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Lecture 10 Competitive Markets 2021

The document discusses the characteristics of perfectly competitive markets, including the roles of buyers and sellers, pricing mechanisms, and profit maximization strategies. It explains the concepts of shutdown versus exit decisions for firms, as well as the implications of market supply and demand changes in both short-run and long-run contexts. Additionally, it highlights the importance of marginal cost and average total cost in determining firm behavior and market equilibrium.

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17 views23 pages

Lecture 10 Competitive Markets 2021

The document discusses the characteristics of perfectly competitive markets, including the roles of buyers and sellers, pricing mechanisms, and profit maximization strategies. It explains the concepts of shutdown versus exit decisions for firms, as well as the implications of market supply and demand changes in both short-run and long-run contexts. Additionally, it highlights the importance of marginal cost and average total cost in determining firm behavior and market equilibrium.

Uploaded by

markcheung04
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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1

DSME 1030GI Economics For


Business Studies I

FIRMS
in
COMPETITIVE MARKETS

Dr. Paul M. Kitney


Term 1, 2021-22
2

A Perfectly Competitive Market

• Perfectly Competitive market

Market with many buyers and sellers

Trading identical products

Each buyer and seller is a price taker – Has no individual influence on


price

Firms can freely enter or exit the market


3

A Perfectly Competitive Market

• Average revenue, AR = TR / Q – Total revenue divided by the


quantity sold

• Marginal revenue, MR = ∆TR / ∆Q - Change in total revenue


from an additional unit sold

• For competitive firms, they set prices such that: P = AR = MR

• Only in competitive markets, do firms set P = MR


4

An Exercise: Calculating TR, AR, MR


5

Profit Maximization in Competitive Markets

Maximize profit - Produce quantity where total revenue minus total


cost is greatest

Compare marginal revenue with marginal cost

If MR > MC: increase production to raise profits

If MR < MC: decrease production to raise profits

Maximize profit where MR = MC = P


6

Profit Maximization Exercise


7

Profit Maximization of a Competitive Firm

• At Q1, MR1 > MC1, so raising production increases profit

• At Q2, MC > MR2, so reducing production increases profit

• Profit Maximization occurs when Qmax is reached, where P=MC

• Marginal Cost Curve – determines the quantity of the good the firm
is willing to supply at any price – This is the firm’s SUPPLY CURVE!
8

Shutdown Versus Exit


• Shutdown – An example is taking an oil rig offline. Baker-Hughes Oil Rig
Count

• A Shutdown is a short-run decision not to produce anything because of


market conditions. Like low oil prices, weak demand.
• Exit is a long-run decision to leave the market altogether.
• The key difference is that for a shut-down the firm must still pay fixed
costs (FC). For an exit, in the long run, costs are zero.
9

The Firm’s Short-run Decision to Shut Down


Cost of Shutdown is the lost revenue = TR

Benefit of shutting down is the cost savings = VC (not FC)

Shutdown decision is given by TR < VC

Or if you divide both sides by Q (TR/Q < VC/Q)

Decision Rule for the Firm is Shutdown if P < AVC

Competitive Firm’s Short-run Supply Curve is the portion


of the MC curve that lies above average variable cost
10

Real Life Shutdowns


https://www.bloomberg.com/news/articles
/2017-10-19/nissan-suspending-
all-local-car-production-for-japan
-from-today-j8yb9t0f

http://www.areadevelopment.com/siteSelection/Q2-
2013/managing-temporary-manufacturing-plant-
shutdowns-6666774.shtml

https://workplace.stackexchange.c
om/questions/3818/what-is-the-
purpose-of-a-holiday-shutdown
11

Real Life Exits


12

Competitive Firm’s Short-Run Supply Curve

• In the short-run, the competitive firm’s supply curve (red part of MC


curve, don’t forget the vertical axis portion) is the MC curve above the
AVC. When P < AVC, Firm is better off shutting down temporarily. This
happens a lot in the Oil Market!
13
Irrelevance of Sunk Costs
• Sunk cost
A cost that has already been committed and cannot be recovered

Should be ignored when making decisions

“Don’t cry over spilt milk”

“Let bygones be bygones”

In the short run, fixed costs are sunk costs. It must pay its fixed costs
whether it produces or shuts down. So, FC should not matter in the
decision to shut down
14

Firm’s Long-run Decision Condition

• Exit the market if:


• Total revenue < total costs: TR < TC
• Same as: P < ATC (Hint: Divide by Q)

• Enter the market if:


• Total revenue > total costs: TR > TC
• Same as: P > ATC
15

Competitive Firm’s Long-Run Supply Curve

In the long run, the competitive firm’s supply curve is its marginal-cost
curve (MC) above average total cost (ATC). The section in red. If the price
falls below average total cost, the firm is better off exiting the market.
16

Market Supply Assumptions

• All existing firms and potential entrants have identical costs.


• Each firm’s costs do not change as other firms enter or exit
the market.
• The number of firms in the market is fixed in the short run
(due to fixed costs) but variable in the long run (due to free
entry and exit
• Each firm supplies quantity where P = MC
• For P > AVC: supply curve is MC curve
• Market supply: Add up quantity supplied by each firm
17

A Market of a Thousand Identical Firms

• In the short run, the number of firms in the market is fixed. As a result, the market
supply curve, shown in panel (b), reflects the individual firms’ marginal-cost
curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of output
supplied to the market is 1,000 times the quantity supplied by each firm
18

Market Supply Assumptions


• In the Long-Run, the number of firms can change due to
entry and exit.
• If P > ATC, firms make positive profit, new firms enter the
market
• If P < ATC, firms make negative profit, firms exit the market
• Long-run equilibrium: The process of entry or exit is
complete — remaining firms earn zero economic profit
(when P = ATC).
• Hence, in the long run, P = MC = minimum ATC.
• The long-run market supply curve is perfectly elastic
(horizontal)
19

A Market of a Thousand Identical Firms

• 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
20

A Market of a Thousand Identical Firms

• In the long run, firms will enter or exit the market until profit is driven to zero. As a
result, price equals the minimum of average total cost, as shown in panel (a). The
number of firms adjusts to ensure that all demand is satisfied at this price. The
long-run market supply curve is horizontal at this price, as shown in panel (b).
21

An Increase In Demand:
Short Run and Long Run Implications

• An increase in Demand leads to an outward shift in the


demand curve.
• In the Short run, Higher quantity and Higher price: P > ATC,
creates positive economic profit. Yay!!!
22

An Increase In Demand:
Short Run and Long Run Implications

• However, short-run profits encourage entry of firms into the


market, so the short-run supply curve shifts right and price falls
back to the P1 but output has risen form Q1 to Q3
• This restores the long-run equilibrium where
• P = min{ATC}, where economic profits are zero
23

Long-run supply curve might slope upward


• Long-run supply curve might slope upward
• Some resource used in production may be available
only in limited quantities
• Increase in quantity supplied – increase in costs –
increase in price
• Firms may have different costs
• Some firms earn profit even in the long run
• Long-run supply curve - More elastic than short-run
supply curve

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