FIRMS IN COMPETITIVE MARKETS J. Mao

Firms in Competitive Markets

¨  Firms in competitive markets are price takers.

Revenue of a diary farm

Firms in Competitive Markets

¨  Total Revenue (TR) = P×Q ¨  Average Revenue (AR) = TR/Q = P

¤  How much revenue does the farm receive for the typical gallon of milk?

¨  Marginal Revenue (MR) = ΔTR/ΔQ ¤  How much additional revenue does the farm receive if

it increases production of milk by 1 gallon? ¤  For firms in competitive markets: MR = P

Exercise Profit Maximization Table

Prof Jonathan Wolff ( Department of Economics University of Notre Dame)Principles of Micro Economics October 8th, 2012 18 / 48

Profit Maximization

Profit Maximization

¨  What Q maximizes profit? ¨  Think at the margin! ¨  Profit = TR – TC = (P – ATC) × Q

• TC = FC + V C

• MC =

dTCdQ =

dV CdQ

dAV C

dQ

=

d

⇣V CQ

⌘

dQ

=

dV C

dQ

1

Q

� V C

Q

2> 0

) MC =

dV C

dQ

> AV C =

V C

Q

dATC

dQ

=

d

⇣TCQ

⌘

dQ

=

dTC

dQ

1

Q

� TC

Q

2> 0

) MC =

dTC

dQ

> ATC =

TC

Q

dProfit

dQ

=

d (PQ� TC)

dQ

= MR�MC = P �MC

1

Profit Maximization

Entry, Exit, and Shutdown

¨  When a firm enters a market, it pays an entry cost. ¤  The entry cost is an initial, one time fixed cost that the firm

needs to pay in order to start its operation. Example: land, office and factory buildings, equipment, etc.

¨  When a firm exits the market, it can sell its existing land and capital and receive a scrap value

¨  When a firm is in the market and doesn’t want to exit, it can still shut down its operation in any given period by not producing anything.

¨  The produce/shutdown decision is a short-run decision.

¨  The entry/exit decision is a long-run decision.

Carolyn’s Cookie Factory

Carolyn’s Cookie Factory: Case 1

¨  Carolyn purchases office space and converts it into a kitchen. Carolyn also buys all her kitchen equipment

¨  Entry cost: office space, kitchen equipment ¨  Per period fixed costs: utilities ¨  Variable costs: wages, flour, eggs, sugar, etc. ¨  Scrap value: the resale value of the kitchen and its

equipment

Carolyn’s Cookie Factory: Case 1

¨  If Carolyn shuts down her factory for a month ¤  Saves: variable costs ¤  Still has to pay: utilities

¨  If Carolyn exits the market ¤  Saves: variable costs, utilities ¤  In addition, gets the re-sale value of the kitchen and

equipment

Carolyn’s Cookie Factory: Case 2

¨  Carolyn purchases kitchen equipment but rents a kitchen (instead of building one herself)

¨  Entry cost: kitchen equipment ¨  Per period fixed costs: rent for kitchen, utilities ¨  Variable costs: wages, flour, eggs, sugar, etc. ¨  Scrap value: the resale value of kitchen equipment

Carolyn’s Cookie Factory: Case 2

¨  If Carolyn shuts down her factory for a month ¤  Saves: variable costs ¤  Still has to pay: rent for kitchen, utilities

¨  If Carolyn exits the market ¤  Saves: variable costs, utilities, rent for kitchen ¤  In addition, gets the re-sale value of equipment

Carolyn’s Cookie Factory: Case 3

¨  Carolyn rents both kitchen and equipment ¨  Entry cost: 0 ¨  Per period fixed costs: rent for kitchen, rent for

equipment, utilities ¨  Variable costs: wages, flour, eggs, sugar, etc. ¨  Scrap value: 0

Carolyn’s Cookie Factory: Case 3

¨  If Carolyn shuts down her factory for a month ¤  Saves: variable costs ¤  Still has to pay: rent for kitchen, rent for equipment,

utilities ¨  If Carolyn exits the market

¤  Saves: variable costs, utilities, rent for kitchen, rent for equipment

Short Run

¨  When a firm shuts down, it saves the variable costs of production

¨  A firm will shut down if TR < VC ¤  => P < AVC

¨  The short-run (SR) supply curve of a firm in a competitive market is the portion of its MC curve above its AVC curve (Equivalently, above its minimum AVC)

SR Firm Supply

Quantity

ATC

AVC

0

Costs

MC

If P < AVC, shut down.

If P > AVC, keep producing in the short run.

If P > ATC, keep producing at a profit.

Firm’s short-run supply curve.

Long Run

¨  In the long run, for simplicity, assume 1.  Entry cost = 0 2.  Scrap value = 0 ¨  Then a firm will enter if TR > TC and exit if TR < TC

¤  => Enter if P > ATC and exit if P < ATC ¨  The long-run (LR) supply curve of a firm in a

competitive market is the portion of its MC curve above its ATC curve (Equivalently, above its minimum ATC)

LR Firm Supply

Quantity

MC = Long-run S

ATC

AVC

0

Costs

Firm enters if P > ATC

Firm exits if P < ATC

Market Supply: Assumptions

¨  All existing firms and potential entrants have identical costs

¨  Each firm’s costs do not change as other firms enter or exit the market

¨  The number of firms in the market is ¤  fixed in the short run ¤  variable in the long run

SR Market Supply

¨  For any given price, each firm supplies a quantity of output so that MC = P.

¨  The market supply curve reflects the individual firms’ marginal cost curves.

SR Market Supply

LR Market Supply

¨  In the long run, firms can enter and exit ¨  If existing firms earn positive profit

¤  New firms will enter, leading to an increase in total quantity supplied n  In addition, fixed costs become variable in the long run,

leading to increased production of existing firms ¤  The increase in supply drives down price

¨  If existing firms incur losses ¤  Firms will exit, leading to a decrease in total quantity

supplied n  As fixed costs become variable, existing firms may also shift

their SR supply curve to the left ¤  The decrease in supply drives up price

¨  The process of entry and exit continues until firms that remain in the market make zero profit

Zero Profit Condition (ZPC)

¨  In the long-run equilibrium of competitive markets, firms make zero economic profit

¨  Since 1.  Zero profit occurs at P = ATC 2.  Firms product at P = MC ¨  ZPC => in LR equilibrium, P = MC = ATC ¨  Recall that MC in intersects ATC at minimum ATC ¨  Therefore, in LR equilibrium, P = minimum ATC

¤  In the long run, perfectly competitive firms produce at the efficient scale

¨  The LR market supply curve is perfectly elastic

LR Market Supply

LR Market Supply

LR Market Supply

LR Market Supply

Why The LR Supply Curve Might Slope Upward

¨  The LR supply curve slopes upward if there is anything that, in the long run, drives up cost as production increases (i.e. as more firms enter the market)

¨  Recall that the LR market supply curve is horizontal if… ¤  all firms have identical costs, and ¤  costs do not change as other firms enter or exit the

market

Firms have different costs

¨  As P rises, firms with lower costs enter the market before those with higher costs.

¨  ZPC: In LR equilibrium, the marginal firm operates at P = minimum ATC and profit = 0.

¨  For lower-cost firms, profit > 0 in the LR ¨  Market price reflects the ATC of the marginal

firm ¨  The LR supply curve slopes upward since increase in

market supply is driven by higher cost firms entering the market

Costs rise (for all firms) as more firms enter the market

¨  In some industries, the supply of a key input is limited (e.g., amount of land suitable for farming is fixed)

¨  The entry of new firms increases demand for this input, causing its price to rise.

¨  This increases all firms’ costs. ¨  Hence, an increase in P is required to increase the

market quantity supplied, so the LR supply curve is upward-sloping

Perfect Competition

¨  Many buyers and many sellers ¨  All goods are the same (homogeneous good) ¨  Perfect information

¤  No search friction ¤  No information asymmetry

Perfect Competition

¨  Many buyers and many sellers ¨  All goods are the same (homogeneous good) ¨  Perfect information

¤  No search friction ¤  No information asymmetry

¨  Free entry and exit ¤  Low entry costs are needed to maintain the long-run

competitiveness of competitive markets

SR vs. LR in General

¨  In general, if we are initially in long-run equilibrium and then demand shifts up..... ¤  The impact on P is larger in the short run than in the

long run ¤  The impact on Q is larger in the long run than in the

short run ¨  i.e., the market supply curve is more elastic in the

long run than in the short run

The Impact of Trade

¨  Assume that in the U.S., ¨  Initial Situation: No imports from China. ¨  New Situation: Imports come in from China at price

PChina

The Impact of Trade Impact of Imports in the Short and Long Run

The Impact of Trade Impact of Imports in the Short and Long Run

The Impact of Trade

¨  Imports in the SR: 200 ¨  Imports in the LR: 300

¤  Everything is imported

The Impact of Trade

¨  List of industries hit by a surge of imports from China ¤  All are intensive users of low-skill labor

Industry Curtain & drapery mills Other household textile prod mill Women's & girls' cut & sew dress Women's & girls' cut & sew suit, Infants' cut & sew apparel mfg Hat, cap, & millinery mfg Glove & mitten mfg Men's & boys' neckwear mfg Other apparel accessories Blankbook, looseleaf binder, Power-driven handtool mfg Electronic computer mfg Electric housewares & fan mfg Wood household furniture mfg Metal household furniture mfg Silverware & plated ware mfg Costume jewelry & novelty mfg Mean of China Surge Industries (N=17)

Import Share of Shipments

(percent)

China Share of Imports (percent)

1997 2007 1997 2007

Percent Change in U.S Employment 1997-2007

8 56 38 65 -47 22 68 25 49 -51 29 67 21 55 -71 48 92 19 49 -91 60 99 08 62 -97 44 80 26 67 -74 58 88 50 63 -78 25 56 02 59 -67 39 80 35 64 -75 18 47 43 52 -51 28 56 18 46 -56 12 49 0 56 -68 52 78 48 76 -54 29 62 18 46 -51 29 55 37 85 -48 44 91 31 73 -82 31 68 31 67 -63 34 70 26 61 -66

Industry Curtain & drapery mills Other household textile prod mill Women's & girls' cut & sew dress Women's & girls' cut & sew suit, Infants' cut & sew apparel mfg Hat, cap, & millinery mfg Glove & mitten mfg Men's & boys' neckwear mfg Other apparel accessories Blankbook, looseleaf binder, Power-driven handtool mfg Electronic computer mfg Electric housewares & fan mfg Wood household furniture mfg Metal household furniture mfg Silverware & plated ware mfg Costume jewelry & novelty mfg Mean of China Surge Industries (N=17)

Import Share of Shipments

(percent)

China Share of Imports (percent)

1997 2007 1997 2007

Percent Change in U.S Employment 1997-2007

8 56 38 65 -47 22 68 25 49 -51 29 67 21 55 -71 48 92 19 49 -91 60 99 08 62 -97 44 80 26 67 -74 58 88 50 63 -78 25 56 02 59 -67 39 80 35 64 -75 18 47 43 52 -51 28 56 18 46 -56 12 49 0 56 -68 52 78 48 76 -54 29 62 18 46 -51 29 55 37 85 -48 44 91 31 73 -82 31 68 31 67 -63 34 70 26 61 -66