# FIRMS IN COMPETITIVE M For firms in competitive markets: MR = P . Pro¯¬¾t Maximization TableExercise

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• 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 C dQ

dAV C

dQ

=

d

⇣ V C Q

dQ

=

dV C

dQ

1

Q

� V C Q

2 > 0

) MC = dV C dQ

> AV C =

V C

Q

dATC

dQ

=

d

⇣ TC Q

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: 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

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