Firms in Competitive Markets What is a Competitive Market The Meaning of Competition o Competitive market market with many buyers and sellers trading identical products so that each buyer and seller is a price taker o Price takers buyers and sellers in competitive markets who must accept the price the market determines o Firms can freely enter or exit the market in a competitive market The Revenue of a Competitive Firm o A firm in a competitive market tries to maximize profit total revenue minus total cost o Total revenue price x quantity o Average revenue total revenue divided by quantity sold Tells us how much revenue a firm receives for the typical unit sold For all firms average revenue equals price of the good o Marginal revenue change in total revenue from an additional unit sold the good For competitive firms marginal revenue equals price of Profit Maximization and the Competitive Firm s Supply Curve Marginal Cost curve is upward sloping Average total cost curve is U shaped Marginal cost curve crosses average total cost curve at the minimum of average total cost Horizontal line at market price is horizontal because the firm is a price taker o For a competitive firm firm s price equals both average revenue and marginal revenue 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 The Firm s Short Run Decision to Shut Down Shutdown a short run decision not to produce anything during a specific period of time because of current market conditions Exit a long run decision to leave the market Sunk cost fixed cost that comes with making the short run decision whether to shut down for a period of time The firm shuts down if the revenue that it would get from producing is less than its variable costs of production A firm chooses to shut down if the price of the good is less than the average variable cost of production 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 If the price doesn t cover the average variable cost the firm is better off stopping production altogether The competitive firm s short run supply curve is the portion of its marginal cost curve that lies above average variable cost Spilt Milk and Other Sunk Costs Sunk cost a cost that has already been committed and cannot be recovered Should be ignored The Firm s Long Run Decision to Exit or Enter a Market The firm exits the market if the revenue it would get from producing is less than its total costs The competitive firm s long run supply curve is the portion of its marginal cost curve that lies above average total cost Measuring Profit in our Graph for the Competitive Firm Profit is the area between price and average total cost The Supply Curve in a Competitive Market The Short Run Market Supply with a Fixed Number of Firms o For any given price each firm in a market supplies a quantity of output so that its marginal cost equals the price o As long as price is above average variable cost each firm s marginal cost curve is its supply curve o The market supply curve is the quantity supplied by each firm in the market added together The Long Run Market Supply with Entry and Exit o If firms already in the market are profitable then new firms will have an incentive to enter the market This entry will expand the number of firms increase quantity of good supplied and drive down prices and profits o If firms in the market are making losses then some existing firms will exit the market Their exit will reduce number of firms decrease quantity of good supplied and drive up prices and profits o At the end of this process of entry and exit firms that remain in the market must be making zero economic profit o Process of entry and exit ends only when price and average total cost are driven to equality o In the long run equilibrium of a competitive market with free entry and exit firms must be operating at their efficient scale A Shift in Demand in the Short Run and Long Run o Because firms can enter and exit in the long run but not in short run the response of a market to a change in demand depends on time horizon o Suppose market for milk begins in long run equilibrium Firms are earning zero profit so price equals minimum of average total cost Now suppose scientists discover that milk has miraculous health benefits As a result demand curve for ilk shifts outward short run equilibrium moves up and to the right As a result the quantity rises and price rises All of the existing firms respond to higher price by raising the amount produced Because each firm s supply curve reflects its marginal cost curve how much they each increase production is determined by marginal cost curve Why the Long Run Supply Curve Might Slope Upward o Some resource used in production may be available only in limited quantities Consider market for farm products Anyone can choose to buy land and start a farm but quantity of land is limited As more people become farmers the price of farmland is bid up which raises the costs of all farmers in the market Thus an increase in demand for farm products cannot induce an increase in quantity supplied without also inducing a rise in farmers costs which in turn means a rise in price The result is a long run market supply curve that is upward sloping o Firms may have different costs Consider market for painters Anyone can enter market for painting services but not everyone has same costs Costs vary in part because some people work faster than others and in part because some people have better alternative uses of their time than others For any given price those with lower costs are more likely to enter than those with higher costs To increase quantity of painting services supplied additional entrants must be encouraged to enter the market o If firms have different costs some firms earn profit even in the long run Price in the market reflects the average total cost of the marginal firm the firm that would exit the market if the price were any lower This firm earns zero profit but firms with lower costs earn positive profit o Because firms can enter and exit more easily in the long run than in the short run the long run supply curve is typically more elastic than the short run supply curve
View Full Document
Unlocking...