Firm Behavior and the Organization of Industry

1. Firm Behavior and the Organization of Industry Firms in Competitive Markets

2. Outline • What is a competitive market? • How do competitive markets decide the quantity of production? • When do firms decide to shut down and exit the market? • How does the firm’s behavior determine the firm’s SR and LR supply curves?

3. What is a competitive market? • There are many buyers and sellers in the market • The goods offered by the sellers are largely similar or identical • Buyers and sellers are price takers • Firms can freely enter or exit the market • Complete information

4. What is a competitive firm? • Firm must be small relative to the size of the market • Individual firms cannot affect the market price • The objective of the firm is to maximize profits • As the price is set in the market as a whole, the individual firm adjusts its output to maximize its profit at the given market price

5. Profit maximization • Profit=TR-TC • TR=PQ • Since P is given the TR will be a straight line from the origin • AR=PQ/Q; AR=P • MR=change in TR/ change in Q • Since price is given, MR=P

6. Profit maximization and the Firm’s Supply Curve • Profit maximization occurs by producing the quantity at which MR=MC • The firm’s MC curve determines the quantity of the good that the firm is willing to supply at any given price • Therefore, MC curve becomes the supply curve of the firm

7. Firm’s SR Decision to Shut Down • Shutdown refers to a SR decision not to produce anything during a specific period of time • Firm shuts down if its P<AVC • The firm has to continue incurring the fixed costs • Sunk cost is a cost that has already been committed and cannot be recovered in the SR

8. Firm’s SR Supply Curve • The firm’s short run supply curve will be its MC curve above its AVC curve and the size of the FC has no impact on the SR supply decision • If P is equal to or greater than Min AVC the firm will produce where P = MR = MC • If P < Min AVC the firm’s loss minimizing strategy is to shut down. Loss will equal TFC (sunk cost)

9. SR Market Supply Curve with a Fixed Number of Firms • The supply curve of each firm is its MC curve above its min AVC point • The market supply curve is the horizontal sum of the quantity supplied by the fixed number of firms in the industry

10. Firm’s LR Decision to Exit or Enter a Market • In the long run firms can change the size of their plants and move along their LAC curves • Firms can enter or leave the industry. They will enter if there is economic profit and leave if they are suffering economic losses • The firm will exit the market if P<ATC • The firm will enter the market if P>ATC

11. Market’s LR Supply Curve with Entry and Exit • The firm’s LR supply curve is the portion of the MC curve that lies above ATC curve • Market price must adjust (via shifts in the short run supply curve) until all firms are making zero economic profit (normal profit) • With normal profit there is no economic profit to attract new entrants and no economic losses to encourage existing firms to exit

12. Market’s LR Supply Curve with Entry and Exit • The process of entry and exit ends only when P=ATC and there is zero economic profit • This equilibrium occurs at the minimum point of ATC • The LR equilibrium of a competitive market with free entry and exit must have firms operating at their efficient scale • LR supply curve for the market is horizontal at P=min ATC • Otherwise firms could make economic profit by changing their plant size which would shift the SR supply curve of the industry

13. SR demand • Market demand curve is the horizontal sum of all the demand curves of individuals • Short run market supply curve is the horizontal sum of all the short run supply curves of all the firms currently in the industry • Each individual firm will produce at its profit max point of MR = MC • Equilibrium is at the intersection of demand and supply curves

14. Shifts in demand in the LR • Occur as shifts in demand in the SR and thus raise profits (losses) for existing firms • This results in entry of new firms or exit of existing firms • An individual firm continues to produce at zero economic profit

15. Shifts in demand in the SR • Shifts in demand will create a movement along the market short run supply curve, changing market price • Each individual firm will adjust output to its new profit max level as price changes, moving along its own short run supply curve • When the demand for a good increases, market price remains same but quantity increases due to increase in the number of firms

16. Why the LR Market Supply Curve may Slope Upwards? • Two reasons: • Production input may be available in limited quantities • Firms may have different costs • In the above cases LR market supply curve will slope upwards even with free entry

17. LR Market Supply Curve Slopes Upwards: Profits in the LR • Firms with different costs have different profits even in the LR • Here, P= ATC of the marginal firm • The marginal firm earns zero profit • Entry does not eliminate the profits • Conclusion: Due to ease of entry and exit in the LR, the LR supply curve is more elastic than the SR supply curve

18. Possible Long Run Supply Curves • Constant cost industry -- horizontal LRS. Changes in the size of the industry do not affect firms’ costs of production • Increasing cost industry – upward sloping LRS. As an industry grows a factor price rises as a result, increasing costs for all firms • Decreasing cost industry – downward sloping LRS. As an industry grows a factor price falls as a result, decreasing costs for all firms • Technological change shifts the LRS