LECTURE #12: MICROECONOMICS CHAPTER 14

1. LECTURE #12: MICROECONOMICSCHAPTER 14 Competitive Markets Profit Maximization Supply Function

2. Firms in Competitive Markets • 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. • There are three characteristics of a [perfectly] competitive market • There are many buyers and sellers. • Goods offered by the sellers are largely the same. • Firms can freely enter or exit the market.

3. Firms in Competitive Markets • The Revenue of a Competitive Firm • Total Revenue: Price times Quantity. TR = P x Q • Average Revenue: Total Revenue divided by Quantity sold. AR = TR / Q • Marginal Revenue: Change in Total Revenue from additional unit sold. MR = DTR / DQ

4. Profit Maximization Vaca Family Dairy Farm • Profit is maximized if the farm produces 4 or 5 gallons of milk (see Profit column). • Profit-Maximizing quantity occurs when marginal revenue = marginal cost. • If MR exceeds MC, increasing output will increase profit • If MR is less than MC, firm will increase profit by decreasing output. • Profit-maximization occurs where MR is equal to MC.

5. Profit Maximization and Competitive Firm's Supply Curve • The Marginal-Cost Curve and the Firm's Supply Decision • Cost curves have special features that are important for our analysis. • The marginal-cost curve is upward sloping. • The average-total-cost curve is U-shaped. • The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. • Marginal and average revenue can be shown by a horizontal line at the market price • To find the profit-maximizing level of output, we can follow the same rules that we discussed above.

6. Profit Maximization • If MR is greater than MC, the firm should increase its output. • MR1 > MC1 • If MC is greater than MR, the firm should decrease its output. • MR2 < MC2 • IF MR = MC, then firm is at profit-maximizing level of output • These rules apply to competitive firms, and firms with market power.

7. Profit Maximization • If market price changes, the firm would set its new level of output by equating marginal revenue and marginal cost.

8. Decision to Shut-Down, Enter or Exit • The Firm's Short-Run Decision to Shut Down • In certain circumstances, a firm will decide to shut down and produce zero output. • There is a difference between a temporary shutdown and an exit from the market. • A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. • Exit refers to a long-run decision to leave the market. • If a firm shuts down temporarily, it still must pay fixed costs. • If a firm exits the industry in the long run, it has no costs.

9. Decision to Shut-Down, Enter or Exit • If a firm shuts down, it will earn no revenue and will have only fixed costs • A firm will shut down if sales revenue less than its variable costs of production: Shut down if TR < VC. • Because TR = P x Q and VC = AVC x Q, we can rewrite this condition as: Shut down if P < AVC. • We now can tell exactly what the firm will do to maximize profit (or minimize loss). • If the price is less than average variable cost, the firm will produce no output. • If the price is above average variable cost, the firm will produce the level of output where marginal revenue (price) is equal to marginal cost

10. Decision to Shut-Down, Enter or Exit If P ≥ AVC, then Firm will set output where MR = MC IF P < AVC, then Firm will Shut-Down – Zero Output • Therefore, the competitive firm's short-run supply curve is the portion of its marginal revenue curve that lies above average variable cost.

11. Decision to Shut-Down, Enter or Exit • The Firm's Long-Run Decision to Exit or Enter a Market • If a firm exits the market, it will earn no revenue, but it will have no costs as well. • Therefore, a firm will exit if the revenue that it would earn from producing is less than its total costs: Exit if TR < TC. • Because TR = P x Q and TC = ATC x Q, we can rewrite this condition as: Exit if P < ATC. • A firm will enter an industry when there is profit potential, so this must mean that a firm will enter if revenues will exceed costs: Enter if P > ATC

12. Decision to Shut-Down, Enter or Exit • In the long run, a firm will remain in a market only if P ≥ ATC, the firm's long-run supply curve will be that portion of its marginal cost curve above the ATC. If: The Firm Will: P > ATC Enter because economic profits are earned P = ATC Not enter or exit because economic profits are zero P < ATC Exit because economic losses are incurred

13. Decision to Shut-Down, Enter or Exit • Measuring Profit in Our Graph for the Competitive Firm • Recall that Profit = TR −TC. • Because TR = P x Q and TC = ATC x Q, we can rewrite this equation: Profit = (P – ATC) x Q. • Using the Profit equation, we can measure the amount of profit (or loss) at the firm's profit-maximizing level of output (or loss-minimizing level of output)

14. Decision to Shut-Down, Enter or Exit

15. Supply Curve in a Competitive Market • The Short Run: Market Supply with a Fixed Number of Firms • Example: a market with 1,000 identical firms • Each firm's short-run supply curve is its MC curve above average variable cost. • Market supply curve: add Q supplied by each firm in the market at every given price.

16. Supply Curve in a Competitive Market • The Long Run: Market Supply with Entry and Exit • If firms in an industry are earning profit, this will attract new firms. • The supply of the product will increase (the supply curve will shift to the right). • The price of the product will fall and profit will decline. • If firms in an industry are incurring losses, firms will exit. • The supply of the product will decrease (the supply curve will shift to the left). • The price of the product will rise and losses will decline. • At the end of this process of entry or exit, firms that remain in the market must be earning zero economic profit.

17. Supply Curve in a Competitive Market • Because Profit = TR –TC, profit will be zero when TR = TC. • Because TR = P x Q and TC = ATC x Q, we can rewrite this as: P = ATC. • Therefore, the process of entry or exit ends when Price and ATC become equal. • This implies that the long-run equilibrium of a competitive market must have firms operating at their efficient scale.

18. Supply Curve in a Competitive Market • Why Do Competitive Firms Stay in Business If They Make Zero Profit? • Profit is equal to total revenue minus total cost. • To an economist, total cost includes all of the opportunity costs of the firm. • When a firm is earning zero economic profit, the firm's revenues are compensating the firm's owners for their opportunity costs.

19. Homework • Questions for Review: 1, 3, 4, 5 (4th Ed: 1, 2, 3, 4) • Problems and Applications: 3, 4, 6, 12 (4th Ed: 4, 5, 7, 11)