Chapter 14: Firms In Competitive Markets1. What is a Competitive Market?a) The Meaning of Competition-Competitive market : a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.-Important characteristics:o There are many buyers and many sellers in the marketo The goods offered by the various sellers are largely the sameo Firms can freely enter or exit the marketb) The Revenue of a Competitive Firm- Total Revenue = P x Q- Average revenue : total revenue divided by the quantity sold- For all firms, average revenue equals the price of the good- Marginal revenue : the change in total revenue from an additional unit sold- For competitive firms, marginal revenue equals the price of the good. 2. Profit Maximization and the Competitive Firm’s Supply Curvea) A Simple Example of Profit Maximization- Profit Maximization can be examined by observing when the profit (TR – TC) is the highest- Can also be found by comparing the marginal revenue and marginal cost from each unit produced. - If marginal revenue is greater than marginal cost, a firm should increase the production of that good- If the marginal revenue is less than marginal cost, the firm should decrease production.b) The Marginal-Cost Curve and the Firm’s Supply Decision- If marginal revenue (MR) is greater than marginal cost (MC), the firm should increase its output- If marginal cost (MC) is greater than marginal revenue (MR), the firm should decrease its output- At the profit-maximizing level of output, marginal revenue (MR) and marginal cost (MC) are exactly equal.- Because a competitive firm is a price taker, its marginal revenue equals the market price. - Since the firm’s marginal-cost curve determines the quantity of the good the firm is willing to supply at any price, the marginal-cost curve is also the competitive firm’s supply curve. c) The Firm’s Short-Run Decision to Shut Down- The firm shuts down if the revenue that it would earn from producing is less than its variable costs of production. o Shut down if: TR < VCo Shut down if P < AVC- The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable costd) Spilt Milk and Other Sunk Costs- Sunk cost : a cost that has already been committed and cannot be replaced- The firm’s short-run supply curve is the part of the marginal-cost curve that lies above average variable cost, and the size of the fixed cost does not matter for this supply decision.e) The Firm’s Long-Run Decision to Exit or Enter a Market- A firm exits the market if the revenue it would get from producing is less than its total costs. o Exit if TR < TCo Exit if P < ATCo Enter if P > ATC- The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.f) Measuring Profit in Our Graph for the Competitive Firm - Profit = TR – TC- Profit = (TR/Q – TC/Q) x Q- In the long run, the competitive firm’s supply curve is its marginal cost curve (MC) above average total cost (ATC). If the price falls below average total cost, the firm is better off exiting the market.2. The Supply Curve in a Competitive Marketa) The Short Run: Market Supply with a Fixed Number of Firms- In the short run, the number of firms in the market is fixed. As a result, the market supply curve reflects the individual firms’ marginal-cost curves.b) The Long Run: Market Supply with Entry and Exit- If all firms have same access to technology for producing a good and access to the same markets to buy the inputs into production, then decisions about entry and exit in a market of this type depend on the incentives facing the owners of existing firms and entrepreneurs who could start new firms. 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 the quantity of the 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 the number of firms, decrease the quantity of the 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 zeroeconomic profit.o Profit = (P – ATC) x Q1. If the price of the good equals the ATC, they have zero profit- The process of entry and exit ends only when price and average total cost are driven to equality.- MC and ATC are equal only when the firm is operating at the minimum of ATC. - In the long run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. - Long run supply curve must be horizontal because there is only one price consistent with zero profit – minimum of ATCc) Why Do Competitive Firms Stay in Business If They Make Zero Profit?- In the zero-profit equilibrium, economic profit is zero, but accounting profit is positive.d) A Shift in Demand in the Short Run and Long Run- Because firms can enter and exit in the long run but not in the short run, the response of a market to a change in demand depends on the time horizon.- Example: A market starts in LR equilibrium and each firm is making zero profit, so the price equals the minimum ATC. If there is an increase in demand in the short run, the firm will make short run profits because the price will be driven up and exceed ATC. This, however, will encourage new firms to enter the market, which will increase supply of the good, and therefore in the new long-run equilibrium,return the price back down. Profits will again be zero, price is back to minimum ATC, but the market has more firms to satisfy greater demand. e) Why the Long-Run Supply Curve Might Slope Upward- Two reasons:o Some resources used in the production may be available only in small quantities: an increase in quantity supplied without also inducing a rise in costs means rise in price.o Firms may have different costs. (Anyone can enter the market as a painter but not everyone has the same costs)- If firms have different costs, some firms earn profit even in the long run. In this case, the price in the market reflects the ATC 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.- Because firms can enter and exit more easily in the long run