Chapter 14: Firms in Competitive Markets

14-1: What is a Competitive Market?

The Meaning of Competition

  • Competitive markets (aka perfectly competitive markets) have two characterstics
    • There are many buyers and sellers
    • The goods offered by different sellers are mostly the same
    • Anonther, optional, condition is thought to characterize competitive markets: a firm can freely enter or exit the market

The Revenue of a Competitive Firm

  • Suppose there is a dairy farm that produces Q quantity of milk at P price
    • Total revenue = P x Q
    • Since the farm is small as an individual firm, the price doesn’t change as more dairy is produced
  • Table representing profits at different quantities: image
    • The average revenue is the revenue divided by the amount of output, which represents the price
      • For all types of firms, average revenue equals the price of the good.
    • The marginal revenue is the change in revenue for each additional unit of output, which also represents the price because the price is fixed
      • For competitive firms, marginal revenue equals the price of the good.

14-2 Profit Maximization and the Competitive Firm’s Supply Curve

A Simple Example of Profit Maximization

  • The following table represents different profits at different quantities: image
    • The dairy farm wants to choose the quantity which makes the most profit (revenue - total cost) which would be 4 or 5 gallons of milk
    • Can also analyze when the marginal revenue is no longer greater than or equal to the marginal cost (Does it cost more to make a gallon of milk than the revenue we’d make? Is the revenue from the gallon of milk greater than its cost?)

The Marginal-Cost Curve and the Firm’s Supply Decision

  • Take into account the curves from last chapter which represented marginal cost, average total cost, average variable cost, and more: image
    • Remember that the price is the same as average and marginal revenue (AR and MR)
    • At Q1, the marginal cost is less than the marginal revenue, so the firm should produce more in order to realize a greater profit
    • At Q2, the marginal cost is greater than the marginal revenue, so the firm should produce less in order to prevent losses
  • This analysis provides three rules for maximizing profit
    • If marginal revenue is greater than marginal cost, the firm should increase its output.
    • If marginal cost is greater than marginal revenue, the firm should decrease its output.
    • At the profit-maximizing level of output, marginal revenue equals marginal cost.
  • If the price were to rise, then the firm would produce a higher quantity in order to make more profit, and if the price were to fall, then the price would produce less
    • The marginal cost curve therefore determines the quantity of good that a firm is willing to produce at any given price; similar to a supply surve with an elastic demand

The Firm’s Short-Run Decision to Shut Down

  • A shutdown is the decision to seize production during a period of time due to market conditions, while an exit refers to a long-term decision to leave a market
    • Shut down firms still have to pay fixed costs while exiting firms don’t have to pay any costs at all
    • Some of these costs can be opportunity costs; if a farmer doesn’t plant crops on his land, then the land is doing nothing and becomes a sunk cost
      • If he instead decides to sell the land, then he exits the market and does not pay this sunk cost
  • A firm will shut down if its total revenue would be less than any of its variable costs of production
    • Represented by TR (Total Revenue) < VC (Variable Costs)
    • Can be rewritten as TR/Q < VC/Q
    • Remember that TR/Q = P (Price) and VC/Q = AVC (Average Variable Costs)
    • Therefore, a firm should shut down if P < AVC
  • Visual Representation: image

Spilt Milk and Other Sunk Costs

  • A sunk cost is a cost that has been committed and cannot be recovered; should not be included when making decisions
  • When deciding whether or not a firm should shut down, we must assume that the firm’s fixed costs are sunk in the short run and should be ignored when making a decision
  • Relates to the adage “don’t cry over spilt milk”; can’t do anything about a sunk cost

The Firm’s Long-Run Decision to Exit or Enter a Market

  • Exiting a market means that you save both variable and fixed costs of production, so a firm exists a market if the revenue it would get from producing is less than the total costs of production
    • Represented by TR < TC (Total Cost)
    • Can be rewritten as TR/Q < TC/Q
    • TC/Q = Average Total Cost
    • Therefore, a firm should exit if P < ATC
    • Additionally, a firm should enter if P > ATC
  • Visual Representation: image

Measuring Profit in Our Graph for the Competitive Firm

  • Recall that Profit = Total Revenue - Total Cost
    • Can be rewritten as Profit = (TR/Q - TC/Q) * Q
    • Profit = (P - ATC) * Q
  • This way of looking at profit allows us to measure profit in the graphs: image

A Brief Recap

image image

14-3: The Supply Curve in a Competitive Market

  • In the short run, it’s unreasonable to assume that firms can easily enter or exit a market, but in the long run they can, so the number of firms will adjust accordingly

The Short Run: Market Supply with a Fixed Number of Firms

  • Consider a market with 1,000 identical firms; each has the same marginal cost curve, so the amount supplied will change depending on the price’s position on the curve
    • Graphs: image

The Long Run: Market Supply with Entry and Exit

  • Assume that everyone has access to the same technology for producing a good and access to the same markets to buy the inputs for production
    • In this scenario, all current and future firms have the same cost curves
  • If the firms in a market are profitable, then more firms will enter the market and decrease prices and profits
  • If the firms in a market are losing money, then firms will exist the market and increase prices and profits
  • These two forces will balance out, and firms that remain in the market will make zero economic profit
  • Recall that Profit = (P - ATC) * Q
    • Since all firms are making zero economic profit, the price and average total cost must be driven to equality over time
  • Firms maximize profit by choosing a quantity where their marginal cost is equal to the price, and the force of entry and exit ends when average total cost is equal to price
    • Thus, marginal cost and average total cost must equal each other which is where the average total cost is at its lowest
      • This point is called a firm’s efficient scale
    • Therefore, in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale
  • Graph: image
  • In the long run, the only price consistent with zero profit is the minimum of average total cost, and all firms must be price takers at this price, creating an elastic supply curve

Why Do Competitive Firms Stay in Business If They Make Zero Profit?

  • Recall that total costs include both implicit and explicit costs
    • Implicit costs are not seen in cash; they are opportunity costs
    • If the opportunity cost of the capital to create a farm is $80k/year of interest, then that might be the profit a farmer makes each year, leading to zero economic profit

A Shift in Demand in the Short Run and Long Run

  • Let’s say that a new scientific study increases the demand for milk
    • The price becomes higher than the minimum ATC, and firms realize a short term profit
  • As the market becomes more profitable, more firms enter, driving down the price and profits of milk
  • As more firms enter, the price goes back down to the minimum ATC, but the quantity produced and consumed of milk is higher than before
  • Figure: image

Why the Long-Run Supply Curve Might Slope Upward

  • There are two reasons why the long-run market supply curve might slope upwards instead of being perfectly elastic
    • The resources used in production are available only in limited quantities
      • There is limited land that you can purchase for farming, and as more farms are created, the price of land goes up as well
      • This means that the input cost of farms goes up, leading to an increase in price and an upwards slope
    • Firms might have different costs
      • Consider the painting market, where different painters are skilled
      • Newcomers have a higher cost because they are less skilled, and if the quantity demanded of painters increase, then the price needs to increase as well to make these newcomer firms profitable
      • Low cost firms make more of a profit, creating an upwards sloping supply curve
  • In both scenarios, some firms profit even in the long run because the price in the market reflects the average total cost of the marginal firm (new firms who would exit quickly if the price was lower)
  • Despite these factors, for the most part, because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is typically more elastic than the short-run supply curve.