Firms in Competitive Markets

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

Profit Maximization

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit Maximization

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

• MR(Q) = MC(Q) → profit-maximizing output level.
• If MR(Q) > MC(Q) increase the output
• If MR(Q) < MC(Q) decrease the output

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What is a Competitive Market?

• Many buyers and sellers ensure no single participant can influence price.
• Identical products are produced by all firms.
• Price takers: Buyers and sellers accept the market price as given.
• Free entry and exit in the long run promotes efficiency.

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit Maximization

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit Maximization

• Rules for profit maximization:
• If P > MC → increase output.
• If P < MC → decrease output.
• If P = MC → profit-maximizing output level.
• MC curve shows the quantity a firm is willing to supply at any price.

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Figure 4

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The 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). If the price falls below average total cost, the firm is better off exiting the market.

Profit Maximization

• Firm’s long-run decision
• Exit the market if P < ATC
• Equivalently, total revenue < total cost (TR < TC)
• Enter the market if P > ATC
• Equivalently, total revenue > total cost (TR > TC)

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit Maximization

• Short-Run Decisions
• Shutdown rule: If P < AVC, firm shuts down (revenue does not cover variable cost).
• If P > AVC, continue producing, even if losses exist (fixed costs are sunk).
• Firms remain in business because accounting profit is still positive.

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Figure 5

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Profit as the Area between Price and Average Total Cost

The area of the shaded box between price and average total cost represents the firm’s profit. The height of this box is price minus average total cost (P – ATC), and the width of the box is the quantity of output (Q). In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm has losses.

(a) A firm with profits

(b) A firm with losses

Market Dynamics

• If firms earn positive economic profits in the short run
• New firms enter
• Supply increases, price falls, profits shrink
• If firms earn losses
• Firms exit
• Supply decreases, price rises, losses shrink
• In the long run, the market settles at zero economic profit and efficient scale

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 7

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Long-Run Market Supply

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).

(a) Firm’s Zero-Profit Condition

(b) Market supply