Competitive Markets
Lecture 8

 

Characteristics of Purely Competitive Firms

 

  1. Purely Competitive firms - accepts the market price in order to sell their products.
    • Characteristics:
      • All firms produce an identical product.
      • A large number of firms are in the market.
      • Each firm supplies only a small portion of the total supplied to the market.
        • One firm cannot influence the price of the market.
      • No barriers to entry or exit
        • Example: If one firm earns economic profit, then rival firms can easily enter the market and try to earn profits
      • The firms maximize profit by adjusting production level, but cannot influence market price.
  2. Why study price takers?
    • Understand why competition is important.
    • Contrast competitive markets with a market controlled by a monopoly
    • Agricultural markets tend to be price takers.

Output in the Short Run

 

1. Marginal Revenue (MR) - is the change in total revenue when firm sells one more one unit.
  • Refer to graph.
  • The farmer only sees the market price.
    • If the farmer sells 1 bushel, he receives $2 (MR). The farmer sells another bushel, he receives another $2 (MR).
    • If the farmer raises his price of corn above the market price, then nobody buys it.
    • If the farmer sells his corn below the market price, then he lowers his revenue (loses money).
    • He can sell all his corn at the market price, so MR = P* = $2.
Price Taker's Demand Curve
A Farmer The Market
Price Price
A demand function for a competitive firm's product The market
Quantity Quantity

2. Profit maximization - the price taker will expand output n the short run until:

P = MR = MC

Note: The MR = MC maximizes profits for monopolies, and other profit driven industries, while MR = P is only valid for price takers.

Blue arrow This will maximize the firm's profits (or minimize its losses).
  MR = $3 and MC = $2. MR > MC, the firm will collect $3 for selling that last "additional" unit that only costs $2 to produce. Profit increases by $1.

MR = $3 and MC = $5. MR < MC, the firm will collect $3 for selling that last unit that costs $5 to produce. The firm should reduce production by 1 unit to increase profits.

Firm  
Price / Per-unit costs  
A competitive firm is earning profits Firm produces quantity q where 
MC = MR = P

Market Price > ATC, the firm is making a profit.

Profit = Total Revenue - Total Cost

Profit = P q - ATC q = (P - ATC) q

Profit = "The green area"

Quantity  
Firm  
Price / Per-unit costs  
A firm is earning profits Profits = TR - TC

Want TR as large as possible.

Want TC as small as possible.

Taking vertical slices (adjusting output q) until TR -TC is maximized.

A competitive firm is max profits The point where profit is maximized is at the production level q when MC = MR = P.
Quantity  

3. Losses and going out of business.

  • Short-run.
    • A firm experiencing losses, but covering its average variable costs, will operate in the short run.
    • Example: AVC = $10 per good, AFC = $10, and the good is selling for $15 per unit.
      • P > AVC.
      • The firm covers all variable costs and the remainder is applied to fixed costs, but the firm earns $5 loss.
    • A firm shuts down when P < AVC.
    • Shutdown - temporary halt in the production or operation of a business.
      • The firm still pays fixed costs during the shutdown.
      • Motels and restaurants shutdown during off seasons.
      • Example: AVC = $10, AFC = $10, and P = $5.
      • The firm shuts down, because it loses are smaller then if firm continues to operate.
  • Long-run.
    • A firm will "go out of business" in the long run whenever P < ATC.
    • Going out of business - firm permanently exits the market and avoids paying fixed costs.
      • If P = $0.25 for a generic soda and the ATC = $0.50.
      • This firm cannot continue to operate for a long time with losses.
A Firm  
Price / Per-unit costs  
A firm is earning a loss Firm produces quantity q where
MC = MR = P

ATC > Market Price, the firm is earning a loss or profit is negative.

Profit = Total Revenue - Total Cost

Profit = P q - ATC q

The loss = "The red area"

Quantity  

4. A firm maximizes profits when it produces at P=MC and the firm can cover variable costs. A firm's short-run supply curve is its marginal cost curve above average variable cost.

Law of Supply - as the price of a product increases, firms will increase quantity supplied.

A Firm's Cost Curves A Firm's Supply Curves
Price / Per-unit costs Price / Per-unit costs
The cost functions for a firm Deriving the supply function
Quantity Quantity

5. The short-run market supply is the horizontal sum of the all firms' short-run supply curves. (Just like the demand curve).

 

Output in the Long Run

 

  • In the long-run, firms earn zero economic profit.
    • A normal rate of return, i.e. accounting profit.
  • If P > ATC, firms earn an economic profit.
    • New firms enter the market.
    • SR Supply increases while the price decreases until it equals P = ATC.
    • Economic profit = 0.
  • If P < ATC, firms earn a loss.
    • Some firms leave the market.
    • SR supply decreases, while the price increases until it equals P = ATC.
    • Economic profit = 0.
  • Long-run equilibrium.
    • The market determines the price and quantity of milk.
      • P* = $2 and market quantity = 10 (thousand).
    • Each firm supplies q quantity of milk
      • Earn zero economic profit.
      • P = ATC = $2.
A Milk Firm's Long-Run Cost Curve The Milk Market
Price / Per-unit costs Price / Per-unit costs
Competitive firms earning zero economic profit Equilibrium in the market
Quantity Quantity (in thousands)
  • Example: The U.S. Gov. says drinking milk does the body good.
    • Consumers start buying more milk (tastes and preferences).
      • The demand curve shifts right.
        • New market price is P2.
        • Quantity supplied and sold is Q2.
    • Firms expand output to q2.
      • Earn economic profits (P2 > ATC).
    • Long-run equilibrium.
      • New firms enter the milk market.
      • Short-run supply increases.
      • Price decreases, until P1 = ATC again.
    • Result:
      • Same market price, P1.
      • More milk produced and sold, Q3.
      • More firms are in the market and all earn zero economic profit.
A Milk Firm's Long Run Cost Curve The Milk Market
Price / Per-unit costs Price / Per-unit costs
Price increases for a competitive industry An industry expands
Quantity Quantity
  • Economic losses and exit.
  • Example: Consumers' income increases and rice is an inferior product.
    • The original demand & supply curves are D1 & S1.
    • Demand curve shifts left.
      • New market price is P2.
      • Quantity supplied and sold is Q2.
    • Firms contract output to q2.
      • Earn economic losses (P2 < ATC).
    • Long-run equilibrium.
      • Some firms leave the rice market.
      • Short-run supply decreases.
      • Price increases, until P1 = ATC again.
    • Result:
      • Same market price, P1.
      • Less rice produced and sold, Q3.
      • Less firms are in the market and all earn zero economic profit.
A Firm Producing Rice The Rice Market
Price / Per-unit costs Price / Per-unit costs
Price falls for a competitive industry An industry contracts
Quantity Quantity

Long run supply - the minimum price which firms will supply various production levels when all factors of production can be adjusted.

  1. Constant-cost industry - industry were resource prices remain unchanged as market output is expanded.
    • Long-run market supply curve is horizontal (perfectly elastic).
    • Illustrated above.
    • An expanding/contracting industry has no impact on the resource markets, because it is a small industry.
  2. Increasing-cost industry - industry were factor prices rise as market output is expanded.
    • Long-run market supply curve is upward-sloping.
    • Most common type of industry.
    • Example: If automobile factory expands production, then resource prices will increase: skilled labor, steel, plastics, etc.
  3. Decreasing-cost industry - industry were factor prices decline as market output is expanded.
    • Long-run market supply curve is downward-sloping.
    • Rare type of industry.
    • Example: Electronic industry. As more and more transistors are etched onto chips, then cost of chips, computers, etc. keep decreasing.
Automobile Firm - Increasing Costs Computer Chip Firm - Decreasing Costs
Price Price
Positively sloped long-run supply curve A negative slope long-run supply curve
Quantity Quantity

P1 and Q1: The original demand and supply curves for both markets.
Consumer demand more cars and electronics, because of higher incomes. The new market price is P2. Both industries earn economic profits, which cause them to expand.

As car industry expands, the resource prices increase (skilled labor, steel, etc.), causing the long-run price and quantity to be P3 and Q3.

As the electronic industry expands, the resources prices decrease (computer chips), causing long-run price and quantity to be P3 and Q3.

 

The Role of Profits

 

  • Profit is a reward for increasing the value of resources.
    • total revenue (consumers' valuation) > total costs (firm's costs of resources).
      • Minimize costs.
      • Operate efficiently.
      • Innovate.
      • Weeds out inefficient firms.
      • Satisfy consumers.
  • Losses are a penalty imposed on firms that reduce the value of resources.
    • Firm will either leave the market, restructure, or bankrupt.
      • New products.
        • Microwave ovens.
        • Personal computers.
        • VCRs.
Blue arrow Competitive markets and profits create wealth and direct resources to produce highly-valued goods..
 

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