Ch 6

The Theory of Producer

Market Structure
The way that firms compete in a market. Four types of Market Structure:
Perfect Competition Perfect Information Monopoly Imperfect Oligopoly Information Monopolistic Competition

Perfect Competition
Characteristic of Perfect Competition: 1.Perfect Information
All the market participants (firms, consumers, input owners) possess all of the information.

2.Many Buyers & Sellers

With perfect information, producers can enter the market freely. No individual firms can affect the market price. Each firm is a price-taker. The firm cannot set a price higher/lower than the market price.

Perfect Competition
Characteristic of Perfect Competition: 3. Homogenous Goods
With perfect information, there is no trade secret. Each firm produces identical products. The goods produced by different producers are Perfect Substitute.

4. Free entry and exit

They can enter the is no trade With perfect information, theremarket freely secret

Profit Maximization
Each firm targets at maximize their Economic Profit. To know how firms meet this target, we need to know how firms make the following decisions?
How much should be produced? What price should be set?

Firms answer these questions by looking at the demand facing the firm and their costs.

Demand Facing a Firm

It is the demand for the firms product. It shows the relationship between the market price and the output that is produced by that particular firm. It is not the same as the market demand for the product. As the firm is a price-taker (it has to accept the market price whenever it enters the market), the price of its product is fixed at the market price.

Demand Facing a Firm

P
Market S

Individual Firm

P1 D Q

P1

Demand Facing a Firm

Properties of the firms demand curve: 1.Horizontal
The price of its product is fixed at P1. Price > P1, Qd =0 Price < P1, Loss

2.If the firm sets the price at P1, it can sell as many as it wants. 3.Ed to the firms product =
All the firms are selling identical products a large no. of perfect substitutes.

Demand Facing a Firm

Properties of the demands demand curve: 4. Price = Marginal Revenue (MR) = Average Revenue (AR)
MR = extra revenue generated from selling one more unit of output. As TR = P x Q, P is fixed,
PQ MR = Q TR MR = Q

MR = P

Demand Facing a Firm

Properties of the demands demand curve: 4. Price = Marginal Revenue (MR) = Average Revenue (AR)
AR = Average revenue generated Q units of output. TR
AR = Q

As TR = P x Q, AR = PxQ
Q AR = P

d = P = MR =AR

SR Profit Maximization
How much should the firm facing demand d produce in the Short Run? Market S Individual Firm

SMC1

P1

P1

d ATC1

AVC1

D q1 Q q In the SR equilibrium, P = AR = MR = MC.

Profit Maximization
If MR > MC
Revenue from selling the extra unit > Cost of that unit Selling more!

If MR < MC
Revenue from selling the extra unit < Cost of that unit Selling less!

If MR = MC
Revenue from selling the extra unit = Cost of that unit Optimal output!

To maximize economic profit, the firm should produce at MR = MC.

Economic Profit
Economic Profit = TR (Explicit Costs + Implicit Costs) Economic Profit = TR (Money Costs + Time Costs) Economic Profit = TR (Variable Costs + Fixed Costs) Profit Normal Economic Profit = TR Opportunity Cost Accounting Profit = TR Explicit Costs

Economic Profit
Example: In the last year, I opened a tutorial centre and earned a TR of $1M and incurred expenses on materials and labour of $900,000. If I was not operating the tutorial centre, I would stay in Cityu and earn $110,000 a year. Was I making an economic profit last year?
Economic Profit = TR (Explicit Costs + Implicit Costs) = $1M ($900,000 + $100,000) = $0 Question: Should I keep on running my business? Yes, as Normal Profit > 0 (TR > explicit costs)

Economic Profit
Although firms are targeting maximize the Economic Profit, their decisions of stay or leave depends on their Normal Profit. There are four situations for a firm: 1.TR > Explicit Costs +Implicit Costs
E. Profit > 0 Firm stays in the market and produce at MR = MC. The owner earn more than working anywhere else.

Economic Profit
E. Profit = TR (Variable Costs + Fixed Costs) TR = P1 x q1 TC = ATC1 x q1 P Individual Firm
SMC1

P1 ATC1

d ATC1
E. profit

AVC1

E. profit = (P1 - ATC1) x q1

P1 > ATC1

E. profit > 0

q1

Economic Profit
2. TR = Explicit Costs + Implicit Costs
E. Profit = 0 (Break-even) Firm stays in the market and produce at MR = MC. As the owner can cover his time cost (Normal Profit = Time cost), he has no better alternative. The revenue generated = the income earned from his best alternative

Economic Profit
E. Profit = TR P (Variable Costs + Fixed Costs) TR = P1 x q1 ATC1P1 TC = ATC1 x q1 E. profit = (P1 - ATC1) x q1 Individual Firm
Break-even point SMC1

d ATC1
AVC1

P1 = ATC1

E. profit = 0
(Break-even)

q1

Economic Profit
3. TR < Explicit Costs + Implicit Costs TR > Explicit Costs
E. Profit < 0 (Economic Loss) Firm stays in the market and produce at MR = MC. As the owner can cover part of his time cost (Normal Profit > 0), he can wait for an increase in demand. If he leaves now, he will loss the entire fixed cost.

Economic Profit
E. Profit = TR P (Variable Costs + Fixed Costs) TR = P1 x q1 ATC1 P1 TC = ATC1 x q1 E. profit = (P1 - ATC1) x q1 Individual Firm
SMC1 ATC1

E. Loss

d
AVC1

P1 < ATC1

E. loss

q1

Economic Profit
4. TR < Explicit Costs + Implicit Costs TR < Explicit Costs
E. Profit < 0 (Economic Loss) Firm leaves the market and produce nothing. As the owner cannot cover his time cost (Normal Profit < 0), he cannot wait for an increase in demand. If he does not leave now, he will loss more than the fixed cost.

Economic Profit
E. Profit = TR P (Variable Costs + Fixed Costs) ATC1 TR = P1 x q1 P1 TC = ATC1 x q1 E. profit = (P1 - ATC1) x q1 Individual Firm
SMC1 ATC1 E. Loss

AVC1

d
Shut down point

P1 = AVC1

E. loss
(Shut down)

q1

Supply Curve of a Firm

Individual Firm

If P = P1, q = q1
If P = P2, q = q2 If P = P3, q = q3 If P = P3, q = 0

P1
P1 P3

SMC1 S1

AVC1

The SR supply curve q3 q2 q1 of a competitive firm is the part of its MC curve above the AVCmin.

Market Supply
The market supply curve is the horizontal summation of individual supply curve. The individual supply curve is the segment of a competitive firms MC curve above the AVCmin. The market supply curve is the horizontal summation of competitive firms MC curves . S = MCi

Comparative Static
How an increase in variable input price (wage) affect a competitive firm in the SR? Wage increases = variable cost increases TVC increases STC = TVC + TFC STC increases AVC = TVC/Q AVC increases ATC = AVC + AFC ATC TVC increases SMC = Q SMC increases

Comparative Static
1. At P1, the firm produces q1 and earns Individual Firm E. profit. SMC2 P 2. Increase of wage SMC1 shifts up the MC and ATC2 ATC of the firm. ATC2 E. Loss dATC1 3. To maximize profit, P1 E. profit AVC1 the firm reduce output to q2. 4. At q2, ATC2 > P1. the q2q1 q firm makes E. loss.

Comparative Static
How an increase in market demand affects the firm in the SR?
P
P2 P1 Market S Individual Firm
SMC1
E. profit

P
P2 P1

d2 d1 ATC1 AVC1

D1 Q

D2 q1q2 q

LR Profit Maximization
If a competitive firm makes E. Profit in the SR, will it be able to keep the profit in the LR? NO! Because there will be new firms entering the market. Because of the entry of new firms, in the LR, no firm can make E. Profit. Every firm will run at Break-Even.

LR Profit Maximization
There are two stages for a firm moving to the LR equilibrium.
1. Increase of capital 2. New firms entering the market

In the LR
1. All factors become variable 2. Free entry

1st stage: 1. In the SR, the firm with capital K1, produces at q1 and earn E. profit. 2. In the LR, the firm will increase capital to make more profit. The firm produces at q2 where MR = P1 = LMC. Profit increases. P
LMC

LR Profit Maximization

P1

SMC1 ATC1
E. profit

LAC

E. profit
q1 q2

2nd stage: 1. As the firm makes profit, new firms enter the market. 2. This increases the market supply of the good 3. Market price and hence the demand of the firm drop. S1 P P 4. New firms enter until each one earns zero E. LMC LAC Profit. S2
P1 P2

LR Profit Maximization

P1
P2

d1 d2

D Q

q3 q2

LR Profit Maximization
In the real world, the two stages are happening at the same time. Once firms make profit, they will try to expand, and potential producers will enter the market simultaneously. In the LR equilibrium, every firm must earn Zero E. Profit. P = AR = MR = LMC = LAC

Comparative Static
How an increase in input price affect a competitive firm in the LR? LTC increases LAC = LTC/Q LAC LTC increases LMC = Q LMC increases

Comparative Static
1. Originally, the firm face demand curve d1 and produce q0. 2. As cost increases, LMC & LAC shift up to LMC2 & LAC2. 3. The firm reduces output to q1, where P1 = LMC2. 4. As output of drops, the market supply drops to S2. 5. Decrease in supply raises P to P2 and d to d2. 6. As the firms demand increases, the firm raise q to q2. 7. At q2, the firm suffers a loss. 8. With loss, some existing firms to leave. So, the market supply drops further to S3. 9. Decrease in supply raises P to P3 and d to d3. 10. Finally, the firm produces at q3 and makes zero E. Profit.

Comparative Static
Market P
P3 P2 P1 S3 S

Individual Firm P
S1
P3 P2 P1 E. Loss
2

LMC2 LMC1 LAC2

d3 d2 d LAC 1
1

D1 Q

q1q2q3 0 q

Concept Map
Competition Price Competition Market Economy How market work?
P P1 D S

Non-Price Competition
(Order)

Command Economy

Q1

Demand
The theory of consumer (Utility)

Supply
Sum of MC curves of all the competitive firms (price-takers)