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

  • 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 an