Market•In the long-run all costs are variable.–Fixed costs can be recovered (no longer fixed).–If a firm shuts down, in the long run it saves all its costs. •Decision to exit market when:–Total Revenue < Total Cost–Total Revenue / Quantity < Total Cost / Quantity–Price < ATC•Long-run supply curve:–Zero if P < ATC–MC if P >= ATC14Short-run vs Long-run Profit•Short-run supply curve: –Zero if P < AVC–MC if P >= AVC•Long-run supply curve:–Zero if P < ATC–MC if P >= ATC•Profit = TR – TC = P*Q – ATC*Q–Since AVC < ATC, in the short-run a firm will produce when AVC<P<ATC leading to losses (negative profit).–In the long run, a firm that has losses will exit the