Transcript firm
1 Firms in Competitive Markets Chapter 14 2 What we learn in this chapter? • In Ch.13 we looked into the details of the cost structure of the firms • The next four chapters study how profit maximising firms decide on the quantity of output to produce and the price at which to sell that output • This decision is based – On the cost structure of the firms – On the kind and level of competition in the market • Ch.14 deals with the equilibrium of the firm in perfectly competitive markets • We will distinguish between the equilibrium of the short run and that of the long run • To gain valuable insights about the market system 3 The meaning of competition • A perfectly competitive market has the following characteristics – There are many buyers and sellers in the market – The goods and services offered by various sellers are largely the same – Firms can freely enter or exit the market • And the following outcomes: – The individual firm produces a small portion of total market output – The firm cannot have any influence over the price it charges • Only a small number of markets are perfectly competitive in real life 4 The firm as a price taker • What distinguishes perfectly competitive markets from other competitive markets is the fact that the firm is a price taker • What do we mean by “price taker”? • The firm takes the price determined by the market as the price that it will receive for it output • In other words the decision of the individual firm about its level output has no impact on price • This is a very important characteristic of perfect competition that we should always remember • It means that the price elasticity of the demand curve for the individual firm is infinite • The demand curve of the firm is horizontal 5 Revenue of a competitive firm • A horizontal demand curve for the individual firm has very important consequences for our analysis • A price-taker competitive firm does not need to lower its price to sell a larger amount because it can sell all its product at this price • Also, the firm can’t increase its price by reducing its output • This makes total revenue of the firm proportional to the amount of output sold on the market • Average revenue tells us how much revenue a firm receives for the typical unit sold • In perfect competition average revenue equals the price of the good or service 6 Total and average revenue • Total revenue for a firm is the selling price multiplied by the quantity sold TR = ( P x Q ) • Average revenue tells us how much revenue a firm receives for the typical unit sold • In perfect competition average revenue equals the price of the good or service Total revenue Average revenue = Quantity (Price Quantity) = Quantity = Price 7 Marginal revenue • When we analysed costs we distinguished between average cost and marginal cost • We must do the same distinction for the revenue side • Marginal revenue is the change in total revenue due to an additional unit sold MR = TR / Q • For competitive firms marginal revenue equals the price of the good or service Marginal Revenue = Price x one MR = Price • Therefore for the competitive firm Price = Average Revenue = Marginal Revenue 8 Profit maximisation • The main objective of every firm is to maximise the profits it earns for its owners • Profit maximising firm is a key assumption of economic theory • Profit maximisation means that the firm will want to produce the quantity of output where the difference between total revenue and total cost is – the biggest if it is positive, corresponding to maximum profit – the smallest if it is negative, corresponding to minimum loss • This assumption is valid irrespective of competition and other market conditions 9 Marginal revenue = Marginal cost • Remember Principle 3 from Ch.1: Rational People Think at the Margin • We now prove this principle while establishing the output level at which the competitive firm maximises its profits • Profit maximisation occurs at the quantity where marginal revenue is equal to marginal cost • If MR MC, the firm can increase its profits by increasing Q • If MR MC, the firm can increase its profits by reducing Q • If MR = MC, profit is maximised because any change in Q will imply lower profits 9 Profit Maximization for the Competitive Firm Costs and Revenue The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. MC ATC P 0 P = AR = MR AVC QMAX Quantity 10 Equilibrium of the firm: too little production Costs and Revenue MC ATC P = MR1 P = AR = MR AVC MC1 MR > MC, increase Q 0 Q1 QMAX Quantity 11 Equilibrium of the firm: too much production Costs and Revenue MC MC2 ATC P = MR2 P = AR = MR AVC MR < MC, decrease Q 0 QMAX Q2 Quantity 13 Other decisions by the firm • Compairing the price with various measures of cost such as the average total-cost and the average variable cost highlights other decisions of the firm • Two decisions are very important: when to shut down the firm and when to exit from the market • A shutdown refers to a short-run decision not to produce anything during a specific period of time • Exit refers to a long run decision to leave the market • The firm considers its sunk costs when deciding to exit, but ignores them when deciding to shut down • Sunk costs are those costs that have already been committed and cannot be recovered by the firm by continuing to operate in the market 14 The firm’s decision to shut down • A firm may temporarily halt production even though it remains in the market • In other words, it plans to restart operations when market conditions are suitable in the future • The firm shuts down if the revenue it gets from producing is less than the variable cost of production Shut down if TR < VC Shut down if TR / Q < VC / Q Shut down if P < AVC • All the formula mean the same thing: not much point in continuing with production if the market price is below even the average variable cost (every unit produced and sold increases total loss) 15 The Firm’s decision to shut down Costs If P > ATC, keep producing at a profit. MC ATC If P > AVC, keep producing in the short run. AVC If P < AVC, shut down. 0 Quantity 16 Marginal cost and supply curve • We saw that the marginal cost curve is of vital importance to the firm for its output decisions • The marginal cost curve of the firm has one other important characteristic • The portion of the marginal cost curve that lies above the average variable cost curve is the competitive firm’s short run supply curve • Below the point where MC curve crosses the AVC curve the firm will shut down • Above that point the firm has an incentive to produce in the short run even if it makes a loss for those prices below the ATC curve • Therefore marginal cost curve is the supply curve 17 Shut down and short run supply Costs Firm’s short-run supply curve MC ATC AVC 0 Quantity 18 The long-run decision to exit • In the long run, under certain circumstances the firm may decide that there is not much point in staying in a specific market or industry • Therefore exits from that market or industry • In the long run, the firm exists from a market or an industry if the revenue it receives from producing is less than its total costs Exit if TR < TC Exit if TR / Q < TC / Q Exit if P < ATC • There is no point in staying in a market or industry if the firm is consistently making losses by staying in that market or industry 19 The long-run decision to enter • In the long run while some firms may exit some markets or industris other firms will decide to enter some markets or industries • In the long run, a firm enters a market or an industry if the revenue it receives from its production is higher than its total costs Enter if TR > TC Enter if TR / Q > TC / Q Enter if P > ATC • Entry decision is symetrical to exit decision • If an industry is consistently making profits, other enterpreneurs will enter that industry by settign up new firms 20 Exit and entry in the long run Costs MC Firm enters if P > ATC ATC AVC Firm exits if P < ATC 0 Quantity 21 The firm’s short run and long run supply curve • The time period we adopt for the analysis has an impact on the supply curve of the firm • We have already defined the short-run and the longrun depending on whether the capital stock is fixed or it becomes variable • Short run supply curve (shut-down decision) – The portion of the marginal cost curve that lies above average variable cost curve • Long run supply curve (exit and entry decisions) – The portion of the marginal cost curve that lies above average total cost curve 22 Profit and loss of competitive firm • We know that the firm maximises profits through the equality of marginal cost and marginal revenue • We can now calculate the profits of the firm • Profits of the competitive firm is the area between price and the average total cost if price is higher than average total cost • Remember: this is economic profit and will be lower than accounting profit • Losses of the competitive firm is the area between the price and the average total cost if price is below average total cost • Remember: a firm may have economic loss despite accounting profits 23 Profit as the area between price and average total cost Price MC ATC Profit P P = AR = MR ATC Profit-maximizing quantity 0 Q Quantity 24 Loss as the area between price and average total cost Price MC ATC ATC P P = AR = MR Loss Loss-minimizing quantity 0 Q Quantity 25 Supply in a competitive market • It is easy to move from the supply of the individual firm to the market supply in a competitive market • Market supply equals the sum of the quantities supplied by individual firms in the market • Market supply in the short run – For any given price, each firm supplies a quantity of output so that P=MR=MC • Market supply in the long run – Firms will enter or exit the market until profit is driven to zero – In the long run price equals the minimum of ATC – The long run market supply curve is horizontal at that price 26 Supply curve in a competitive market (a) Firm’s Zero-Profit Condition Price (b) Market Supply Price MC P= minimum ATC 0 ATC Supply Quantity (firm) 0 Quantity (market) 27 Change in demand in the short run • An intellectual experiment will help us understand better the equilibrium in the competitive market • Assume that the demand curve shifts up (demand increases) in a market in long-run equilibrium • The shift in the demand curve will raise the equilibrium price and quantity in the short run • Firms earn profits because price now exceeds average total cost • A fall in demand reduces price and quantity in the short run causes losses because price is now below the average total cost • If demand falls so much that price falls below average variable cost some firms will shut down 28 Initial condition: firm and market at long run equilibrium Market Firm Price Price MC ATC S1 A P1 Long-run supply P1 D1 0 Quantity (firm) 0 Q1 Quantity (market) 29 Increase in demand: short run Market Firm Price Price Profit MC ATC B P2 P2 P1 P1 S1 A D1 0 Quantity (firm) 0 Q1 Q2 Long-run supply D2 Quantity (market) 30 Change in demand in the long run • Let us continue with the example the long run • Over time the short run supply curve shifts • Increase in demand: – Short run profits encourage new firms to enter the market – Price fall as supply curve shifts to right • Fall in demand: – Short run losses force firms to exit from market – Price increases as supply curve shits left • For both cases, in the new long run equilibrium profits return to zero and price returns to minimum average total cost but • The number of firms in the market has changed 31 Increase in demand: long run Market Firm Price Price MC ATC B A P1 S1 C P1 S2 Long-run supply D2 D1 0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market) 32 (a) Initial Condition Firm Market Price Price MC P1 ATC Short-run supply P P1 A Long-run supply Demand 0 Quantity (firm) 0 Q1 Quantity (market) (b) Short-Run Response Market Firm Price Price Profit B MC ATC P2 P2 P 1 P1 S1 A D1 0 Quantity (firm) 0 Q1 Q2 Long-run supply D2 Quantity (market) (c) Long-Run Response Firm Market Price Price MC ATC P1 P2 P1 B A S1 C S2 Long-run supply D2 D1 0 Figure 14-8 Quantity (firm) 0 Q 1 Q 2 Q 3 Quantity (market) The firm and the market: short and long run 33 The slope of the long run supply curve • In perfect competition, usually all firms should have the optimal size (remember: economies of scale) • Therefore the long run supply curve should be flat • However this may not always be true • Some resources used in production may be available only in limited quantities for some industries • As demand for the product goes up the price of these resources will increase • Also, if firms don’t have identical cost structures the supply curve represents their average cost structure • In such cases the increase output may come from more or less efficient firms 34 Conclusion • We now apply our knowledge of costs to markets with different levels of competition • We begin with a perfectly competitive market – Many seller and buyers each with a small share of the market – Homogenous products – Free entry and exit • The firm becomes a price taker in competitive markets: the price of the product equals both the firm’s average revenue and its marginal revenue • The competitive firm’s total revenue is therefore proportional to its output 35 Conclusion • To maximise profits the firm chooses the quantity of output where marginal revenue equals marginal cost • By definition, at this quantity price is also equals marginal cost, i.e the cost of producing one additional output of that product • P = MR = MC is the golden rule for the equilibrium of the the firm in perfectly competitive markets • In the short run, the firm will choose to shut down temporarily if the price of the good is less than average variable cost • In the long run, it will choose to exit if the price is less than average total cost 36 Conclusion • Profits (losses) of the firm is the difference between total revenue and total costs • In the long run, equilibrium price will be such that the price will also equal the lowest average total cost of production • This is achieved by firms who enter and exit the market by looking at the profits in that industry • Therefore in the long run the adjustment in supply happens through changes in the number of optimal sized firms • Freedom to enter and exit imply zero economic profits in the long run for perfectly competitive markets