Chapter 14: Firms in Competitive Markets. Total revenue = price per unit sold number of units sold = p q

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1 Chapter 14: Firms in Competitive Markets Profit and Revenue The firm's goal is to maximize profit. Profit = total revenue - total cost (opportunity cost) Total revenue = price per unit sold number of units sold = p q We will see that industry structure affects how much firms produce (q) and the price they receive for their products. 1

2 Perfect competition Characteristics: 1. There are many buyers and sellers in the market 2. The goods offered by the various sellers are largely the same Note: 1 and 2 firms in the market are price takers The actions of any single buyer or seller in the market have a negligible impact on price. Thus, each buyer and seller takes the market price as given. 3. No barriers to entry. (Can anyone enter the market, set up a business, and sell the product?) As an example, let's look at the market for an agricultural product - -- wheat. Assume that Willy sells wheat.! What is the market demand curve for wheat?! What is the demand curve for Willy's wheat? 2

3 Start by drawing the market demand and supply curve. This gives equilibrium price ($3.00 per bushel) and quantity (5 billion bushels).! Assume that Willy grows 12 bushels of wheat. What price will he get for his wheat on the market?! What if Willy grows 24 bushels of wheat? What price will he get for his wheat on the market? We end up with Willy's demand curve. How much will Willy want to sell? He wants to maximize his TOTAL profit. 3

4 Use marginal analysis. Compare the MB of growing an additional bushel of wheat to the MC. What is the MB for Willy of producing another bushel of wheat? MB = marginal revenue = total revenue/ q produced = MR MR = price of bushel of wheat = $3.00 (for any bushel) MR = demand curve Let's do an example: Quantity (in bushels) Price Total Revenue MR 1 $3 $ 3 2 $3 $ 6 $3 3 $3 $ 9 $3 4 $3 $12 $3 MR = price for the competitive firm Why? 4

5 What is the cost to Willy of producing a bushel of wheat? The MC! Marginal analysis says:! If MR>MC of a bushel, Willy should grow the bushel since it would be profitable.! If MR<MC of a bushel, Willy should not grow the bushel since it would not be profitable. If Willy produces an additional bushel of wheat when MR<MC, he will subtract from his total profits. 5

6 Profit per unit is the vertical distance between MR and MC. When MR > MC each bushel adds to Willy's total profit. When MR < MC, each bushel subtracts from Willy's total profit. Willy should produce until MR = MC. he should produce q* bushels. 6

7 General rule for profit maximization At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal. This shows us how the competitive firm decides the quantity of good to produce. Competitive firm is price-taker. Thus, marginal revenue = price. Thus, profit-maximizing q is where p=mc. 7

8 What is Willy's total profit when he grows q* bushels of wheat? We need to take fixed costs into account. Profit = total revenue - total cost p* q* ATC* q* Total revenue Total cost Profit = area p*aq*o = area cbqo = p*abc Willy is making a profit! NOTE (some math): Profit = p q - ATC q = (p-atc) q If p>atc profit is positive If p<atc profit is negative How do we know if a firm is making an economic profit? When total revenue > total cost p*>atc* What if economic profit = zero? Then Willy is making enough revenue to cover his costs. (Remember that costs are opportunity costs. Include foregone wages, and foregone interest, for example. Even if economic profit = zero, Willy has generated enough revenue to compensate him for these opportunity costs.) What if economic profits are negative? 8

9 The Shutdown Point Will Willy shutdown his wheat farm if he makes an economic loss? Answer: Eventually but not necessarily right away! Consider a store that sells things from Hawaii called TFH (Things From Hawaii). Total revenue = $100 a day Total cost = fixed cost + variable costs = $120 a day If it stays in business it loses $20 a day. 9

10 Should it shut down? Compare fixed and variable costs with total revenue. Total revenue = $100 a day Total cost = fixed cost + variable costs = $120 a day = $50 + $70 = $120 a day! Run business and lose $20 a day! Shut down and lose $50 a day. Run business, at least for a while. Minimize losses! Total revenue total variable costs run business, lose less than if business is closed. Assume that the fixed costs were generated by a 6 month lease. The cost of the lease is a sunk cost. Defn. A cost that has already been committed and cannot be recovered. Note: Because nothing can be done about sunk costs, you can ignore them when making decisions about business strategy (and various aspects of life!). (Don't cry over spilt milk!) Lesson: Fixed costs are sunk costs in the short run. Thus the firm can safely ignore them when deciding how much to produce. 10

11 Assume 6 months has passed. Now the lease runs out it becomes a variable cost. Now for Things From Hawaii (TFH): Total revenue = $100 a day Total cost = fixed cost + variable costs = $120 a day = $0 + $120 = $120 a day! Run business and lose $20 a day! Shut down and lose $0 a day. TFH should shut-down when rent becomes a variable cost. Minimize losses! 11

12 Total revenue < total variable costs shut down business, lose less than if business is open. Shut down if TR< VC TR/q < VC/q p < AVC Total revenue total variable costs run business, lose less than if business is closed. Don't shut down if TR VC TR/q VC/q p AVC 12

13 Deriving the competitive firm's short-run supply curve. 1. MR = MC q* is equilibrium. 2. Run the firm and supply q* when price is p*. 3. What if price fell to p'? Should produce q' to maximize profits. But p'<avc don't operate the firm quantity = zero. (The Shutdown Rule applies!) Supply 0 when price is p' 4. Supply until p = AVC. 5. Once p = AVC, the short-run supply curve = the MC curve. Short-run supply curve = portion of MC curve that lies above AVC. Deriving the competitive firm's long-run supply curve. Easy. If firm exits, it loses all revenue from production. However, now (in the long-run) it saves on both fixed and variable costs. Exit if Enter if TR < TC TR/q < TC/q p < ATC TR TC TR/q TC/q p ATC Long-run supply curve = portion of MC cost that lies above ATC 13

14 What about the market (industry) S curve? Market supply = quantity supplied by all the firms in the market Just add up how much each firm will supply at each price (just like demand). How does the market and firm respond to changes in demand in perfect competition? 1. Find where D = S in market. This gives equilibrium (Q*, p*). 2. Recall that firm has no effect on price --- Willy is a "price-taker. So p* is price firm Willy receives on market for his wheat he will produce q* bushels. Now suppose there is a permanent increase in the demand for wheat. The new price is p' and quantity is Q'. 3. Note that price and quantity of wheat has increased in market. 4. This means that MR=d is higher. The demand for Willy's wheat has increased. Now Willy makes positive economic profits since p>atc. He increases production to q'. 5. Other firms see Willy making positive economic profits. They are induced to enter the market. And they can easily enter the market since there are no barriers to entry. 6. Now there are more firms in the market. This shifts out the market supply curve. 7. Price falls but Q keeps increasing. 14

15 8. Now p is lower, so economic profit is lower. But, there still is an economic profit. So there will be an inducement for new firms to enter the market. More firms enter. 9. Q keeps increasing but p is falling. 10. p is back to where it was before and there are no economic profits. Willy is making normal profits again. No longer any entry to the industry. (When p = ATC no inducement to enter industry.) 11. Supply curve now is stationary since no more firms are entering. 12. We are back in long-run equilibrium. 15

16 Will price always fall back to long-run price? Here it does since none of the costs change. But, more realistic to think of costs changing as more firms enter the industry. It is possible that when more firms enter the industry, costs go up for all firms. How could this happen? Firms may bid up the price of an input, for example. This would shift up ATC if the input was a fixed cost. As a result, p does not fall back to its original level. The long-run supply curve may be upward sloping. 16

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