WEEK 6 - Chapter 14: Firms in Competitive Markets Flashcards
Recall.
You may recall that a market is competitive if each buyer and seller is small compared with the size of the market and, therefore, has little ability to influence market prices.
In contrast, if a firm can influence the market price of the good it sells, it is said to have market power. In the four chapters that follow this one, we examine the behaviour of firms with market power, such as your local water company.
The meaning of competition.
A competitive market, sometimes called a perfectly competitive market, has two characteristics:
. There are many buyers and many sellers in the market.
. The goods offered by the various sellers are largely the same.
. Firms can freely enter or exit the market in the long run.
As a result of these conditions, the actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.
What is a price taker?
A buyer or seller who takes the price as given by market conditions.
What is average revenue and marginal revenue?
Just as the concepts of average and marginal were useful in the last chapter when analysing costs, they are also useful when analysing revenue.
average revenue - total revenue divided by the quantity sold
marginal revenue - the change in total revenue from an additional unit sold
Profit maximisation and the competitive firm’s supply curve.
The goal of a competitive firm is to maximise profit, which equals total revenue minus total cost.
We have just discussed the competitive firm’s revenue and in the last chapter we discussed the firm’s costs. We are now ready to examine how the firm maximises profit and how that decision leads to its supply curve.
Profit maximising quantity.
One of the Ten Lessons from Economics in chapter 1 is that rational people think at the margin.
If marginal revenue is greater than marginal cost a firm should increase quantity supplied because it will put more money in their pockets (marginal revenue) than it takes out (marginal cost).
If marginal revenue is less than marginal cost a firm should decrease production.
If a firm thinks at the margin and make incremental adjustments to the level of production, they end up producing the profit-maximising quantity (where MC and MR intersect).
Marginal cost curve and the firm’s supply decision.
Figure 14.1 also shows a horizontal line at the market price (P).
The price line is horizontal because a competitive firm is a price taker – the price of the firm’s output is the same regardless of the quantity that the firm decides to produce.
What’s more, because a competitive firm’s price is equal to both its average revenue and marginal revenue, this line also represents the firm’s average revenue (AR) and marginal revenue (MR) curves.
We can use Figure 14.1 to find the quantity of output that maximises profit.
Describe profit maximisation for a competitive firm.
MC, ATC and P=AR=MR intersect. This is the breakeven point. At this point there is no economic profit or loss. This occurs in perfectly competitive markets because free markets hate profits.
If firms are able to set P above where MC and ATC intersect, then they will gain economic profit.
If firms have P below where MC and ATC intersect, then they will come across economic loss.
The firms short-run decision to shut down.
So far we have been analysing the question of how much a competitive firm will produce.
In some circumstances, however, the firm will decide to close its doors and not produce anything at all.
Here we need to distinguish between a firm temporarily ceasing production, and the permanent exit of a firm from the market.
Shutdown Vs Exit.
A shutdown refers to a short-run decision by a firm to produce nothing for a specific period of time because of current market conditions.
Exit refers to a long-run decision by a firm to leave the market.
The long-run and short-run decisions differ because most firms cannot avoid their fixed costs in the short run but are able to do so in the long run.
That is, a firm that shuts down temporarily still has to pay its fixed costs, whereas a firm that exits in the market does not have to pay any costs at all, fixed or variable.
What is a sunk cost?
A cost that has already been committed and cannot be recovered.
Eg. A farmer decides not to produce any crops one season, the land lies fallow and he cannot recover this cost.
When making the short-run decision whether to shut down for a season, the fixed cost of land is said to be a sunk cost.
In contrast, if the farmer decides to leave farming altogether he can sell the land. When making the long-run decision whether to exit the market, the cost of land is not sunk.
When does a firm shutdown?
Shut down if TR < VC
OR
TR=Q < VC=Q
OR
P < AVC
(Basically all the same thing)
That is, a firm chooses to shut down if the price of the good is less than the average variable cost of production. This rule makes sense. When choosing to produce, the firm compares the price it receives for the typical unit with the average variable cost that it must incur to produce the typical unit.
If the price does not cover the average variable cost, the firm is better off stopping production altogether. The firm still loses money (because it has to pay fixed costs) but it would lose even more money by staying open. The firm can reopen in the future if conditions change so that price exceeds average variable cost.
When does a firm exit?
Exit if TR < TC
OR
Exit if TR=Q < TC=Q
We can simplify this further by noting that TR/Q is average revenue, which equals the price P, and that TC/Q is average total cost ATC.
Therefore, the firm’s exit rule is: Exit if P < ATC
That is, a firm chooses to exit if the price of the good is less than the average total cost of production.
When does a firm enter?
The entry criterion is: Enter if P > ATC
The rule for entry is exactly the opposite of the rule for exit.
Profit as the area between price and ATC.
Profit = (P - ATC) x Q
