Firms in competitive markets Chapter 14 Characteristics Competitive Market • large number of sellers & buyers • homogenous (identical) products • low barriers to entry (free entry and exit from the industry) • Each buyer and seller is a price taker Price takers & Price makers Demand curve for a Price taker Demand curve for a Price maker Demand curve for Individual firm under Competitive Market Market D curve Firm’s D curve P = AR = MR Revenue Concepts • Total revenue (TR): Total number of dollars (or dong) received by a firm from the sale of a product • TR = P x Q • Average revenue (AR): Total revenue per unit of a product sold • AR = TR/Q = (P x Q) / Q = P • Marginal Revenue (MR): Additional revenue received resulting from the sale of an extra unit of output P ΔQ ΔTR • MR = = =P ΔQ ΔQ Product Price (Average Revenue) $131 131 131 131 131 131 131 131 131 131 131 Quantity Demanded (Sold) 10 Total Revenue $ 131 262 393 524 655 786 917 1048 1179 1310 ] ] ] ] ] ] ] ] ] ] Marginal Revenue $131 131 131 131 131 131 131 131 131 131 Price, average and marginal revenue, total revenue (dollars) P TR 917 786 655 524 393 262 P = AR = MR D = MR 131 Quantity demanded (sold) 10 Profit Maximisation in the Short Run Two approaches to profit maximisation: • Total Revenue minus Total Cost Approach • Marginal Revenue, Marginal Cost Approach IMPORTANT! Rules for Profit Maximisation • Optimum output where: TR – TC = greatest or • Optimum output where: MR = MC – or MR closest to MC but MR > MC – MC cuts MR curve from below Total Revenue – Total Cost Approach (Price = $131) Total Total Total Fixed Product Revenue Cost 10 $ 131 262 393 524 655 786 917 1048 1179 1310 $ 100 100 100 100 100 100 100 100 100 100 100 Total Variable Cost $ 90 170 240 300 370 450 540 650 780 930 Total Cost $ 100 190 270 340 400 470 550 640 750 880 1030 Profit – $100 – 59 –8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280 Efficiency and Competitive Market • Price of product X = the relative worth of product X to the society (or the marginal benefit/satisfaction the society gets from an additional unit of X) • Marginal Cost of product X is the cost of producing an additional unit of X (MC measures the sacrifice of other goods in using resources to produce more of X) Efficiency and Competitive Market • Allocative efficiency (Social Efficient Level)  P > MC : resources are under allocated  P < MC : resources are over allocated  P = MC : resources are best allocated/utilised • Productive efficiency (Efficient Scale)  P = ATC Short-Run Supply Curve • For the individual firm: the SR supply curve is the MC curve above the AVC curve • For the entire industry: horizontal sum of firms’ MC curves above AVC Short-run market supply (a) Individual firm supply Price (b) Market supply MC Price Supply $2.00 $2.00 1.00 1.00 100 200 Quantity (firm) 100,000 200,000 Quantity (market) 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 Long run Equilibrium under Competitive Market  P = ATC = MR = MC  why? Long-run equilibrium under Competitive Market P S1 $ ATC P1 AR1 D1 D O Q (millions) (a) Industry O Q (thousands) (b) Firm Long-run equilibrium under Competitive Market P $ S1 Se ATC P1 AR1 D1 PL ARL DL D O Q (millions) (a) Industry: As firms making supernormal profits , new firms will enter the industry S curve shifts to right Price falls O QL Q (thousands) (b) Firm Long-run equilibrium under Competitive Market P $ Se S1 ATC PL ARL DL P1 AR1 D1 D O Q (millions) (a) Industry: As firms making losses , some firms will leave the industry S curve shifts to left Price rises O QL Q (thousands) (b) Firm Long run Equilibrium • Long-run market supply (a) Firm’s Zero-Profit Condition Price (b) Market supply Price MC ATC P= minimum ATC Supply Quantity (firm) Quantity (market) 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) Supply Curve in a Competitive Market • A shift in demand in the short run & long run • Market – in long run equilibrium – P = minimum ATC – Zero economic profit • Increase in demand – Demand curve – shifts outward – Short run • Higher quantity • Higher price: P > ATC – positive economic profit 31 Supply Curve in a Competitive Market • A shift in demand in the short run & long run • Because: positive economic profit in short run • Long run – firms enter the market – Short run supply curve – shifts right – Price – decreases back to minimum ATC – Quantity – increases • Because there are more firms in the market – Efficient scale 32 An increase in demand in short run and long run (a) (a) Initial Condition Market Price Firm A market begins in long-run equilibrium… Short-run supply, S A P1 Long-run supply Price …with the firm earning zero profit MC ATC P1 Demand, D1 Q1 Quantity (market) Quantity (firm) The market starts in a long-run equilibrium, shown as point A in panel (a) In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost 33 An increase in demand in short run and long run (b) (b) Short-Run Response Market Price Firm Price But then an increase in demand raises the price… …leading to short-run profits S1 ATC B P2 P1 A Long-run supply D1 Q1 Q2 MC P2 P1 D2 Quantity (market) Quantity (firm) Panel (b) shows what happens in the short run when demand rises from D1 to D2 The equilibrium goes from point A to point B, price rises from P1 to P2, and the quantity sold in the market rises from Q1 to Q2 Because price now exceeds average total cost, firms make profits, which over time34 encourage new firms to enter the market An increase in demand in short run and long run (c) (c) Long-Run Response Market Price Firm When profits induce entry, supply increases and the price falls,… S1 B P2 P1 A C Q1 Q2 Q3 …restoring longrun equilibrium MC S2 Long-run supply D1 Price ATC P1 D2 Quantity (market) Quantity (firm) This entry shifts the short-run supply curve to the right from S1 to S2, as shown in panel (c) In the new long-run equilibrium, point C, price has returned to P1 but the quantity sold has increased to Q3 Profits are again zero, price is back to the minimum of average total cost, but the market has35 more firms to satisfy the greater demand ... supplied to the market is 1,000 times the quantity supplied by each firm Long run Equilibrium under Competitive Market  P = ATC = MR = MC  why? Long-run equilibrium under Competitive Market P S1... maximisation under Competitive Market P $ MC S D = AR = MR AR AC Pe ATC D O O Q (millions) (a) Industry Qe Q (thousands) (b) Firm SR Profit maximisation under Competitive Market P $ MC S D =... Long-run market supply (a) Firm’s Zero-Profit Condition Price (b) Market supply Price MC ATC P= minimum ATC Supply Quantity (firm) Quantity (market) In the long run, firms will enter or exit the market