Principles of Microeconomics Chapter 14 A market is competitive if each buyer and seller is small compared to the size of the market and has little ability to influence market prices If a firm can influence the market price of the good it sells it has market power Competitive market sometimes called a perfectly competitive market has many buyers and many sellers in the market offering almost identical products These market participants have a negligible impact on the market forcing them to accept the price that the market determines becoming price takers In competitive markets firms can freely enter or exit the market A firm in a competitive market tries to maximize profit Total revenue is proportional to the amount of output 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 the sale of each additional unit of output For competitive firms marginal revenue equals the price of the good Profit is total revenue minus total cost If marginal revenue is greater than marginal cost production of a good should increase because it will increase marginal revenue as marginal cost increases And vice versa For a competitive firm the firm s price equals both its average revenue and its marginal revenue 3 general rules for profit maximization If marginal revenue is greater than marginal cost the firm If marginal cost is greater than marginal revenue the firm should increase its output should decrease its output At the profit maximizing level of output marginal revenue and marginal cost are exactly equal Because a competitive firm is a price taker its marginal revenue equals the market price Because 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 Shutdown a firm s short term decision not to produce anything for a certain time because of current market conditions Exit a firm s long term decision to leave the market If a firm shuts down it loses all revenue from the sale of its product while having to pay fixed costs but it saves the variable costs of making its product The firm shuts down if the revenue that it would earn from producing is less than its variable costs of production Shut down if total revenue variable costs Shut down if price is average variable cost The competitive firm s short run supply curve is the portion of its marginal cost curve that lies above average variable cost Sunk cost a cost that has already been committed and cannot be firms still have to pay fixed costs when they shut down these are sunk costs Firms can ignore them when deciding how much to recovered produce The firm exits the market if the revenue it would get from producing is less than its total costs Exit if total revenue total costs Exit if price average total cost ENTER if price average total cost The competitive firm s long run supply curve is the portion of its marginal cost curve that lies above average total cost Profit P ATC x Q At the end of the process of entry and exit firms that remain in the market must be making zero economic profit A firm has zero profit if and only if the price of the good equals the average total cost of producing the good If price is above ATC profit is positive encouraging new firms to If price is below ATC profit is negative encouraging firms to exit This process ends only when price and ATC are driven to equality If price is to equal both marginal cost and ATC these two measures must equal each other Marginal cost and ATC are equal when the firm is operating at minimum of average total cost i e efficient enter scale In the long run equilibrium of a competitive market with free entry and exit firms must be operating at their efficient scale In a market with free entry and exit there is only one price consistent with zero profit minimum of ATC long run market supply curve must be horizontal at this price any price above this level would generate profit leading to entry and an increase in qS any price below this level would generate losses leading to exit and a decrease in qS Zero profit equilibrium includes TOTAL costs which include opportunity costs of owners Therefore it compensates owners for Economic profit is zero but accounting profit is positive A short run increase in demand will bring a positive profit price will increase firms will produce more price will exceed ATC generating Sometimes long run supply curve or marginal cost curve will slope 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 forgone profit upward
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