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Chapter 14 Firms in Competitive Markets

Chapter 14 Firms in Competitive Markets. What is a Competitive Market?. Characteristics: Many buyers & sellers Goods offered are largely the same Firms can freely enter &/or exit the market Buyers & sellers are price takers. Revenue of a Competitive Firm. Total Revenue = Price x Quantity

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Chapter 14 Firms in Competitive Markets

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  1. Chapter 14 Firms in Competitive Markets

  2. What is a Competitive Market? • Characteristics: • Many buyers & sellers • Goods offered are largely the same • Firms can freely enter &/or exit the market • Buyers & sellers are price takers

  3. Revenue of a Competitive Firm • Total Revenue = Price x Quantity (remember these types of firms can’t change price, so they have to change Q) • Average Revenue = TR/Quantity • Marginal Revenue = Change in TR/Change in Q • For perfectly competitive firms, AR & MR are equal to the price

  4. Profit Maximization • If MR > MC, increasing output raises profit • If MR < MC, decreasing output raises profit • Therefore, profit maximization is where MR = MC

  5. Profit Maximization • Since MR = Market Price for perfectly competitive firms, it looks like…

  6. Profit Maximization • Since MC determines Q, it becomes the competitive firm’s supply curve

  7. Short-Run Decision to Shut Down • Shutdown vs. Exit • If you temporarily shut down, you still pay fixed costs • You shut down if TR < VC or similarly, P < AVC • Competitive Firm’s short-run supply curve is portion of MC curve above AVC

  8. Short-Run Decision to Shut Down

  9. Sunk Costs • Cost has already been committed and cannot be recovered – ignore them in decisionmaking • Cases: Near Empty Restaurants & Off-Season Miniature Golf

  10. Firm’s Long-Run Decision to Exit or Enter a Market • Firm will exit market if revenue it would get from producing is less than its total costs (exit if P < ATC) • Firm will enter market if P > ATC • Firm’s long-run supply curve is the portion of its MC curve that lies above ATC

  11. Measuring Profit • Profit = (P – ATC) x Q

  12. Short Run: Fixed # of Firms • As long as P > AVC, each firm’s MC curve is its supply curve • Market is just a sum of the Q for each indiv. firm

  13. Long Run: Entry & Exit • Firms will enter or exit based on incentives (are existing firms profitable?) • At the end of the process, firms that remain in the market must be making zero economic profit • This happens when P = ATC or TR = TC SO…

  14. Long-Run Equilibrium • If firms maximize profit at P = MC and P = ATC to make economic profits equal zero then… The level of production will be at the efficient scale where MC = ATC

  15. Why stay in business with Zero Profit? • Zero profit includes opportunity costs, so to stay in business, firm’s revenues must be compensating owner for opp. costs

  16. Shift in Demand in Short & Long Run • Side by Side Analysis • If market is in long-run equilibrium, firms earn zero profit and P = min. of ATC • If demand increases, price increases and firms will produce more in short run… so, P is now greater than ATC and firms are earning profit • Profit attracts new firms and supply curve shifts to right, lowering price and returning us to zero economic profit

  17. Side by Side Analysis

  18. Why Long-Run Supply Curve Might Slope Upward • Normally, we assume all entrants to market face same costs and ATC was unaffected by entry of others, so long-run Supply curve of industry is horizontal line at minimum of ATC

  19. Why Long-Run Supply Curve Might Slope Upward • 2 possible reasons why this might not be the case: • If a resource is limited in quantity, entry will increase price of resource and raise ATC • If firms have different costs, it’s likely those with lowest costs enter industry first. If demand then increases, firms that would enter will likely have higher costs

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