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Firms in Competitive Markets

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PowerPoint Slides prepared by:

Andreea CHIRITESCU

Eastern Illinois University

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Profit Maximization

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Profit Maximization

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    • 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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Profit Maximization

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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 1

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Profit Maximization for a Competitive Firm

Costs

and

Revenue

This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-variable-cost curve (AVC). It also shows the market price (P), which equals marginal revenue (MR) and average revenue (AR). At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production increases profit. At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so reducing production increases profit. The profit-maximizing quantity QMAX is found where the horizontal price line intersects the marginal-cost curve.

Quantity

0

ATC

AVC

P

P

MC

MC1

MC2

Q2

Q1

QMAX

The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.

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Profit Maximization

  • Short-Run Decisions
    • Shutdown rule: If P < AVC, firm shuts down (revenue < variable cost).
    • If P > AVC, continue producing, even if losses exist (fixed costs are sunk).

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Figure 3

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The Competitive Firm’s Short-Run Supply Curve

Costs

In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC) above average variable cost (AVC). If the price falls below average variable cost, the firm is better off shutting down.

Quantity

0

ATC

MC

AVC

1. In the short run, the firm produces on the MC curve if P>AVC,...

2. ...but

shuts down

if P<AVC.

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Near-empty restaurants & off-season miniature golf

  • Restaurant – stay open for lunch?
    • Fixed costs – not relevant
    • Variable costs – relevant
    • Shut down if revenue from lunch < variable costs
    • Stay open if revenue from lunch > variable costs

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Profit Maximization

  • Firm’s long-run decision
    • Exit the market if
      • Total revenue < total costs; TR < TC
        • Same as: P < ATC
    • Enter the market if
      • Total revenue > total costs; TR > TC
        • Same as: P > ATC

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Figure 4

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The Competitive Firm’s Long-Run Supply Curve

Costs

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.

Quantity

0

MC

1. In the long run, the firm produces on the MC curve if P>ATC,...

2. ...but exits if P<ATC

ATC

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Figure 5

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Profit as the Area between Price and Average Total Cost

Price

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.

Quantity

0

(a) A firm with profits

Profit

MC

ATC

P=AR=MR

P

Q

(profit-maximizing quantity)

ATC

Price

Quantity

0

(b) A firm with losses

Loss

MC

ATC

P=AR=MR

P

Q

(loss-minimizing quantity)

ATC

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Profit Maximization

  • Measuring profit
    • If P > ATC
      • Profit = TR – TC = (P – ATC) ˣ Q
    • If P < ATC
      • Loss = TC - TR = (ATC – P) ˣ Q
      • Negative profit

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Supply CurveMeasuring Profit

  • Long run
    • Firms can enter and exit the market
    • If P > ATC – firms make positive profit
      • New firms enter the market
    • If P < ATC – firms make negative profit
      • Firms exit the market

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Supply Curve

  • Long run
    • Entry and exit continue until firms earn zero economic profit (P = ATC)
      • Because MC = ATC: Efficient scale
    • Long run supply curve – perfectly elastic
      • Horizontal at minimum ATC

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Figure 7

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Long-Run Market Supply

Price

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).

Quantity

(firm)

0

(a) Firm’s Zero-Profit Condition

MC

ATC

Price

Quantity

(market)

0

(b) Market supply

P=

minimum

ATC

Supply

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Zero-Profit Equilibrium

  • Zero economic profit does not mean firms shut down.
  • Total revenue covers all costs, including opportunity costs.
  • Firms remain in business because accounting profit is still positive.

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Market Dynamics

  • Positive economic profits in the short run:
    • New firms enter.
    • Supply increases, price falls, and profits shrink.
  • If firms earn losses:
    • Firms exit.
    • Supply decreases, price rises, and losses shrink.
  • In the long run, the market stabilizes 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.