#### Transcript what is a competitive market?

```PowerPoint Presentations for
Principles of Microeconomics
by Mankiw/Kneebone/McKenzie
Marc Prud’homme
University of Ottawa
FIRMS IN
COMPETITIVE
MARKETS
Chapter 14
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FIRMS IN COMPETITIVE MARKETS
 In this chapter we examine the behaviour of
competitive firms.
 A market is competitive if each buyer and
seller is small compared to the size of the
market and, therefore, has little ability to
influence market prices.
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WHAT IS A COMPETITIVE MARKET?
 The goal of this chapter is to examine how firms
make production decisions in competitive
markets.
 As a background for this analysis, we begin by
considering what a competitive market is.
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The Meaning of Competition
 Competitive market: a market in which there are
many buyers and many sellers so that each has a
negligible impact on the market price (price
takers)
 Three characteristics:
1. There are many buyers and many sellers in
the market.
2. The goods offered by the various sellers are
largely the same.
3. Firms can freely enter or exit the market.
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The Revenue of a Competitive Firm
 A firm in a competitive market tries to
maximize profit, which equals total revenue
minus total cost.
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The Revenue of a Competitive Firm
P
: Price
 Q : Quantity
 TR : Total revenue
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TABLE 14.1:
Total, Average, and Marginal Revenue for a Competitive Firm
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The Revenue of a Competitive Firm
 The fourth column in the table shows average
revenue.
 Average revenue tells us how much revenue
a firm receives for the typical unit sold.
 Average revenue (AR): total revenue divided
by the quantity sold
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The Revenue of a Competitive Firm
 The fifth column in the table shows marginal
revenue.
 Marginal revenue (MR): the change in total
revenue from an additional unit sold
 For competitive firms, marginal revenue
equals the price of the good.
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QuickQuiz
When a competitive firm doubles the amount
it sells, what happens to the price of its output
and its total revenue?
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PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
 Lets examine how the firm maximizes profit
and how that decision leads to its supply
curve.
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A Simple Example of Profit Maximization
 The analysis of the firm’s supply decision starts
with the example in Table 14.2.
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TABLE 14.2:
Profit Maximization: A Numerical Example
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A Simple Example of Profit Maximization
 One of the ten principles of economics in
Chapter 1 is that rational people think at the
margin.
 If
, then increase milk production.
 If
, then decrease milk production.
 If
profits.
, now the firm is maximizing
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The Marginal-Cost Curve and
the Firm’s Supply Decision
 To extend this analysis of profit maximization,
consider the cost curves in Figure 14.1.
 The marginal-cost curve (MC) is upward
sloping.
 The average-total-cost curve (ATC) is Ushaped.
 The marginal-cost curve crosses the averagetotal-cost curve at the minimum of average
total cost.
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The Marginal-Cost Curve and
the Firm’s Supply Decision
 The figure also shows a horizontal line at the
market price (P).
 The price line is horizontal because the firm is
a price taker.
 For a competitive firm, the firm’s price equals
both its average revenue (AR) and its
marginal revenue (MR).
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FIGURE 14.1:
Profit Maximization for a Competitive Firm
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The Marginal-Cost Curve and
the Firm’s Supply Decision
 Three rules that are key to rational decision
making for profit maximization:
1. If marginal revenue is greater than marginal
cost, the firm should increase its output.
2. If marginal cost is greater than marginal
revenue, the firm should decrease its output.
3. At the profit-maximizing level of output,
marginal revenue and marginal cost are
exactly equal.
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FIGURE 14.2:
Marginal Cost as the Competitive Firm’s Supply Curve
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The Firm’s Short-Run Decision to Shut Down
 Under some circumstances, a firm will decide
to shut down and not produce anything at
all.
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The Firm’s Short-Run Decision to Shut Down
 Shutdown versus Exit
 A shutdown refers to a short-run decision not to
produce anything during a specific period of
time because of current market conditions.
 An exit refers to a long-run decision to leave
the market.
 The short-run and long-run decisions differ
because most firms cannot avoid their fixed costs
in the short run but can do so in the long run.
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The Firm’s Short-Run Decision to Shut Down
Cartoonresource/Shutterstock
 What determines a firm’s shutdown
decision?
 If the firm shuts down, it loses
all revenue from the sale of its
product.
 At the same time, it saves the
variable costs of making its product
(but must still pay the fixed costs).
 Thus, the firm shuts down if the
revenue that it would earn from
producing is less than its variable
costs of production.
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The Firm’s Short-Run Decision to Shut Down
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FIGURE 14.3:
The Competitive Firm’s Short-Run Supply Curve
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Spilt Milk and Other Sunk Costs
 Sunk cost: a cost that has already been committed
and cannot be recovered
 Because nothing can be done about sunk costs,
they can be ignored when making decisions about
various aspects of life, including business strategy.
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The Firm’s Long-Run
Decisions to Exit or Enter the Market
 If the firm exits, it again will lose all
revenue from the sale of its product,
but now it saves on both fixed and
variable costs of production.
alexmillos/Shutterstock
 The firm exits the market if the
revenue it would get from
producing is less than its total costs.
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The Firm’s Long-Run
Decisions to Exit or Enter the Market
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The Firm’s Long-Run
Decisions to Exit or Enter the Market
 The exit price coincides with the minimum
point on the average-total-cost curve.
 The shutdown price coincides with the
minimum point on the average-variable-cost
curve.
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The Firm’s Long-Run
Decisions to Exit or Enter the Market
 The firm will enter the market if it is profitable,
which occurs if the price of the good
exceeds the average total cost of
production.
 The entry criterion is:
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FIGURE 14.4:
The Competitive Firm’s Long-Run Supply Curve
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Measuring Profit in Our Graph
for the Competitive Firm
 It is useful to analyze the firm’s profit in more detail.
 This way of expressing the firm’s profit allows us to
measure profit in our graphs.
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FIGURE 14.5:
Profit as the Area between Price and Average Total Cost
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QuickQuiz
How does the price faced by a profitmaximizing competitive firm compare to its
marginal cost? Explain.
When does a profit-maximizing competitive firm
decide to shut down?
When does a profit-maximizing competitive firm
decide to exit a market?
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Active Learning
Identifying a Firm’s Profit
A competitive firm
Determine this firm’s
total profit.
Costs, P
Identify the area on the
graph that represents
the firm’s profit.
MC
MR
ATC
P = \$10
\$6
50
Q
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Active Learning
Costs, P
Profit per unit
= P – ATC
= \$10 – 6
= \$4
A competitive firm
MC
MR
P = \$10
ATC
profit
\$6
Total profit
= (P – ATC) x Q
= \$4 x 50
= \$200
Q
50
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Active Learning
Identifying a Firm’s Profit
Determine
this firm’s total loss,
assuming AVC < \$3.
Identify the area on
the graph that
represents
the firm’s loss.
A competitive firm
Costs, P
MC
ATC
\$5
MR
P = \$3
30
Q
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Active Learning
A competitive firm
Costs, P
MC
Total loss
= (ATC – P) x Q
= \$2 x 30
= \$60
ATC
\$5
P = \$3
loss
loss per unit = \$2
MR
30
Q
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THE SUPPLY CURVE IN A
COMPETITIVE MARKET
 Lets discuss the supply curve for a market.
 There are two cases to consider:
1. A market with a fixed number of firms
2. A market in which the number of firms
can change as old firms exit the market
and new firms enter
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The Short Run: Market Supply
with a Fixed Number of Firms
 Consider first a market with 1000 identical
firms.
 For any given price, each firm supplies a
quantity of output so that its marginal cost
equals the price.
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FIGURE 14.6:
Market Supply with a Fixed Number of Firms
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The Long Run: Market Supply
with Entry and Exit
 If firms already in the market are profitable, then
new firms will have an incentive to enter the
market.
 This entry will expand the number of firms,
increase the quantity of the good supplied, and
drive down prices and profits.
 Vice versa.
 At the end of this process of entry and exit, firms
that remain in the market must be making zero
economic profit.
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FIGURE 14.7:
Market Supply with Entry and Exit
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The Long Run: Market Supply
with Entry and Exit
 The long-run equilibrium of a competitive
market with free entry and exit must have
firms operating at their efficient scale.
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Why Do Competitive Firms Stay
in Business If They Make Zero Profit?
In the zero-profit equilibrium, economic
profit is zero, but accounting profit is
positive.
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A Shift in Demand in the
Short Run and Long Run
 Because firms can enter and exit a market in
the long run but not in the short run, the
response of a market to a change in demand
depends on the time horizon.
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FIGURE 14.8:
An Increase in Demand in the Short Run and Long Run
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FIGURE 14.8 (continued)
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FIGURE 14.8 (continued)
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Why the Long-Run Supply
Curve Might Slope Upward
 There are two reasons that the long-run
market supply curve might slope upward:
1. Some resources used in production may
be available only in limited quantities.
2. Firms may have different costs.
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FIGURE 14.9:
An Upward Sloping Long-Run Supply Curve
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QuickQuiz
In the long run with free entry and exit, is the
price in a market equal to marginal cost,
average total cost, both, or neither?
Explain with a diagram.
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Classroom Activity
A Profitable Opportunity?
•
•
As a recent graduate of this college, you have landed a job in
production management for Universal Clones Inc. You are
responsible for the entire company on weekends.
Quantity
•
Average Total Cost
500
200
501
201
Your current level of production is 500 units. All 500 units
have been ordered by your regular customers.
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Classroom Activity
A Profitable Opportunity? (continued)
•
The phone rings. It’s a new customer who wants to buy
1 unit of your product. This means you would have to
increase production to 501 units. Your new customer
offers you \$450 to produce the extra unit.
A. Should you accept this offer?
B. What is the net change in the firm’s profit?