PowerPoint Lecture Notes for Chapter 14: Firms in Competitive Markets Principles of Microeconomics 4th edition, by N.

Gregory Mankiw PowerPoint Slides by Ron Cronovich

14

Firms in Competitive Markets

PRINCIPLES OF

MICROECONOMICS
F OURT H E DITIO N

N. G R E G O R Y M A N K I W
PowerPoint Slides by Ron Cronovich
2006 Thomson South-Western, all rights reserved

Having introduced the cost concepts in the previous chapter, we now begin to use those concepts to see how firms making production and pricing decisions in different market structures. In this chapter, we explore firm behavior under perfect competition. The next chapter covers the other extreme end of the competition spectrum monopoly. The following two chapters cover the intermediate cases oligopoly and monopolistic competition, respectively.

In this chapter, look for the answers to these questions: What is a perfectly competitive market?

What is marginal revenue? How is it related to

total and average revenue?

How does a competitive firm determine the

quantity that maximizes profits?

When might a competitive firm shut down in the

short run? Exit the market in the long run?

What does the market supply curve look like in the

short run? In the long run?
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 1

Introduction: A scenario
Three years after graduating, you run your own
business.

You have to decide how much to produce, what

price to charge, how many workers to hire, etc.

What factors should affect these decisions?

Your costs (studied in preceding chapter) How much competition you face

We begin by studying the behavior of firms in

perfectly competitive markets.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Characteristics of perfect competition

1. 1. Many Many buyers buyers and and many many sellers sellers 2. 2. The The goods goods offered offered for for sale sale are are largely largely the the same. same. 3. 3. Firms Firms can can freely freely enter enter or or exit exit the the market. market.

Firms can freely enter or exit the market means there are no barriers or impediments to entry or exit. E.g., the government does not restrict the number of firms in the market.

Because of 1 & 2, each buyer and seller is a

price taker takes the price as given.

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FIRMS IN COMPETITIVE MARKETS

The revenue of a competitive firm

Total revenue (TR) Average revenue (AR) Marginal Revenue (MR):

The change in TR from selling one more unit.

TR = P x Q AR = TR =P Q TR Q

These revenue concepts are analogous to the cost concepts (TC, ATC, MC) in the previous chapter.

MR =

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

ACTIVE LEARNING

Exercise
Q 0 1 2 3 4 5

1:

Fill in the empty spaces of the table.

P $10 $10 $10 $10 $10 $10 $40 $10 $50
5

This easy exercise requires students to apply the definitions from the previous slide. It also demonstrates that MR = P for a competitive firm. (The table in this exercise is similar to Table 1 in the chapter.)

TR

AR n.a. $10

MR

ACTIVE LEARNING

Answers
Q 0 1 2 3 4 5

1:
TR Q

Fill in the empty spaces of the table.

P $10 $10 $10 $10 $10 $10 TR = P x Q $0 $10 AR = TR Q MR =

n.a. $10 $10 $10 $10 $10

Notice Notice that that $10 $20 MR MR = =P P

$30 $40 $50 $10 $10

$10 $10
6

MR = P for a competitive firm A competitive firm can keep increasing its output
without affecting the market price.

So, each one-unit increase in Q causes revenue

to rise by P, i.e., MR = P. MR MR = =P P is is only only true true for for firms firms in in competitive competitive markets. markets.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Profit Maximization What Q maximizes the firms profit? To find the answer,
Think at the margin. If increase Q by one unit, revenue rises by MR, cost rises by MC.

If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Profit Maximization
(continued from earlier exercise) At any Q with MR > MC, increasing Q raises profit. At any Q with MR < MC, reducing Q raises profit.
CHAPTER 14

(The table on this slide is similar to Table 2 in the textbook.)

Profit = MR MC
$6 4 2 0 2

Q 0 1 2 3 4 5

TR $0 10 20 30 40 50

TC $5 9 15 23 33 45

Profit MR MC $5 $10 $4 1 10 5 10 7 10 7 10 5 12 10 8 6

For most students, seeing the complete table all at once is too much information. So, the table is animated as follows: Initially, the only columns displayed are the ones students saw at the end of the exercise in Active Learning 1: Q, TR, and MR. Then, TC appears, followed by MC. It might be useful to remind students of the relationship between MC and TC. Then, the Profit column appears. Students should be able to see that, at each value of Q, profit equals TR minus TC. The last column to appear is the change in profit. When the table is complete, we use it to show it is profitable to increase production whenever MR > MC, such as at Q = 0 , 1, or 2. it is profitable to reduce production whenever MC > MR, such as at Q = 5.

FIRMS IN COMPETITIVE MARKETS

MC and the firms supply decision

Rule: MR = MC at the profit-maximizing 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.
CHAPTER 14

Costs MC

This slide is similar to Figure 1 in the chapter. Ive omitted the AVC and ATC curves (which appear in Figure 1 in the chapter) because they are not needed at this point.

P1

MR

Qa Q1 Qb

Q
10

FIRMS IN COMPETITIVE MARKETS

MC and the firms supply decision

If price rises to P2, then the profitmaximizing quantity rises to Q2. The MC curve determines the firms Q at any price. Hence, the MC curve is the firms supply curve. Q1
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Costs MC P2 MR2

P1

MR

Q2

Q
11

Shutdown vs. Exit Shutdown:

A short-run decision not to produce anything because of market conditions.

Exit:
A long-run decision to leave the market.

A firm that shuts down temporarily must still pay

its fixed costs. A firm that exits the market does not have to pay any costs at all, fixed or variable.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

12

A firms short-run decision to shut down

If firm shuts down temporarily,

The cost of shutting down is TR, the revenue the firm loses if it shuts down. The benefit of shutting down is VC, because the firm doesnt have to pay its variable costs if it shuts down. (It still must pay its FC, though.) If the benefit of shutting down exceeds the cost, its worthwhile for the firm to shut down.

revenue falls by TR costs fall by VC

So, the firm should shut down if TR < VC. Divide both sides by Q: TR/Q < VC/Q So we can write the firms decision as:
Shut down if P < AVC

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FIRMS IN COMPETITIVE MARKETS

13

A competitive firms SR supply curve

The firms SR Costs supply curve is the portion of its MC curve If P > AVC, then above AVC. firm produces Q where P = MC.
If P < AVC, then firm shuts down (produces Q = 0).
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

In edit mode, it looks like the text boxes are on top of each other. But in presentation mode, the text boxes display only one at a time.

MC ATC AVC

Q
14

The irrelevance of sunk costs

Sunk cost: a cost that has already been

committed and cannot be recovered.

Sunk costs should be irrelevant to decisions,

you must pay them regardless of your choice.

FC is a sunk cost: The firm must pay its fixed

costs whether it produces or shuts down.

So, FC should not matter in the decision to shut

down.

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FIRMS IN COMPETITIVE MARKETS

15

A firms long-run decision to exit

If firm exits the market,

The cost of exiting is TR, the revenue the firm loses if it leaves the market. The benefit of exiting is TC, because the firm no longer pays its costs if it leaves the market. If the benefit of existing is greater than the cost, then its worthwhile for the firm to exit.
16

revenue falls by TR costs fall by TC

So, the firm should exit if TR < TC. Divide both sides by Q to rewrite the firms
decision as: Exit if P < ATC

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FIRMS IN COMPETITIVE MARKETS

A new firms decision to enter the market

In the long run, a new firm will enter the market if

it is profitable to do so: if TR > TC.

Similarly, a prospective entrant compares the benefits of entering the market (TR) with the costs (TC), and enters if the benefits exceed the costs.

Divide both sides by Q to express the firms

entry decision as: Enter if P > ATC

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FIRMS IN COMPETITIVE MARKETS

17

The competitive firms LR supply curve

The firms LR supply curve is the portion of its MC curve above LRATC.

Costs MC LRATC

Q
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 18

ACTIVE LEARNING

2A : Identifying a firm firms profit

A competitive firm

Rather than tell students that profit equals (P ATC) x Q, this exercise requires students to figure it out for themselves.
MR ATC

Determine this firms total profit. Identify the area on the graph that represents the firms profit.

Costs, P MC P = $10 $6

If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file.

50

19

ACTIVE LEARNING

Answers

2A :
A competitive firm

The height of the rectangle is P ATC, profit per unit. The width of the rectangle is Q, the number of units.
MR ATC

Costs, P profit per unit = P ATC = $10 6 = $4 MC P = $10

profit
$6

Total profit = ( P ATC) x Q = $4 x 50 = $200

50

The area of the rectangle = height x width = (profit per unit) x (number of units) = total profit.
20

ACTIVE LEARNING

2B : Identifying a firm firms loss

A competitive firm

Students that didnt figure out the answer to the previous exercise should be able to get this one. If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file.

Determine this firms total loss. Identify the area on the graph that represents the firms loss.

Costs, P MC ATC

$5 P = $3 MR Q

30

21

ACTIVE LEARNING

Answers

2B :
A competitive firm

The height of the rectangle is ATC P, loss per unit. The width of the rectangle is Q, the number of units.
ATC

Costs, P Total loss = ( ATC P) x Q = $2 x 30 = $60 MC

$5 P = $3

loss

loss per unit = $2 MR

30

The area of the rectangle = height x width = (loss per unit) x (number of units) = total loss.
22

Market supply: assumptions

1) All existing firms and potential entrants have identical costs. 2) Each firms costs do not change as other firms enter or exit the market. 3) The number of firms in the market is fixed in the short run (due to fixed costs) variable in the long run (due to free entry and exit)
23

In the real world, there are many markets in which assumptions (1) and (2) do not hold. We make them here for simplicity. Later in the chapter, we will see how our results change if we drop either of these assumptions. Assumption (3) is more reasonable: In the real world, it is much easier for firms to enter or exit in the long run than in the short run.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

The SR market supply curve As long as P AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.

Recall from Chapter 4:

At each price, the market quantity supplied is the sum of quantity supplied by each firm.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

24

The SR market supply curve

Example: 1000 identical firms. At each P, market Qs = 1000 x (one firms Qs)
One firm MC P3 AVC P2 P1 10 20 30 Market S

Identical means all firms have the same cost curves. Note: P1 is minimum AVC. At any price below P1, each firm will shut down, and market quantity supplied will equal zero. Hence, the market supply curve begins at price = P1 and Q = 10,000.
Q (market)

P
P3 P2 P1

Q (firm)
10,000

20,000 30,000
25

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Entry & exit in the long run In the LR, the number of firms can change due
to entry & exit.

If existing firms earn positive economic profit,

new firms enter SR market supply curve shifts right P falls, reducing firms profits Entry stops when firms economic profits have
been driven to zero.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

26

Entry & exit in the long run In the LR, the number of firms can change due
to entry & exit.

If existing firms incur losses,

Some will exit the market. SR market supply curve shifts left. P rises, reducing remaining firms losses. Exit stops when firms economic losses have
been driven to zero.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

27

The zero-profit condition Long-run equilibrium:

The process of entry or exit is complete, remaining firms earn zero economic profit.

Zero economic profit occurs when P = ATC. Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.

Recall that MC intersects ATC at minimum ATC. Hence, in the long run, P = minimum ATC.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 28

The LR market supply curve

In the long run, the typical firm earns zero profit. P
P= min. ATC One firm MC LRATC long-run supply

The LR market supply curve is horizontal at P = minimum ATC.

Market

That the LR market supply curve is horizontal at P = min ATC will become more clear shortly, when students see the SR and LR effects of an increase in demand.

Q (firm)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Q (market)
29

Why do firms stay in business if profit = 0?

Recall, economic profit is revenue minus all

costs including implicit costs, like the opportunity cost of the owners time and money.

Students often wonder why firms bother to stay in business if they make zero profit. The textbook gives a nice discussion of this, briefly summarized on this slide.

In the zero-profit equilibrium, firms earn enough

revenue to cover these costs.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

30

SR & LR effects of an increase in demand

A firm begins in but then an increase driving profits to zero leading to SR Over time, profits induce entry, long-run eqm in demand raises P, and restoring long-run eqm. profits for the firm. shifting S to the right, reducing P P
One firm MC Profit P2 P1 ATC P2 P1 A B C long-run supply D1 Q1 Q2 Q3 D2

Market S1 S2

This slide replicates Figure 8 from the textbook. In edit mode, the text boxes in the top part of the slide appear to be on top of each other. But in slide-show mode, the text boxes display one at a time. If students did not previously understand why the LR market supply curve is horizontal, this slide may help.

Q (firm)
CHAPTER 14

Q (market)
31

FIRMS IN COMPETITIVE MARKETS

Why the LR supply curve might slope upward

The LR market supply curve is horizontal if

1) all firms have identical costs, and 2) costs do not change as other firms enter or exit the market.

Here are two of the assumptions we made previously, when we began the process of deriving the LR market supply curve.

If either of these assumptions is not true,

then LR supply curve slopes upward.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

32

1) Firms have different costs

As P rises, firms with lower costs enter the market

before those with higher costs.

The marginal firm is the firm that would exit the market if the price were any lower.

Further increases in P make it worthwhile

for higher-cost firms to enter the market, which increases market quantity supplied.

Hence, LR market supply curve slopes upward. At any P,

For the marginal firm, P = minimum ATC and profit = 0. For lower-cost firms, profit > 0.
FIRMS IN COMPETITIVE MARKETS 33

CHAPTER 14

2) Costs rise as firms enter the market

In some industries, the supply of a key input is

limited (e.g. theres a fixed amount of land suitable for farming).

Another example: Theres a limited amount of beachfront property. An expansion of the beach resort industry will bid up the price of such property, and raises costs in the industry.

The entry of new firms increases demand for this

input, causing its price to rise.

This increases all firms costs. Hence, an increase in P is required to increase

the market quantity supplied, so the supply curve is upward-sloping.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

34

Conclusion: The efficiency of a competitive market

Profit-maximization: Perfect competition: So, in the competitive eqm:

MC = MR P = MR P = MC

Recall from Chapter 7: a competitive market equilibrium is efficient. This chapter has shown why: P = MR under perfect competition, so P = MC in the competitive market equilibrium. Reviewing these concepts now sets the stage for the next few chapters, where firms with market power set their price above marginal cost, leading to market inefficiencies and a potential role for government intervention.
35

Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. total surplus.

So, the competitive eqm is efficient, maximizes In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

CHAPTER SUMMARY For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.

If P > AVC, a firm maximizes profit by producing

the quantity where MR = MC. If P < AVC, a firm will shut down in the short run.

If P < ATC, a firm will exit in the long run. In the short run, entry is not possible, and an
increase in demand increases firms profits.

With free entry and exit, profits = 0 in the long run,

and P = minimum ATC.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 36

A firm with profits

Costs, P MC
revenue per unit = P profit per unit = P ATC cost per unit = ATC

This slide is hidden and will not display in your presentation. I have included it here in case you would like to substitute it for Active Learning 2A.
MR ATC

profit

The height of the rectangle is P ATC, profit per unit. The width of the rectangle is Q, the number of units.

Q
profit-maximizing quantity
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

37

The area of the rectangle = height x width = (profit per unit) x (number of units) = total profit.

A firm with losses

Costs, P MC ATC
cost per unit = ATC revenue per unit = P

This slide is hidden and will not display in your presentation. I have included it here in case you would like to substitute it for Active Learning 2B. The height of the rectangle is ATC P, loss per unit. The width of the rectangle is Q, the number of units.
38

loss

loss per unit

MR Q

Q
loss-minimizing quantity
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

The area of the rectangle = height x width = (loss per unit) x (number of units) = total loss.