Week 8 More Week 7 accidentally put in macroeconomics Flashcards
The graph on the right shows the marginal revenue, marginal cost, and average total cost curves for a firm in a perfectly competitive market.
If this firm produced at the profit-maximizing output level, what would be the size of this firm’s profits or losses?
1.) Using the rectangle drawing tool, illustrate the size of this firm’s profits or losses if it produces at the profit-maximizing output level. Label the area appropriately.
Carefully follow the instructions above and only draw the required object.
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If firms in a perfectly competitive market are earning profits or incurring losses in the short run, then in the long run these profits or losses will either cause new firms to enter or existing firms to leave the market.
This will result in a shift in the
For a perfectly competitive industry that is initially in long-run equilibrium, a short-run shock to the market may cause firms to earn profits or incur losses in the short run.
In the long run, these profits or losses will either cause new firms to enter or existing firms to leave the market. This will result in a shift in the industry supply curve until profits are zero.
Given the long-run adjustment process that takes place after a supply or demand shock, we know that the industry supply curve must be
horizontal, since the supply curve shifts until price is back to its original level and profits are back to zero.
In assessing the performance of a perfectly competitive market, we can say that
any departure from the equilibrium necessarily reduces social surplus.
price efficiently allocates goods and services to buyers and sellers.
no individual can be made better off without making someone else worse off.
In a monopolistically competitive market, a firm earning negative economic profit in the short run will ____________.
The decision rule for a monopolistically competitive market operating in the short run is exactly the same as for a monopoly and a competitive firm. The firm should continue to operate if total revenue covers all of the variable costs and some of the fixed costs. However, if total revenues do not cover the variable costs, shut down is optimal. That is, the firm should produce if price is greater than average variable cost.
What happens in a monopolistically competitive market when firms exit the market?
In a monopolistically competitive market, firms can earn economic profits in the short run. However, this can lead to the entry of new firms in the market. As the new firms enter, the demand curve for each monopolistically competitive firm becomes flatter and shifts inward with entry, until there are no longer positive economic profits.
With the growth of the Internet, there are a large number of online retailers as well as buyers in the online retail market.
One might think that different firms would charge very similar prices for the same good because
The cost of searching online is low
In the online retail market, consumers have more or less perfect information as the costs of searching for a good are very low. It is also easier for sellers to adjust their prices based on competitors’ pricing. The fact that there are many sellers means that, for identical products, competition should force prices down to marginal cost.
John Maynard Keynes (a famous British economist) said “In the long run we are all dead.” An important message in this chapter is, to paraphrase Keynes, “In the long run, all profits in a monopolistically competitive market are dead.”
Consider a monopolistically competitive industry earning positive economic profits in the short run.
In the long run, a monopolistically competitive industry earns zero economic profits because
new firms enter, shifting a firm’s demand curve to the left.
Monopolistically competitive firms might earn positive economic profits in the short run due to
product differentiation.
Consider the market for college textbooks. Assume this market is monopolistically competitive. A representative firm’s demand (D), marginal revenue (MR), marginal cost (MC), and average cost (AC) curves are illustrated in the figure on the right.
This industry ____________.
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Monopolistically competitive firms maximize profit by producing where marginal revenue equals marginal cost. This occurs at 5 thousand textbooks. The corresponding profit-maximizing price, according to the demand curve, is $65.00. The average cost of producing 5 thousand textbooks is less than the $65.00 price, so the firm is earning profits. If firms are earning profits, then new firms will enter in the long run, and if firms are incurring losses, then some existing firms will exit in the long run. In this example, firms are earning profits, which will result in firms entering, so the industry is not in long-run equilibrium.
How is performance (market efficiency) determined
By conduct (firm behaviour) which is in turn determined by industry structure
A competitive market, sometimes called a perfectly competitive market, has these characteristics:
- There are many buyers and many sellers in the market;
- They are all small;
- The goods offered by the various sellers are the same (homogeneous);
Therefore, each buyer and seller is a price taker.
- Firms can freely enter or exit the market in the long run.
Price taker
A buyer or seller who takes the price as given by market conditions, they have no market power.
Imperfect competition
Imperfect competition is a source of market failure. Therefore, this perfectly competitive market structure is not associated with market failure.
Perfect competition Structure: revenue measures and revenue curves
TR AR MR
Total revenue (TR) = P x Q
Average revenue (AR) = TR / Q = P
Marginal revenue (MR) = ∆ TR / ∆ Q
8.1.1. Perfect Competition Structure: revenue measures and revenue curves
As the firm is a price taker, it has a perfectly elastic (flat) demand (D) curve at the existing market price (P).
TR = P × Q and P is fixed for a competitive firm. Therefore, when Q rises by one unit, TR rises by P. For perfectly competitive firms, MR = P.
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What is the difference between short run and long run
In the short run at least one input is fixed whereas in the long run all inputs are variable
Perfect competition profit maximisation
Add the cost curves (MC, ATC, AVC) to the revenue curve.
At Q1, MR > MC. If the firm increased production by one unit, the additional revenue (P) would exceed the additional costs (MC1). The firm should increase production.
At Q2, MR < MC. The firm should reduce production.
The profit maximising quantity is Qmax
(where MC = MR).
Therefore, a profit maximising firm will produce quantity of output Qmax.
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Perfect competition firm supply
The competitive firm’s profit maximising quantity is found at the intersection of the price and marginal cost curves.
When the price is P1, the firm produces quantity Q1.
When the price rises to P2, the new profit maximising quantity is Q2.
Because the firm’s MC curve determines how much the firm is willing to supply at any price, the MC curve is also the competitive firm’s supply curve.
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Perfect competition
Shutdown
A short run decision by a firm to produce nothing for a specific period of time because of current market conditions. In some circumstances the firm will decide to close its doors and not produce anything at all.
Perfect competition
Exit
A long run decision by a firm to leave the market completely.
Perfect competition
short run shutdown
To decide whether to shutdown in the short run, the firm compares the loss it will make if it stays open and continues production (production loss) to the loss it will make if it shuts down ( = loss on its expenditure on fixed inputs) (shutdown loss)
Perfect competition effects of shutdown
If the firm shuts down, it loses all revenue from the sale of its product. But it saves the variable costs of making its product. Therefore, the firm follows the rule:
Shutdown if TR < VC
Perfect competition short run shutdown rewritten equation
By dividing both sides of this inequality by the quantity produced (Q), this rule can be rewritten as:
Shutdown if AR < AVC
AR is equal to the price for all firms. Therefore, the rule becomes:
Shutdown if P < AVC
Perfect competition
Conduct: short run shutdown decision (1)
TR = P x Q
TC = ATC x Q
Production Loss: (ATC - P) x Q
Shutdown Loss: (ATC - AVC) * Q
Production loss < Shutdown Loss
Stay open and continue production
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Perfect competition
Conduct: short run shutdown decision (2)
TR = P x Q
TC = ATC x Q
Production Loss: (ATC - P) x Q
Shutdown Loss: (ATC - AVC) * Q
Production loss > Shutdown Loss
Shut down and cease production
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Perfect competition
Conduct: short run shutdown decision (3)
The firm stays open
The firm stays open if the price it receives is more than the average variable cost of producing the typical unit. [P > AVC]
Perfect competition
Conduct: short run shutdown decision (3)
The firm shuts down
The firm shuts down if the price it receives is less than the average variable cost of producing the typical unit. [P < AVC]
Perfect competition
Conduct: short run shutdown decision (3)
When a firm shuts down it still loses money (it has to pay fixed costs) but it would lose even more money by staying open (i.e. production loss > shutdown loss)
The competitive firm’s short run supply curve is the portion of its marginal cost curve that lies above average variable cost.
Perfect competition
Conduct: long run exit
The long run and short run decisions differ because firms cannot avoid their fixed costs in the short run but are able to do so in the long run (i.e. there are no exit losses on fixed inputs in the long run).
If the firm exits the market it will lose all revenue from the sale of its product, but it saves on all the costs of production.
The long run and short run decisions differ because firms cannot avoid their fixed costs in the short run but are able to do so in the long run (i.e. there are no exit losses on fixed inputs in the long run).
If the firm exits the market it will lose all revenue from the sale of its product, but it saves on all the costs of production. Thus, in the long run, the firm follows the rule:
Exit if TR < TC
Rewritten long run exit equation
By dividing both sides of this inequality by the quantity produced (Q), this rule can be rewritten as:
Exit if AR < ATC
AR is equal to the price for all firms. Therefore, the rule becomes:
Exit if P < ATC
Long run entry equation
The rule for entry is exactly the opposite of the rule for exit:
Enter if P > ATC
Perfect competition
long run exit decision (1)
TR = P x Q
TC = ATC x Q
Loss: (ATC - P) x Q
P < ATC
Exit market
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Perfect competition
Conduct: long run exit decision (2)
TR = P x Q
TC = ATC x Q
Profit: (P - ATC) x Q
P > ATC
Enter market
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8.1.2. Conduct: long run exit decision (3)
the firm exits
The firm exits the market if the price it receives is less than the average total cost of producing the typical unit.
[ P < ATC ]
8.1.2. Conduct: long run exit decision (3)
The firm enters
The firm enters the market if the price it receives is more than the average total cost of producing the typical unit.
[ P > ATC ]
8.1.2. Conduct: long run exit decision (3)
Long run supply curve
The competitive firm’s long run supply curve is the portion of its marginal cost curve that lies above average total cost.
Perfect competition
Performance: short run market supply
In the short run, the number of firms in the market is fixed.
For any given price, each firm supplies a quantity of output so that its marginal cost (MC) equals the price (MR).
As long as price is above average variable cost, each firm’s marginal cost curve is its supply curve.
The total quantity of output supplied to the market equals the sum of the quantities supplied by each of the individual firms.
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Perfect competition
Performance: long run market supply
Decisions about entry and exit in a competitive market depend on the incentives facing the owners of existing firms and the entrepreneurs who could start new firms.
Perfect competition
Performance: long run market supply
Firms are profitable
If firms already in the market are profitable then new firms will enter the market. Entry increases the number of firms, increasing the quantity supplied and driving down prices and profits.
Perfect competition
Performance: long run market supply
Firms are making losses
If firms in the market are making losses then some existing firms will exit the market. Exit reduces the number of firms, decreasing the quantity supplied and drive up prices and profits.
Perfect competition
Performance: long run market supply
long run equilibrium
At the end of this process of entry and exit, firms that remain in the market must be making zero economic profit (price equals average total cost, P = ATC).
When this happens, the market is in long run equilibrium.
Perfect competition
Performance: efficiency at long run equilibrium
Competitive firms produce so that price equals marginal cost (P = MC, no mark up over marginal cost).
Free entry and exit forces price to equal average total cost.
Therefore, in the long run equilibrium of a competitive market, marginal cost is equal to average total cost.
The intersection of these two cost curves occurs at the minimum of average total cost. Therefore, in the long-run equilibrium of a competitive market, firms must be operating at their efficient scale.
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Perfect competition
Performance: long run equilibrium in firm and market
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Perfect competition
Short run event: an increase in market demand raises the price
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Perfect competition
Short run event: entry increases supply and price falls again
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Structure: monopolistic competition
Monopolistic competition is a market structure in which many firms sell products that are similar but not identical. It has the following characteristics:
- Many sellers — there are many firms competing for the same group of customers;
- They are small in size;
- Product differentiation
- Free entry
monopolistic competition
Product differentiation
each firm produces a product that is at least slightly different from those of other firms;
Rather than being a price taker, each firm faces a downward-sloping demand curve (it has some market power, like monopoly).
monopolistic competition
Free entry
— in the long run, firms can enter (or exit) the market without restriction. The number of firms in the market adjusts until economic profits are driven to zero (like perfect competition).
monopolistic competition
Conduct: profit maximisation
The MR and D curves always start at the same point on the vertical axis because the marginal revenue of the first unit sold equals the price of the good.
The marginal revenue on all units after the first is less than the price of the good. Thus, the firm’s MR curve lies below its D = AR curve.
The profit-maximising quantity is found at the intersection of the MC and MR curves (where MC = MR).
After the firm chooses the quantity of output, it uses the demand curve to find the price consistent with that quantity.
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monopolistic competition
Performance: short run equilibrium
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monopolistic competition
Performance: long run equilibrium (1)
Entries
When firms are making profits, new firms have an incentive to enter the market.
Entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market.
monopolistic competition
Performance: long run equilibrium (1)
exits
Conversely, when firms are making losses, firms in the market have an incentive to exit.
Customers have fewer products from which to choose which expands the demand faced by those firms that remain in the market.
monopolistic competition
Long-run equilibrium
Because of these shifts in demand, a monopolistically competitive firm eventually finds itself in the long-run equilibrium where price equals average total cost and the firm earns zero economic profit (like perfect competition).
monopolistic competition
Performance: long run equilibrium (2)
Notice that the demand curve just touches the ATC curve. The two curves are tangential to each other. This point of tangency occurs at the same quantity where MR = MC.
In the long run equilibrium, these firms produce on the downward sloping portion of their ATC curves.
The quantity of output at this point is smaller than the efficient scale (like monopoly).
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monopolistic competition
Performance: long run equilibrium (2)
Excess capacity of the firm
The difference between the profit maximising quantity and the efficient scale is know as the excess capacity of the firm.
These firms have some degree of market power. In long run equilibrium, their MC is below ATC. Thus, for P to equal ATC, P must be above MC (mark up over marginal cost, like monopoly).
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Performance: monopolistic versus perfect competition
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