Week 12 : Firms in competitive markets
1. Large number of buyers & sellers
- buyer’s purchase are so small they have no impact on market price
- seller’s output is so small in comparison to market demand it has no impact on market price
- seller’s input purchases are so small they have very little impact on input prices
- both seller’s & buyers are price takers
2. Undifferentiated products
- consumers perceive all products to be identical no matter who produces them
3. Complete information about prices
- consumers only care about price when buying products in the market.
This results in the law of one price, and all transactions occur at a single market price
4. Equal access to resources
- all firms, current & new have access to the same tech & inputs.
- inputs such as labor, capital, & materials
This industry has a free entry
- means that if its possible for new firms to enter they shall
- doesn’t mean that it costs nothing
- means that everyone has the same chance in entering
In a perfectly competitive market, a firm is a price taker, it can only decide how much product it
needs to produce so that it can maximize its profit
Calculations
The rate at which total revenue changes with respect to a change is output is called Marginal
∆
Revenue (MR),
∆
Each additional unit sold increases total revenue by an amount equal to the market price, that is
MR = P. This is an important identity.
Marginal Cost (MC) is the rate at which cost changes with respect to a change in output,
∆
that MC = .
∆
- As long as MR exceeds MC, increasing the quantity raises profit.
- Therefore, if MR is greater that MC, the firm should increase production because it will put more
money in their pocket (MR) than it takes out (MC).
- If the MR is less than MC – as it is for six, seven and eight lawns- the firm should decrease
production.
- Therefore, a price-taking firm maximises its profit when it produces a quantity at which the
MC = MR = Market price.
Basically,
- If MR is greater than MC, the firm should increase its output,
- If MC is greater than MR, the firm should decrease its output,
- At the profit-maximising level of output, MR and MC are exactly equal.
Reminder:
- The MC cost curve becomes upward sloping as production increases due to diminishing marginal
product.
- The average-total-cost curve(ATC) is U-shaped.
- The MC cost curve crosses the average-total-cost curve at the minimum of average total cost.
- In case of perfectly competitive firm, P = MR = AR.
- The MC curve is also the competitive firm’s supply curve.
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𝑄𝑄
𝑇𝐶
𝑇𝑅
, The firm’s short run decision to shut down
Shut down: Exit:
- produce nothing for a specific period of time - leave the market
because of the current market conditions - doesn’t have to pay any costs, fixed or variable
- still has to pay fixed costs - no sunk cost
- fixed cost is called a sunk cost
How to decide whether to shut down?
- The firm chooses to shut down if the price of the good is less than the average variable cost of
production.
- If the price does not cover AVC, the firm is better off stopping production altogether.
- The firm still loses money (because it has to pay fixed costs), but it would loose even more
money by staying open.
- can reopen in the future if conditions change so that price exceeds AVC.
How to decide whether to exit?
- if the revenue it would get from producing is less than its total costs. (FC + VC)
- enter the market if price of the good exceeds the average total costs (ATC) of production.
Enter: if P>ATC
Exit: if P<ATC
Measuring profit
If the price is above the ATC, the firm has positive profit.
If the price is below the ATC, the firm has definite losses. (deadweight loss)
Zero profit in the long-run (entry & exit)
- If the firms in the market are profitable, then new firms will have an incentive to enter the
market. The entry will expand the number of firms, increase the quantity of good supplied &
drive down prices and profits.
- Then it will cause some losses for firms, some will exit the market due to the competition. Their
exit will reduce the number of firms, decrease the quantity of the good supplied and drive up
prices and profits.
- Firms that remain in the market must be making zero economic profit. In other words, the
process of entry and exit ends only when price and ATC are driven to equality.
- with free entry and exit, the price will be equal to ATC, as economic profit is zero, that
P – ATC = 0
- competitive firm produces at point when price equals MC. Therefore, in long-run MC = ATC = P.
- in long run where economic profit is zero, the firm must be operating at the minimum of ATC.
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1. Large number of buyers & sellers
- buyer’s purchase are so small they have no impact on market price
- seller’s output is so small in comparison to market demand it has no impact on market price
- seller’s input purchases are so small they have very little impact on input prices
- both seller’s & buyers are price takers
2. Undifferentiated products
- consumers perceive all products to be identical no matter who produces them
3. Complete information about prices
- consumers only care about price when buying products in the market.
This results in the law of one price, and all transactions occur at a single market price
4. Equal access to resources
- all firms, current & new have access to the same tech & inputs.
- inputs such as labor, capital, & materials
This industry has a free entry
- means that if its possible for new firms to enter they shall
- doesn’t mean that it costs nothing
- means that everyone has the same chance in entering
In a perfectly competitive market, a firm is a price taker, it can only decide how much product it
needs to produce so that it can maximize its profit
Calculations
The rate at which total revenue changes with respect to a change is output is called Marginal
∆
Revenue (MR),
∆
Each additional unit sold increases total revenue by an amount equal to the market price, that is
MR = P. This is an important identity.
Marginal Cost (MC) is the rate at which cost changes with respect to a change in output,
∆
that MC = .
∆
- As long as MR exceeds MC, increasing the quantity raises profit.
- Therefore, if MR is greater that MC, the firm should increase production because it will put more
money in their pocket (MR) than it takes out (MC).
- If the MR is less than MC – as it is for six, seven and eight lawns- the firm should decrease
production.
- Therefore, a price-taking firm maximises its profit when it produces a quantity at which the
MC = MR = Market price.
Basically,
- If MR is greater than MC, the firm should increase its output,
- If MC is greater than MR, the firm should decrease its output,
- At the profit-maximising level of output, MR and MC are exactly equal.
Reminder:
- The MC cost curve becomes upward sloping as production increases due to diminishing marginal
product.
- The average-total-cost curve(ATC) is U-shaped.
- The MC cost curve crosses the average-total-cost curve at the minimum of average total cost.
- In case of perfectly competitive firm, P = MR = AR.
- The MC curve is also the competitive firm’s supply curve.
Page 1 of 8
𝑄𝑄
𝑇𝐶
𝑇𝑅
, The firm’s short run decision to shut down
Shut down: Exit:
- produce nothing for a specific period of time - leave the market
because of the current market conditions - doesn’t have to pay any costs, fixed or variable
- still has to pay fixed costs - no sunk cost
- fixed cost is called a sunk cost
How to decide whether to shut down?
- The firm chooses to shut down if the price of the good is less than the average variable cost of
production.
- If the price does not cover AVC, the firm is better off stopping production altogether.
- The firm still loses money (because it has to pay fixed costs), but it would loose even more
money by staying open.
- can reopen in the future if conditions change so that price exceeds AVC.
How to decide whether to exit?
- if the revenue it would get from producing is less than its total costs. (FC + VC)
- enter the market if price of the good exceeds the average total costs (ATC) of production.
Enter: if P>ATC
Exit: if P<ATC
Measuring profit
If the price is above the ATC, the firm has positive profit.
If the price is below the ATC, the firm has definite losses. (deadweight loss)
Zero profit in the long-run (entry & exit)
- If the firms in the market are profitable, then new firms will have an incentive to enter the
market. The entry will expand the number of firms, increase the quantity of good supplied &
drive down prices and profits.
- Then it will cause some losses for firms, some will exit the market due to the competition. Their
exit will reduce the number of firms, decrease the quantity of the good supplied and drive up
prices and profits.
- Firms that remain in the market must be making zero economic profit. In other words, the
process of entry and exit ends only when price and ATC are driven to equality.
- with free entry and exit, the price will be equal to ATC, as economic profit is zero, that
P – ATC = 0
- competitive firm produces at point when price equals MC. Therefore, in long-run MC = ATC = P.
- in long run where economic profit is zero, the firm must be operating at the minimum of ATC.
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