Firms in Competitive Markets

Dr. Katherine Sauer Principles of Microeconomics ECO 2020

Overview: I.The Firms Marginal Revenue and Demand II. The Firms Output III. The Firms Profits: Graphically IV. Market Dynamics V. Efficiency

Recall the characteristics of a competitive market: many sellers homogeneous product no barriers to entry A firm in a competitive market is a price taker. That is, whatever the market price is, that is the price the firm will charge. - if charge more, will lose sales to other firms - no reason to charge less

I. The Firms Marginal Revenue and Demand Assume the firm sets its price equal to the market price, P*. So, then TR = P* x Q AR = P*

MR = TR2 TR1 = P* x Q2 P* x Q1 = P*( Q2 Q1) Q2 Q1 Q2 Q1 Q2 Q1

= P*

For a competitive firm: marginal revenue is always equal to the market price.

The demand curve for a competitive firm is a horizontal line at the market price. - because the firm is just one of many firms selling an identical product, its demand curve is perfectly elastic - if the firm charged higher than the market price, no one would buy from it - the firm would not charge a price lower than the market price

Market for Soybeans

P S P

Farmer Frans Soybeans

P*

P*

D = MR

Q*

Market for Soybeans

P S P

Farmer Frans Soybeans

P2 P*

P2 P*

D2 = MR2 D = MR

D2 D

Q* Q2

Suppose that it is announced that soy can help promote heart health.

When the forces of supply and demand affect the market price, the individual firms - demand - marginal revenue curves will shift. If market price rises: firm demand and MR shift up (increases). If market price falls: firm demand and MR shift down (decreases).

II. The Firms Level of Output We learned previously that the firm will produce the level of output where marginal revenue is equal to marginal cost. Graphically: P
MC

P*

D= MR

q*

Mathematically: Paulos Ping Pong Balls is a firm that operates in a competitive market. The ping pong balls sell for $3 per package. Output 0 1 2 3 4 5 6 7 8 9 Price 3 3 3 3 3 3 3 3 3 3 TR 0 3 6 9 12 15 18 21 24 27 TC 1.50 2.00 3.00 4.50 6.50 9.00 12.00 15.50 19.50 24.00 MR --3 3 3 3 3 3 3 3 3 MC --0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 Profit -1.50 1.00 3.00 4.50 5.50 6.00 6.00 5.50 4.50 3.00

This firm will produce 6 units of output. This firm will charge $3 per unit.

Recall that if the market price is less than the firms average variable cost, the firm will temporarily shut down and produce q*=0. - need to look at AVC vs P where MR = MC to determine
P

MC AVC * P*

AVC

D= MR

q*=0

q where MR = MC

When the market price is greater than the average variable cost at the quantity where MR = MC, then produce that quantity. P
MC

P* AVC * AVC

D= MR

q*

III. The Firms Profits Graphically Recall that a firms profits depend on the relationship between price and average total cost. A competitive firm takes the market price as given, and will compare this to the average total cost at the profit maximizing level of output to determine its profits. - at the quantity where MR = MC, compare the price to the ATC

A. At q*, P > ATC

P profits MC

P* ATC* ATC AVC

D= MR

(P ATC)q > 0

q*

B. At q*, P = ATC
P

There is no profit area to illustrate because profits are equal to zero.

MC ATC

ATC* =

P*

D= MR

AVC

(P ATC)q = 0 breaking even

q*

C. At q*, P < ATC

P loss MC ATC* P* D= MR ATC

AVC

(P ATC)q < 0

q*

Recap: 1) Competitive firms take the market price as given. P = MR = D for the firm 2) Produce the level of output where MR = MC. Double check that P > AVC at that quantity. 3) Compare the price to the ATC at that quantity to determine profits or losses. Note: graphically, Ill often leave off the AVC curve and just have you focus on the ATC.

IV. Market Dynamics Recall that when the market equilibrium changes, the firms demand curve / marginal revenue changes as well. This will affect the firms output and profits.

Initially, Farmer Fran is earning a loss. Market for Soybeans

P S P

Farmer Frans Soybeans

MC

ATC

P*

P*

D = MR

Q*

q*

Suppose that it is determined that soy helps promote hearth health. Now Fran is earning a profit and is selling a higher output. Market for Soybeans
P S P

Farmer Frans Soybeans

MC P2 P* P2 P*

ATC

D2 = MR2 D = MR

D2 D

Q* Q2

q* q2

Because Fran is in a competitive industry earning positive profits, wed expect other farmers to plant soybeans in the long run. Market for Soybeans
P S S3 P

Farmer Frans Soybeans

MC P2 P3 P* P2 P3 P*

ATC

D2 = MR2 D3 = MR3 D = MR

D2 D

Q* Q2 Q3

q3 q* q2

Long Run Equilibrium in a Competitive Market: In the long run, firms in a competitive market will each earn zero profits. In order to earn zero profits, the price and average total cost must be equal at q*. This will occur at the point where: MR = MC = ATCmin = P

V. Efficiency We previously learned about the minimum efficient scale. - the quantity that minimizes average total cost If a firm is producing at this level of output, we would call the firm productively efficient. - producing the level where ATC is minimized If a competitive firm is breaking even, it is also being productively efficient. - always in the long run - sometimes in the short run

If the price a firm charges is exactly equal to its marginal cost, we call the firm allocatively efficient. - a competitive firm is always allocatively efficient