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ECN 104 (388)
Chapter 14

Chapter 14 Notes

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ECN 104
Tsogbadral Galaabaatar

ECN104 – Chapter 14 Notes Chapter 14 Notes • Questions o What is a perfectly competitive market? o What is marginal revenue? How is it related to total and average revenue? o How does a competitive firm determine the quantity that maximizes profits? o When might a competitive firm shut down in the short run? Exit the market in the long run? o What does the market supply curve look like in the short run? In the long run? • Introduction: A Scenario o Three years after graduation, you run your own business o You must decide how much to produce, what price to charge, how many workers to hire, etc. o What factors should affect these decisions?  Your costs (studied in preceding chapter)  How much competition you face o We begin by studying the behaviour of firms in perfectly competitive markets • Characteristics of Perfect Competition o 1. Many buyers and many sellers o 2. The goods offered for sale are largely the same. o 3. Firms can freely enter or exit the market. o Because of 1 and 2, each buyer and seller is a price taker – takes the price as given • The Revenue of a Competitive Firm o Total Revenue (TR) = Profit x Output (P x Q) o Average Revenue (AR) = Total Revenue (TR) / Output (Quantity) = P (Profit) o Marginal Revenue (MR) (Change in TR from selling one more unit) = (Change in Total Revenue) / (Change in Output) • MR = P for a Competitive Firm o A competitive firm can keep increasing its output without affecting the market price o So, each one-unit increase in Output causes revenue to rise by P (Profit), E.g., MR = P o MR = P is only true for firms in competitive markets. • Profit Maximization o What Output maximizes the firm’s profit? o To find the answer, “think at the margin.”  If you increase Output by one unit, revenue rises by MR, cost rises by MC o If MR > MC, then increase Output to raise profit o If MR < MC, then reduce Output to raise profit • Shutdown vs. Exit o Shutdown: A short-run decision not to produce anything because of market conditions o Exit: A long-run decision to leave the market o A key difference:  If shutdown in short run, must still pay FC  If exit in long run, zero costs • A Firm’s Short-run Decision to Shut Down o Cost of shutting down: revenue loss = TR o Benefit of shutting down: cost savings = VC (firm must still pay FC) o So, shut down if TR < VC o Divide both sides by Output: TR/Q < VC/Q o So, firm’s decision rule is:  Shut down if P < AVC • A Competitive Firm’s Short-Run Supply Curve o The firm’s Short-Run supply curve is the portion of its MC curve above AVC o If P > AVC, then firm produces Q where P = MC o If P < AVC, then firm shuts down (produces Q = 0) • The Irrelevance of Sunk Costs o Sunk Cost: a cost that has already been committed and cannot be recovered o Sunk Costs should be irrelevant to decisions; you must pay them regardless of your choice o FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down o So, FC should not matter in the decision to shut down. • A Firm’s Long-Run Decision to Exit o Cost of exiting the market: revenue loss = TR o Benefit of exiting the market: cost savings = TC o So, firm exits if TR < TC o Divide both sides by Q to write the firm’s decision rule as: Exit if P < ATC • A New Firm’s Decision to Enter Market o In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC o Divide by sides by Q to express the firm’s entry decision as: Enter if P > ATC • The Competitive Firm’s Supply Curve o The firm’s long-run supply curve i
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