Chapter 15 Flashcards by Yara Mohammad

Competitive market

A market with many buyers and sellers trading identical products so that each buyer and seller is a price taker

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Characteristics of a competitive market

-Market has many buyers and many sellers
-Goods offered by the various sellers are identical
—Because of the first two: each buyer and seller is a price taker (takes the price as given)
-Firms can freely enter or exit the market

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Examples of perfectly competitive market

Farming, fishing, wood pulping and paper milling, the manufacture of paper cups and shopping bags, grocery and fresh flower retailing, photo finishing, lawn services, plumbing, painting, dry cleaning are examples.

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Revenue of a competitive firm

A firm in a competitive market, like most other firms in the economy, tries to maximize profit (total revenue minus total cost).

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Total revenue

TR = P ˣ Q

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Average revenue

AR = TR / Q

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Marginal revenue

MR = ∆TR / ∆Q

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For all types of firms, average revenue…

equals the price of the good

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MR=P

for only competitive firms.

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A competitive firm…

Can keep increasing its output without affecting the market price.

So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P

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What Q maximizes a firm’s profit?
If Q increases by one unit …

Revenue rises by MR, cost rises by MC

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If MR > MC…

increase Q to raise profit

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If MR < MC…

decrease Q to raise profit

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Maximize profit for Q where…

MR = MC

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The MC curve is the firm’s …

Supply curve

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Shutdown…

A short-run decision not to produce anything because of market conditions.

Exit…

A long-run decision to leave the market.

Difference between shutdown and exit…

If shut down in SR, must still pay FC.
If exit in LR, zero costs.

Should a firm shut-down in the short run?

Shut down if TR < VC, TR/Q< VC/Q ,or P < AVC

Cost of shutting down = revenue loss
= TR
Benefit of shutting down = cost savings
= VC
(because the firm must still pay FC)

Should a firm shut-down in the short run?(2)

firm will shut down if
P < AVC
If the price doesn’t cover the average variable cost, the firm is better off stopping production altogether.

Sunk cost

A cost that has already been committed and cannot be recovered
Should be ignored when making decisions
You must pay them regardless of your choice
In the short run, FC are sunk costs
So, FC should not matter in the decision to shut down

Should a firm exit or enter in the long run?

Cost of exiting market = revenue loss = TR
Benefit of exiting market = cost savings = TC (remember, FC = 0 in long run)

Firm’s long-run decision…
Exit market if…
Enter market if…

Exit the market if: TR < TC (same as: P < ATC)
Enter the market if: TR > TC (same as: P > ATC)

Profit-Maximizing Rules for a Competitive Firm..

Find Q at which P = MC
If P < AVC, shut down immediately and remain out of business
If AVC < P < ATC, operate in the short run but exit in the long run
If ATC < P, stay in business and enjoy your profits!

The Short Run: Market Supply with a Fixed Number of Firms Assumptions…

* Assumptions - All existing firms and potential entrants have identical cost curves - Each firm’s costs do not change as other firms enter or exit the market * Number of firms - Fixed in the short run (due to fixed costs) - Variable in the long run (due to free entry and exit)

As long as P > AVC

Each firm will produce its profit-maximizing quantity, where MR = MC

For P > AVC: (curve)

Supply curve is MC curve

Entry & Exit in the Long Run: If existing firms earn positive economic profit (P > ATC ) :

In the long run, the number of firms can change due to entry and exit: If existing firms earn positive economic profit (P > ATC ) : - New firms enter, SR market supply shifts right - P falls, reducing profits and slowing entry

Entry & Exit in the Long Run: If existing firms incur losses (P < ATC) :

If existing firms incur losses (P < ATC) : - Some firms exit, SR market supply shifts left - P rises, reducing remaining firms’ losses

The Zero-Profit Condition: Long-run equilibrium:

- The process of entry or exit is complete - Remaining firms earn zero economic profit

The Zero-Profit Condition: Zero economic profit: when P = ATC

- Since firms produce where P = MR = MC - The zero-profit condition is P = MC = ATC - Recall that MC intersects ATC at min ATC - Hence, in the long run, P = min ATC

Why Do Competitive Firms Stay in Business If They Make Zero Profit?

- Profit = Total revenue − Total cost - Total cost includes all opportunity costs - Zero-profit equilibrium - Economic profit is zero - Accounting profit is positive

Long-Run Supply Curve: Long-run supply curve is horizontal if:

- All firms have identical costs, and - And costs do not change as other firms enter or exit the market

Long-Run Supply Curve: Long-run supply curve might slope upward if:

- Firms have different costs - Or costs rise as firms enter the market

Long-Run Supply Curve: Firms have different costs

- As P rises, firms with lower costs enter the market before those with higher costs. - Further increases in P make it worthwhile  for higher-cost firms to enter the market,  which increases market quantity supplied. - Hence, LR market supply curve slopes upward

Costs rise as firms enter the market

The entry of new firms increases demand for this input, causing its price to rise - This increases all firms’ costs — Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping

Profit-maximization: Q where MC = MR The competitive equilibrium is efficient

- Profit-maximization: Q where MC = MR Perfect competition: P = MR So, in the competitive equilibrium: P = MC - The competitive equilibrium is efficient Maximizes total surplus because P = MC MC is the cost of producing the marginal unit P is value to buyers of the marginal unit