Transcript Chapter Fourteen

WHAT IS A COMPETITIVE MARKET?
• A perfectly competitive market…..
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There are many buyers and sellers in the market.
The goods offered by the various sellers are the same.
Firms can freely enter or exit the market.
Perfect information and resource mobility.
• The actions of any single buyer or seller have a
negligible impact on the market price.
• Each buyer and seller takes the market price as given.
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PROFIT MAXIMIZATION
• A competitive firm’s goal is to maximize profit.
• This means that the firm will want to produce the
quantity that maximizes the difference between
total revenue and total cost.
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Profit Maximization: A Numerical Example
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PROFIT MAXIMIZATION
• If MR > MC
• If MR < MC
increase Q
decrease Q
• If MR = MC
Profit is maximized.
• Profit maximization occurs at the quantity where
marginal revenue equals marginal cost.
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PROFIT MAXIMIZATION
• Profit equals total revenue minus total costs.
• Profit = TR – TC
• TR = Price times Quantity
• TC = FC + VC (opportunity cost, implicit, explicit)
• The perfect competitor will receive economic
profit if the market price results in TR > TC.
• This cannot be a long-run equilibrium.
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The Firm’s Decisions (SR, LR)
• A shutdown refers to short-run decision not to
produce anything during a specific period of time
because of current market conditions.
• Exit refers to long-run decision to leave the market.
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The Firm’s Short-Run Decision
• In the short run firms in an industry will shut
down if the revenue they would get from
producing in this market is less than the variable
cost of producing (MR = MC).
• Shut down if TR < VC
• Revenues don’t cover cost of variable inputs (wages)
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The Firm’s Long-Run Decision
• In the long run, firms will exit an industry if the
revenue they would get from producing in this
market is less than the total cost of producing
(MR = MC).
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Exit if TR < TC
Revenues don’t cover all costs (don’t re-new lease)
The grass is greener elsewhere
Resources move away from low value use
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The Firm’s Long-Run Decision
• In the long run firms will enter an industry if such
an action would be profitable.
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Enter if TR > TC
Revenues more than cover all costs (re-new lease)
The grass is greener here
Resources move toward high value use
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The Long Run: Market Entry and Exit
• In the long run firms will enter or exit the market
until profit is driven to zero.
• At the end of the this process (entry/exit), firms
that remain will be making zero economic profit.
• No incentive for firms to enter or exit (balance)
• Lollipop activity
• I Love Lucy – Hamburger Diner
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Why Do Competitive Firms Stay in
Business If They Make Zero Profit?
• Profit equals TR - TC.
• TC includes all of the opportunity costs.
-implicit and explicit
• At the zero-profit equilibrium, the firm’s revenue
compensates the owner for the time & money to
keep the business going (normal profit).
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A Demand Shift: SR & LR Analysis
• An increase in demand raises price and quantity in
the short run.
• Firms earn profits at higher price (TR > TC).
• This will lead to entry and the price will decrease
back to the original price (higher output).
• Can you tell the story for a decrease in demand?
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Summary
• To maximize profit, a firm chooses the quantity of
output where marginal revenue = marginal cost.
• In the short run, when a firm cannot cover its
variable costs, they will choose to shut down.
• In the long run, when a firm cannot cover both
fixed and variable costs, they will choose to exit.
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Summary
• In a price-taking market with free entry and exit,
profits are driven to zero in the long run.
• Changes in demand result in industry adjustments.
• In the long run, the price and number of firms
adjusts the market to the zero-profit equilibrium.
-balance, no incentive to enter or exit
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