ECON 208 Chapter Notes - Chapter 9: Variable Cost, Market Price, Demand Curve

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Published on 16 Apr 2013
McGill University
Economics (Arts)
ECON 208
of 7
Chapter 9 Competitive Markets
9.1 Market Structure and Firm Behaviour
Market structure: all features of a market that affect the behaviour and performance of firms in
that market, such as the number and size of sellers or the type of product they sell, the extent of
knowledge about one another’s actions, the degree of freedom of entry, and the degree of
product differentiation
Competitive Market Structure
Market power: the ability of a firm to influence the price of a product or the terms under which
it is sold
competitiveness of the market is the degree to which individual firms lack such market power
A market is said to have a competitive structure when its firms have little or market power. The
more market power the firms have, the less competitive is the market structure.
Extreme form of competitive market structure occurs when each firm has zero market power =
there are so many firms in the market that each must accept the price set by the forces of
market demand and market supply. Firms can sell as much as they choose at the prevailing
market price and as having no power to influence that price. Cant sell at higher price
Perfectly competitive market structure / perfectly competitive market = no need for individual
firms to compete actively with one another since none has any power over the market; one
firms ability to sell its product doesn’t depend on the behaviour of any other firm
Competitive Behaviour
The degree to which individual firms actively vie with one another for business
Visa and American express = each has the power to decide the fees that people will pay for the
use of their credit cars, within limits set by buyers’ tastes and the fees of competing cards;
either firm could raise its fees and still continue to attract some customers; even tho they
actively compete with each other, they do so in a market that doesn’t have perfectly
competitive structure;
wheat farmers are perfectly competitive markets since they don’t actively compete with each
other since the only way they can affect their profits is by changing their own outputs of wheat
or their own productions costs.
The Significance of Market Structure
when a firms decides how much output to produce to maximize profits, it needs to know the
demand for its product and its costs of production
details of market structure determine how we get from the industry demand curve to the
demand curve facing any individual firm in that industry
9.2 The Theory of Perfect Competition
Perfect competition: a market structure in which all firms in an industry are price takers and in
which there is freedom of entry into and exit from the industry
The Assumptions of Perfect Competition
1) All the firsms in the industry sell an identical product. Economists say that the firms sell a
homogeneous product (in the eyes of purchases, every unit of the product is identical to every
other unit)
2) Consumers know the nature of the product being sold and the prices charged by each firm
3) the level of each firm’s output at which its LRAC reaches a minimum is small relative to the
industry’s total output. (This is a precise way of saying that each firm is small relative to the size
of the industry.)
4)The industry is characterized by freedom of entry and exit; that is, any new firm is free to
enter the industry and start producing if it so wishes, and any existing firm is free to cease
production and leaved the industry. Existing firms cannot block the entry of new firms, and
there are no legal prohibitions or other barriers to entering or exiting the industry.
1-3 imply that each firm in a perfectly competitive industry is a price taker (a firm that can alter
its rate of production and sales without affecting the market price of its product); no market
power, must accept market price but it can sell as much as it wants at that price
Difference between the wheat farmers and the credit card companies is the degree of market
power. Each firm that is producing wheat is an insignificant part of the whole market and has no
power to influence the price of wheat. American express and Visa have power to influence the
credit card market because each firm’s sales represent a significant part of the total sales of
credit card services.
The Demand Curve for a Perfectly Competitive Firm
Even though the demand curve for the entire industry is negatively sloped, each firm in a
perfectly competitive market faces a horizontal demand curve (perfectly elastic) because
variations in the firm’s output have no significant effect on price because their effect on total
industry output will be negligible
Total, Avg, and Marginal Revenue
Total revenue (TR): total amount received by the firm from the sale of a product; TR=p x Q
Average revenue (AR): total revenue divided by quantity sold; this is the market price when all
units are sold at the same price; AR = TR/Q = (p x Q)/Q = p
Marginal revenue (MR): the change in a firm’s total revenue resulting from a change in its sale
by 1 unit; whenever output changes by more than 1 unit, the change in revenue must be divided
by the change in output to calculate the approximate MR; MR=ΔTR/ΔQ
as long as the firm’s own level of output cannot affect the price of the product it sells, then the
firm’s MR = AR = price (horizontal line at market price = the firms demand curve) for a price-
taking firm; the horizontal line shows that any quantity the firm chooses to sell will be
associated with this same market price
If the market price is unaffected by variations in the firm’s output, the firm’s demand curve, its
avg revenue curve, and its marginal revenue curve all coincide in the same horizontal line
For a firm in perfect competition, price equals marginal revenue
9.3 Short-Run Decisions
Should the Firm Produce at All?
If the firm chooses to produce nothing, it will have an operating loss equal to its fixed costs. If it
produces, it will add the variable cost of production to its costs and the receipts from the sale of
its product to its revenue.
Since fixed costs have to be paid no matter what, the firm should produce as long as it can find
some level of output for which revenue exceeds variable cost. But, if its revenue <variable cost
at every level of output, the firm will lose more by producing than by not producing at all
Rule 1: a firm should not produce at all if, for all levels of output, the total variable cost of
producing that output exceeds the total revenue from selling it. Equivalently. The firm shouldn’t
produce at all if, for all levels of output, the avg variable cost of producing the output exceeds
the market price.
Shut-down price: the price that is equal to the minimum of a firm’s avg variable costs. It is
indifferent between producing and not producing. At prices below this, a profit-maximizing firm
will shut down and produce no output.
How Much should the Firm Produce? (206)
If any unit of production adds more to revenue than it does to cost, producing and selling that
unit will increase profits. A unit of production raises profits if the marginal revenue obtained
from selling it exceeds the marginal cost of producing it. An extra unit of production will reduce
profits if the marginal revenue < marginal cost.
If a further unit of production will ^ the firm’s revenues by more than it ^costs (MR>MC), the
firm should expand its output. If the last unit produced ^revenues by less than it ^costs
(MR<MC), the profit- maximizing firm should reduce its output. The only time a firm should
leave its output unaltered is when the last unit produced adds the same amount to revenues as
it does to costs (MR=MC)
Rule 2: if it is worthwhile for the firm to produce at all, the firm should produce the output at
which marginal revenue equals marginal cost.
For price-taking firms, AR = MR=market price
A profit-maximizing firm that is operating in a perfectly competitive market will produce the
output that equates its marginal cost of production with the market price of its product (as long
as price exceeds avg variable cost).
Perfectly competitive industry = market determines price product is sold at, firm picks quantity
of output that maximizes profits (when price = MC) = then no incentive to change its output
unless prices or costs change
The perfectly competitive firm adjusts its level of output in response to changes in the market-
determined price
Short-Run Supply Curves
The Supply Curve for One Firm (207)
For prices below the AVC, the firm will supply zero units (rule 1). For prices above AVC, the
competitive firm will choose its level of output to equate price and marginal cost (Rule 2)
A competitive firm’s supply curve is given by the portion of its marginal cost curve that’s above
its AVC curve
The Supply Curve for an Industry
In perfect competition, the industry supply curve is the horizontal sum of the marginal cost
curves (above the level of avg variable cost) of all firms in the industry.