Chapter 14 Firms in Competitive Markets

FIRMS IN COMPETITIVE MARKETS Chapter 14 . 14-1 WHAT IS A COMPETITIVE MARKET?  The goal of this chapter is to examine how firms make production decisions in competitive markets.  As a background for this analysis, we begin by considering what a competitive market is. . 14-2 WHAT IS A COMPETITIVE MARKET? THE MEANING OF COMPETITION  Competitive market: A market in which there are many buyers and many sellers so that each has a negligible impact on the market price (price takers).  Three characteristics: 1. There are many buyers and many sellers in the market. 2. The goods offered by the various sellers are largely the same. . 14-3 3. Firms can frehe market. WHAT IS A COMPETITIVE MARKET? THE REVENUE OF A COMPETITIVE FIRM  A firm in a competitive market tries to maximize profit, which equals total revenue minus total cost. . 14-4 WHAT IS A COMPETITIVE MARKET? THE REVENUE OF A COMPETITIVE FIRM (CONTINUED) P : Price Q : Quantity  TR : Total revenue . 14-5 TABLE 14.1 Total, Average, and Marginal Revenue for a Competitive Firm . 14-6 WHAT IS A COMPETITIVE MARKET? THE REVENUE OF A COMPETITIVE FIRM (CONTINUED)  The fourth column in the table shows average revenue.  Average revenue tells us how much revenue a firm receives for the typical unit sold.  Average revenue (AR): Total revenue divided by the quantity sold. . 14-7 WHAT IS A COMPETITIVE MARKET? THE REVENUE OF A COMPETITIVE FIRM  The fifth column in (CONTINUED) the table shows marginal revenue.  Marginal revenue (MR): The change in total revenue from an additional unit sold.  For competitive firms, marginal revenue equals the price of the good. . 14-8 Quick Quiz  When a competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue? . 14-9 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE  Let’s examine how the firm maximizes profit and how that decision leads to its supply curve. . 14-10 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE A SIMPLE EXAMPLE OF PROFIT MAXIMIZATION  The analysis of the firm’s supply decision starts with the example in Table 14.2. . 14-11 TABLE 14.2 Profit Maximization: A Numerical Example . 14-12 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE MARGINAL-COST CURVE AND THE FIRM’S SUPPLY DECISION  To extend this analysis of profit maximization, consider the cost curves in Figure 14.1.  The marginal-cost curve (MC) is upward sloping.  The average-total-cost curve (ATC) is U-shaped.  The MC crosses the ATC at the minimum of average total cost. . 14-13 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE MARGINAL-COST CURVE AND THE FIRM’S SUPPLY DECISION (CONTINUED)  The figure also shows a horizontal line at the market price (P).  The price line is horizontal because the firm is a price taker.  For a competitive firm, the firm’s price equals both its average revenue (AR) and its marginal revenue (MR). . 14-14 FIGURE 14.1 Profit Maximization for a Competitive Firm . 14-15 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE MARGINAL-COST CURVE AND THE FIRM’S SUPPLY DECISION (CONTINUED)  Three rules are key to rational decision making for profit maximization: 1. If marginal revenue is greater than marginal cost, the firm should increase its output. 2. If marginal cost is greater than marginal revenue, the firm should decrease its output. 3. At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal. . 14-16 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN  Under some circumstances, a firm will decide to shut down and not produce anything at all. . 14-17 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN (CONTINUED)  Shutdown versus exit:  A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.  An exit refers to a long-run decision to leave the market.  The short-run and long-run decisions differ because most firms cannot avoid their fixed costs in the short run but can do so in the long run. . 14-18 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE What determines a firm’s shutdown decision?  If the firm shuts down, it loses all revenue from the sale of its product.  At the same time, it saves the variable costs of making its product (but must still pay the fixed costs).  Thus, the firm shuts down if the revenue that it would earn from producing is less than its variabl on. . 14-19 Cartoonresource/Shutterstock THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN (CONTINUED)  PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN (CONTINUED) . 14-20 FIGURE 14.3 The Competitive Firm’s Short-Run Supply Curve . 14-21 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE SPILT MILK AND OTHER SUNK COSTS  Sunk cost: A cost that has already been committed and cannot be recovered.  Because nothing can be done about sunk costs, they can be ignored when making decisions about various aspects of life, including business strategy. . 14-22 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE FIRM’S LONG-RUN DECISION TO EXIT OR ENTER A MARKET  If the firm exits, it again will lose all revenue from the sale of its product, but now it saves on both fixed and variable costs of production.  The firm exits the market if the revenue it would get from producing is less than its total costs. . 14-23 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE FIRM’S LONG-RUN DECISION TO EXIT OR ENTER A MARKET (CONTINUED) EXIT IF TR < TC . 14-24 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE THE FIRM’S LONG-RUN DECISION TO EXIT OR ENTER A MARKET (CONTINUED)  The exit price coincides with the minimum point on the average-total-cost curve.  The shutdown price coincides with the minimum point on the average-variable-cost curve. . 14-25 FIGURE 14.4 The Competitive Firm’s Long-Run Supply Curve . 14-26 PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE MEASURING PROFIT IN OUR GRAPH FOR THE COMPETITIVE FIRM  It is useful to analyze the firm’s profit in more detail.  This way of expressing the firm’s profit allows us to 14-27 measure profit in . FIGURE 14.5 Profit as the Area between Price and Average Total Cost . 14-28 Quick Quiz  How does the price faced by a profitmaximizing competitive firm compare to its marginal cost? Explain.  When does a profit-maximizing competitive firm decide to shut down?  When does a profit-maximizing competitive firm decide to exit a market? . 14-29 Active Learning Identifying a Firm’s Profit A competitive firm Determine this firm’s total profit. Costs, P Identify the area on the graph that represents the firm’s profit. P = $10 MC MR ATC $6 50 . Q 14-30 Active Learning Answers Costs, P A competitive firm Profit per unit = P – ATC = $10 – 6 = $4 MC MR P = $10 ATC profit $6 Total profit = (P – ATC)×Q = $4×50 = $200 . 50 Q 14-31 Active Learning Identifying a Firm’s Profit Determine this firm’s total loss, assuming AVC < $3. A competitive firm Costs, P MC ATC Identify the area on the graph that represents the firm’s loss. $5 MR P = $3 30 . Q 14-32 Active Learning Answers A competitive firm Costs, P MC Total loss = (ATC – P)×Q = $2×30 = $60 ATC $5 P = $3 loss loss per unit = $2 MR 30 . Q 14-33 THE SUPPLY CURVE IN A COMPETITIVE MARKET  Let’s discuss the supply curve for a market.  There are two cases to consider: 1. A market with a fixed number of firms 2. A market in which the number of firms can change as old firms exit the market and new firms enter . 14-34 THE SUPPLY CURVE IN A COMPETITIVE MARKET THE SHORT RUN: MARKET SUPPLY WITH A FIXED NUMBER OF FIRMS  Consider first a market with 1000 identical firms.  For any given price, each firm supplies a quantity of output so that its marginal cost equals the price. . 14-35 FIGURE 14.6 Market Supply with a Fixed Number of Firms . 14-36 THE SUPPLY CURVE IN A COMPETITIVE MARKET THE LONG RUN: MARKET SUPPLY WITH ENTRY AND EXIT  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. (Vice versa.)  At the end of this process of entry and exit, firms that remain in the market must be making zero 14-37 economic profit. . FIGURE 14.7 Market Supply with Entry and Exit . 14-38 THE SUPPLY CURVE IN A COMPETITIVE MARKET THE LONG RUN: MARKET SUPPLY WITH ENTRY AND EXIT (CONTINUED)  The long-run equilibrium of a competitive market with free entry and exit must have firms operating at their efficient scale. . 14-39 THE SUPPLY CURVE IN A COMPETITIVE MARKET 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. . 14-40 THE SUPPLY CURVE IN A COMPETITIVE MARKET A SHIFT IN DEMAND IN THE SHORT RUN AND LONG RUN  Because firms can enter and exit a market 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. . 14-41 FIGURE 14.8 An Increase in Demand in the Short Run and Long Run . 14-42 FIGURE 14.8 An Increase in Demand in the Short Run and Long Run (Continued) . 14-43 FIGURE 14.8 An Increase in Demand in the Short Run and Long Run (Continued) . 14-44 THE SUPPLY CURVE IN A COMPETITIVE MARKET WHY THE LONG-RUN SUPPLY CURVE MIGHT SLOPE UPWARD  Two reasons why the long-run market supply curve might slope upward: 1. Some resources used in production may be available only in limited quantities. 2. Firms may have different costs. . 14-45 FIGURE 14.9 An Upward Sloping Long-Run Supply Curve . 14-46 Quick Quiz  In the long run with free entry and exit, is the price in a market equal to marginal cost, average total cost, both, or neither?  Explain with a diagram. . 14-47 Classroom Activity A Profitable Opportunity? • As a recent graduate of this college, you have landed a job in production management for Universal Clones Inc. You are responsible for the entire company on weekends. • Your costs are shown below. Quantity Average Total Cost 500 200 501 201 • Your current level of production is 500 units. All . 500 units haveyour regular 14-48 Classroom Activity A Profitable Opportunity? • (continued) The phone rings. It’s a new customer who wants to buy 1 unit of your product. This means you would have to increase production to 501 units. Your new customer offers you $450 to produce the extra unit. A. Should you accept this offer? B. What is the net change in the firm’s profit? . 14-49