Goals

1. Lecture Notes: Econ 203 Introductory MicroeconomicsLecture/Chapter 14: Competitive Markets M. Cary LeaheyManhattan CollegeFall 2012

2. Goals • Analysis of one extreme pole of corporate behavior – perfect competition; the other pole – monopoly is the subject of the next chapter • First application of the “buzz words” developed in the prior chapter: • Production function • Price and marginal revenue (MR) and cost (MC) • Marginal costs and average total costs (ATC) • Fixed versus variable costs • Distinction between short- and long-runs

3. Introduction: revenue, price and costs of a competitive firm Total revenue (T) TR = P X Q Average revenue (AR) AR = TR/Q = P Marginal revenue (MR) MR = ∆TR/ ∆Q Since a competitive firm can keeping changing output without changing price (a price taker), each marginal (one unit) change in revenue is equal to the product of one unit of output. So MR = P for competitive markets 3

4. Profit maximization Profit maximization is found at the margin (the last unit produced). So increasing Q by one unit increases costs by MC and revenue by MR If MR > MC, then increase Q to raise profit. If MR , MC, then reduce Q to raise profit. 4

5. Profit maximization –$5 $5 $4 $6 1 9 6 4 5 15 8 2 7 23 10 0 7 33 12 –2 5 45 0 Q TR TC Profit MR MC Profit = MR–MC At any Q with MR > MC,increasing Q raises profit. 0 $0 $10 1 10 10 2 20 10 At any Q with MR < MC,reducing Q raises profit. 3 30 10 4 40 10 5 50

6. Marginal cost and the firm’s supply decision At Qa, MC < MR. So, increase Qto raise profit. At Qb, MC > MR. So, reduce Qto raise profit. At Q1, MC = MR. Changing Qwould lower profit. Costs MC P1 MR Q Q1 Qa Qb 0 Rule: MR = MC at the profit-maximizing Q.

7. Marginal cost and the firm’s supply decision If price rises to P2, then the profit-maximizing quantity rises to Q2. The MC curve determines the firm’s Q at any price. Hence, MC P2 MR2 P1 MR Q2 Q1 0 Costs the MC curve is the firm’s supply curve. Q

8. Shutdown versus exit Shutdown refers to temporary decision not to produce output because of market condtions. (This can be a long time such a firm such as Caterpillar). Exit refers to the long-run decision to leave the market. The key difference is if a firm shuts down, the firm must pay (cover) FC. If exit in the long run, zero costs. Costs of shutting down, loss of revenue TR Benefit of shutting down, cost saving of variable cost (VC) So shut down is TR < VC, or TR/Q < VC/Q, or P < AVC 8

9. The firm’s SR supply curve is the portion of its MC curve above AVC. A competitive firm’s SR supply curve Costs MC If P > AVC, then firm produces Q where P = MC. ATC AVC If P < AVC, then firm shuts down (produces Q = 0). Q 0

10. The irrelevance of sunk cost Fixed costs are sunk costs: costs that have already been committed and cannot be recovered (water under the bridge) Sunk costs are irrelevant to decision-making, as they are paid regardless of your choice So fixed costs do not enter the decision to shut down. Only variable costs matter for the shut down decision. 10

11. When to exit or enter the market Long run decision to exit Costs of exiting is revenue loss TR Benefits of exiting is the cost saving TC (zero FC in long run) Firm exits if TR < TC or TR/Q < TC/Q or P < ATC Conversely to decide to enter the market. In the long-run, a new firm will enter if it is profitable, or TR > TC Divide by Q, then TR/Q > TC/Q or P > ATC 11

12. The firm’s LR supply curve is the portion of its MC curve above LRATC. The competitive firm’s supply curve Costs MC Q 0 LRATC

13. Market supply: assumptions and market supply curve All existing firms and possible entrants have identical costs. Each firms costs do not change as other firms enter/leave market. The number of firms in the market is Fixed in short run due to fixed costs Variable in the long run due to ‘free” entry and exit As long as P > AVC, each firm will produce it profit-maximizing output where MC = MR Market supply is the sum of the quantities supplied by all firms. 13

14. The SR market supply curve S One firm Market P3 P3 P P MC P2 P1 P1 P2 AVC 30 10 20 Q Q 10,000 30,000 20,000 (market) (firm) 0 Example: 1000 identical firms At each P, market Qs = 1000 x (one firm’s Qs)

15. Entry and exit in the long run In the long run, the number of firms can change due to entry/exit. If existing firms earn profits, then new firms enter, SR supply curve shifts to the right. P falls, reducing profits and slowing entry. If existing firms suffer losses, some firms exit, SR supply curve shifts left, P rises , reducing remaining firms losses. All existing firms and possible entrants have identical costs. 15

16. Zero profit condition in the long run In the long-run equilibrium is obtained when the entry/exit process is complete and the remaining firms earn economic profit. Zero economic profit occurs when P = ATC Since production occurs where P = MR = MC = ATC in long run, since MC equals ATC at minimum ATC So in long run P = minimum ATC Firms stay in business with zero profit, since it includes all costs including the opportunity cost of the owners time and money. So economic profit = zero; accounting profit > zero 16

17. The LR market supply curve One firm Market P P LRATC MC long-run supply P = min. ATC Q Q (market) (firm) 0 The LR market supply curve is horizontal at P = minimum ATC. In the long run, the typical firm earns zero profit.

18. SR & LR effects of an increase in demand Market P P S1 MC S2 ATC Profit P2 P2 long-run supply P1 P1 D2 D1 Q Q Q1 Q2 Q3 (market) (firm) 0 A firm begins in long-run eq’m… …but then an increase in demand raises P,… …leading to SR profits for the firm. Over time, profits induce entry, shifting S to the right, reducing P… …driving profits to zero and restoring long-run eq’m. One firm B A C

19. Why is the long run supply curve positively sloped? The long run supply could be horizontal like the short run curve if: Costs do not change in response to entry/exit Otherwise the supply curve is the “normal” positive slope If firms have different costs, lower cost firms enter before those with higher costs, Further changes in P make it worthwhile for less efficient firms to enter the market increasing quantity supplied. So for the marginal firm, P = minimum ATC and profit = 0. For lower cost firms, profit > 0 If costs change as firms enter the market (as more farmers till a fixed number of acres), costs rise and prices rise. The cost for all firms rise, giving a positively sloped curve, as prices have to rise to increase aggregate supply. 19

20. Summary and conclusion Competitive market is efficient Profit maximization MC = MR Perfect competition P = MR With competitive equilibrium P = MC Since MC is the cost of the last extra unit equal to the value to buyers of that marginal unit, then the competitive equilibrium maximizes total (consumer and producer) surplus Shutdown; a will shut down is P < AVC Exit, a firm will exit if P < ATC With free entry and exit profits are zero in the long-run, where P = minimum ATC (= MC) 20