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Chapter 14

ECO1104 Chapter 14: ECO1104 - Chapter 14

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Gordon Lenjosek

ECO1104: Microeconomics Chapter 14: Firms in Competitive Markets  Competitive Market o Competitive market: A market in which there are many buyers and many sellers so that each has a negligible impact on the market price (price taker).  Assumptions used to build model of perfect competition: 1. There are many buyers and many sellers in the market. 2. The goods offered by the various sellers are largely the same. 3. Firms can freely enter or exit the market. o The revenue of a competitive firm o Equations  Total Revenue = Price x quantity   AR  o Marginal Revenue (MR): Change in total revenue from an additional unit of output sold  It is the slope of TR function  For competitive firms, marginal revenue equals the price of the good  P = MR always  If firm sells one more (less) unit o output, TR increases (decreases) by P  That is NOT TRUE in monopolized markets o Average Revenue (AR): Total revenue divided by quantity sold  Tells us how much revenue a firm receives for typical unit sold  Revenue per unit sold o Where does firm’s price come from? o Price taker: Price that firm charges for its product is dictated by the market  Firm can only charge that price  Maximizing profits o This occurs at output level where (TR – TC) is the highest, or MR = MC o If you observe firm producing at level where MR is NOT equal to MC, then you can only conclude that it is not making as much profit as possible.  It does not mean that the firm is making losses  If MR > MC, more should be produced  If MR < MC, Less should be produced  If MR = MC, now firm is maximizing profits o Example:  At any Q with M > MC, increasing Q raises profit (Q = 0, 1, 2)  At any Q with MR < MC, reducing Q raises profit (Q = %)  At Qa, MC < MR. So, increase Q to raise profit  At Qb, MC > MR. So, reduce Q to raise profit.  At Q1, MC + MR. Changing Q would lower profit.  If price rises to P2, then the profit-maximizing quantity rises to Q2  The MC curve determines the firm’s Q at any price  Hence, the MC curve is the firm’s supply curve  Shutdown versus Exit o Shutdown: A short-run decision not to produce anything because of market conditions  Cost of shutting down: Revenue loss = TR  Benefit: Costs saving = VC  The firm must still pay FC  So, the firm will shut down if TR < VC  Divide both sides by Q: TR/Q < VC/Q  The firm’s decision rule:  Shutdown if P < AVC  In other words, if the cost of shutting down (revenue loss per unit) is less than the benefit (variable cost savings per unit), then the firm should shut down o Exit: A long-run decision to leave the market o Key difference:  If the firm shuts down in the short run, it must still pay FC  If the firm exits in the long run, it incurs zero costs  A competitive Firm’s Short Run Supply Curve o The firm’s SR supply curve is the portion of its MC curve above AVC (and o otherwise) 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 one type of sunk cost: The firm must pay its fixed costs whether it produces or shuts down o So, FC should/does 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  There is no FC in the long run  So TC = VC and ATC = AVC o So, the firm exits if TR < TC o Divide both sides by Q to write the firm’s decision rule as:  Exit if P < ATC o In other words, if the cost of exiting (revenue loss per unit) is less than the benefit (total cost savings per unit), then the firm should exit  A new Firm’s Decision to Enter Market o Similarly, a prospective entrant compares the benefits of entering the market (TR) with the costs (TC), and enters if the benefits exceed the costs o In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC o Divide both sides by Q to express the firm’s entry as:  Enter if P > ATC  The Competitive Firm’s Long Run Supply Curve o The firm’s LR supply curve is the portion of its MC curve above LRATC (and o otherwise)  A Firm’s Profit o Profit = Revenue – Total Cost (TC)  Revenue = Price x output = pQ o Profit = pQ – TC or Profit = Q (p - ) o Profit = Q (p – AC) o And profit per unit of output is:   Identifying a Firm’s Profit 1. Determine this firm’s total profit 2. Identify the area on the graph that represents the firm’s profit  Profit per unit = Revenue per unit – cost per unit = P – ATC = $10 – 6 = $4  Total profit = (P – ATC) x Q = $4 x 50 = $200  Identifying a Firm’s Loss 1. Determine this firm’s total loss, assuming AVC < $3 2. Identifying the area on the graph that represents the firm’s loss. “Assuming AVC < $3” is needs to prevent shut-down in the SR, i.e., to ensure that the firm produces Q = 30 instead of Q = 0  Loss per unit = Cost per unit – revenue per unit = ATC – P = $5 – 3 = $2  Total Loss = (ATC – P) x Q = $2 x 30 = $60  Market Supply: Assumptions 1. All exiting firms and potential entrants have identical costs 2. Each firm’s costs do not ch
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