ECON 208 Chapter Notes - Chapter 9: Takers, Economic Equilibrium, Profit Maximization

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Chapter 9
Nov.6.12
Market Structure and Firm Behavior
Significance of market structure
1. Understand behavior of an individual firm
2. Evaluate overall efficiency of market outcomes
- Focus on competitive market structures
- Firms maximize profits = TR TC
- Individual firm demand curve is not = to the industry demand curve
- From the industry demand curve we can infer firm’s demand curve
Competitive market structure
- Competitiveness of the market = influence that individual firms have on
market prices
- The less power an individual firm has to influence the market price, the more
competitive is that market’s structure
- Zero market power: extreme form of competitive market, perfectively
competitive market, firms are able to sell as much as they want at the market
price
- Each individual firm are price takers
- Competitive behavior = degree to which individual firms actively vie with one
another
Assumptions of perfect competition:
- All firms sell a homogenous product
- Customers know the product and each firm’s price
- Each firm reaches its minimum LRAC at a level of output that is small relative
to the industry’s total output
- Firms are price takers
- Firms are free to exit and enter the industry
Demand curve for a perfectly competitive firm
- Each firm faces a horizontal demand curve
- The industry demand curve is downward sloping
Short-run decisions
Should the firm produce at all?
if it produces: fixed costs + variable costs
if it doesn’t produce: fixed costs
- The firm will not produce if TVC > TR of the output
- If AVC > market price then the firm does not produce
- At the “shut-down price” the firm can just cover its AVC so it is indifferent
between producing and not producing
How much should the firm produce?
- If price > AVC the firm doesn’t shut down
- When the firm decides to increase production in 1 unit, then for each extra
unit the firm has to contemplate:
1. If MR > MC produce more q
2. If MR = MC no incentive to change q
3. If MR < MC produce less q
- The rule: choose output where price = MC (the market determines
equilibrium price, the firm picks its output that maximizes its own profits)
Competitive industry’s supply curve = horizontal summation of the individual MC
curves (above minimum AVC curves)
Short-run equilibrium in a competitive market
- When an industry is in short-run equilibrium:
- market price is such that the market clears
- each firm is maximizing its profits at this price
- Profit per unit = price ATC
- How large are each firm’s profits in this short-run equilibrium?
either positive, negative, or zero
1. Zero profits: price = ATC
2. Positive profits: price > ATC, makes positive profits in the area between
ATC and below the price level
3. Negative profits: price < ATC, suffers losses in the area between ATC
and above the price level
Long-run decisions
- Short-run vs. long-run profit maximization for a competitive firm
- In LR equilibrium competitive firms produce at the minimum point on the
LRAC curve, economic profits = zero
- In LR competitive equilibrium each firm’s average cost of production is the
lowest attainable given technology limits factor price
- Firms are able to make abnormal profits and other firms enter the market
- The price then decreases because supply has increased
- If firms exit the industry, supply decreases and the price increases
Entry and exit in the LR:
- If existing firms have +profits new firms will enter the industry
- If existing firms have 0profits there are no incentives for firms to enter or exit
- If existing firms have profits there is an incentive for them to exit
Changes in technology:
- Market with firms where price = ATC, profits = 0
- New firms enter the market
- Technological development reduce costs
- Industry output is expanded and reduces price
- At this new price old firms will not cover long-run costs
- If price > AVC they will still produce, otherwise they will exit
- New long-run equilibrium market price will be lower
- Output will be higher than under old technology
Continuous technological change:
- Plants of different ages and with different costs exist side by side
- Price governed by the minimum ATC of the lowest-cost plants
- Old plants are discarded when the price < AVCs
Declining industries:
- What happens when a competitive industry in LR equilibrium experiences a
continual decrease in demand?
- Response of firms:
- continue operating with existing equipment as long as variable costs can be
covered
- antiquated equipment if often the effect rather than the cause of the
industry’s decline
- Response of the government:
- tempted to support industry to avoid unemployment (i.e. grants/subsidies)
- intervention to increase mobility and reduce social/personal costs is a viable
long-run policy
Long-run industry supply curve:
- Suppose market demand for the industry’s product increases
- Price will increase
- Profits will rise
- Entry of other firms will occur
- Prices will eventually fall
- The LRAC will
- The new long-run equilibrium will be at a higher quantity but with a lower
market price