Micro Ch14 Lecnotes

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PowerPoint Lecture Notes for Chapter 14: Firms in Competitive MarketsPri ncipl es of Micr oeconomics 4th edition, by N. Gregory Mankiw

PowerPoint Slides by Ron Cronovich

2006 Thomson South-Western, all rights reserved

N . G R E G O RY M A N K I W

PowerPoint Slidesby Ron Cronovich

14

P R I N C I P L E S O F

F O U R T H E D I T I O N

MICROECONOMICS

Firms in Competitive MarketsFirms in Competitive Markets

Having introduced the cost concepts in the previous chapter, wenow begin to use those concepts to see how firms making

production and pricing decisions in different market structures. Inthis chapter, we explore firm behavior under perfect competition.The next chapter covers the other extreme end of the competitionspectrum monopoly. The following two chapters cover theintermediate cases oligopoly and monopolistic competition,respectively.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 1

In this chapter, look for the answers tothese 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?


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 inperfectly competitive markets.


Characteristics of perfect competition

1. Many buyers and many sellers2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

1. Many buyers and many sellers2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

Because of 1 & 2, each buyer and seller is aprice taker takes the price as given.

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


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The revenue of a competitive firm

Total revenue ( TR )

Average revenue ( A R )

Marginal Revenue ( MR ):The change in TR fromselling one more unit.

TR Q

MR =

TR = P x Q

TR Q

AR = = P

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

A A CC TT II V V E LE L EE A A R R NN II NN GG 11 ::ExerciseExercise

Fill in the empty spaces of t he table.

5

$50$105

$40$104

$103

$102

$10$101

n.a.$100

TR P Q MR AR

$10

This easy exercise requires students to apply the definitions fromthe 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.)

A A CC TT II V V E LE L EE A A R R NN II NN GG 11 :: Answers Answers

Fill in the empty spaces of t he table.

6

$50$105

$40$104

$103

$10

$10

$10

$10$102

$10$101

n.a.

$30

$20

$10

$0$100

TR = P x Q P Q TR Q

MR =TR

Q AR =

$10

$10

$10

$10

$10

Notice thatMR = P

Notice thatMR = P


M R = 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 = P is only true for firms in competitive markets.

MR = P is only true for

firms in competitive markets.


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Profit Maximization What Q maximizes the firms profit? To find the answer,

Think at the marg in .

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.


Profit Maximization

505

404

303

202

101

45

33

23

15

9

$5$00

Profit =MR MC

MC MR ProfitTC TR Q At any Q withMR > MC ,

increasing Q raises profit.

5

7

7

5

1

$5

1010

10

10

20

2

4

$6

1210

8

6

$4$10

(continued from earlier exercise)

At any Q withMR < MC ,reducing Q

raises profit.

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

For most students, seeing the complete table all at once is toomuch information. So, the table is animated as follows:Initially, the only columns displayed are the ones students saw atthe end of the exercise in Active Learning 1: Q, TR, and MR.

Then, TC appears, followed by MC. It might be useful to remindstudents of the relationship between MC and TC.Then, the Profit column appears. Students should be able to seethat, 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.


P 1 MR

MC and the firms supply decision

At Q a , MC < MR .So, increase Q to raise profit.

At Q b , MC > MR .So, reduce Q to raise profit.

At Q 1, MC = MR .Changing Q would lower profit. Q

Costs

MC

Q 1Q a Q b

Rule: MR = MC at the profit-maximizing Q .

This slide is similar to Figure 1 in the chapter. Ive omitted theAVC and ATC curves (which appear in Figure 1 in the chapter)

because they are not needed at this point.


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P 1 MR

P 2 MR 2

MC and the firms supply decision

If price rises to P 2,then the profit-maximizing quantityrises to Q 2.

The MC curvedetermines thefirms Q at any price.

Hence,

Q

Costs

MC

Q 1 Q 2

the MC curve is thefirms supply curve.


Shutdown vs. Exit Shutdown :

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

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

A firm that shuts down temporarily must still payits fixed costs. A firm that exits the market doesnot have to pay any costs at all, fixed or variable.


A firms short-run decision to shut down If firm shuts down temporarily,

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

The cost of shutting down is TR, the revenue the firm loses if itshuts down.

The benefit of shutting down is VC, because the firm doesnthave to pay its variable costs if it shuts down. (It still must pay itsFC, though.)

If the benefit of shutting down exceeds the cost, its worthwhilefor the firm to shut down.


The firms SRsupply curve isthe portion of its MC curveabove AVC .

Q

Costs

A competitive firms SR supply curve

MC

ATC

AVC

If P > AVC , thenfirm produces Q where P = MC .

If P < AVC , thenfirm shuts down(produces Q = 0).

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 atime.


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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.


A firms long-run decision to exit If firm exits the market,

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

The cost of exiting is TR, the revenue the firm loses if it leavesthe market.

The benefit of exiting is TC, because the firm no longer pays itscosts if it leaves the market.

If the benefit of existing is greater than the cost, then itsworthwhile for the firm to exit.


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 .

Divide both sides by Q to express the firmsentry decision as:

Enter if P > ATC

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


The firmsLR supply curveis the portion of its MC curveabove LRATC .

Q

Costs

The competitive firms LR supply curve

MC

LRATC


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A A CC TT II V V E LE L EE A A R R NN II NN GG 22 A A ::Identifying a firmIdentifying a firm s profits profit

Determinethis firmstotal profit.

Identify thearea on thegraph thatrepresentsthe firms

profit.

19

Q

Costs, P

MC

ATC P = $10 MR

50

$6

A competitive firm

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

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

profit

A A CC TT II V V E LE L EE A A R R NN II NN GG 22 A A :: Answers Answers

20

Q

Costs, P

MC

ATC P = $10 MR

50

$6

A competitive firm

profit per unit= P ATC = $10 6= $4

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

The height of the rectangle is P ATC, profit per unit.

The width of the rectangle is Q, the number of units.

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

A A CC TT II V V E LE L EE A A R R NN II NN GG 22 BB::Identifying a firmIdentifying a firm s losss loss

Determinethis firmstotal loss.

Identify thearea on thegraph thatrepresentsthe firmsloss.

21

Q

Costs, P

MC

ATC

A competitive firm

$5

P = $3 MR

30

Students that didnt figure out the answer to the previous exerciseshould be able to get this one.

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

loss MR P = $3

A A CC TT II V V E LE L EE A A R R NN II NN GG 22 BB:: Answers Answers

22

Q

Costs, P

MC

ATC

A competitive firm

loss per unit = $2

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

$5

30

The height of the rectangle is ATC P, loss per unit.


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


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Market supply: assumptions

1) All existing firms and potential entrants haveidentical costs.

2) Each firms costs do not change as other firmsenter 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)

In the real world, there are many markets in which assumptions (1)and (2) do not hold. We make them here for simplicity. Later inthe 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 mucheasier for firms to enter or exit in the long run than in the short

run.


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 thesum of quantity supplied by each firm.


The SR market supply curve

MC

P 2

Market

Q

P

(market)

One firm

Q

P

(firm)

S

P 3

Example: 1000 identical firms. At each P , market Q s = 1000 x (one firms Q s )

AVC P 2

P 3

30

P 1

2010

P 1

30,00010,000 20,000

Identical means all firms have the same cost curves.

Note: P 1 is minimum AVC. At any price below P 1, each firm willshut down, and market quantity supplied will equal zero.

Hence, the market supply curve begins at price = P 1 and Q =

10,000.


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.


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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.


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 .


The LR market supply curve

MC Market

Q

P

(market)

One firm

Q

P

(firm)

In the long run,the typical firmearns zero profit.

LRATC

long-runsupply

P =

min. ATC

The LR market supplycurve is horizontal atP = minimum ATC .

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


Why do firms stay in business if profit = 0? Recall, economic profit is revenue minus all

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

In the zero-profit equilibrium, firms earn enoughrevenue to cover these costs.

Students often wonder why firms bother to stay in business if theymake zero profit. The textbook gives a nice discussion of this,

briefly summarized on this slide.


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S 1

Profit

D 1

P 1long-runsupply

D 2

SR & LR effects of an increase in demand

MC

ATC

P 1

Market

Q

P

(market)

One firm

Q

P

(firm)

P 2P 2

Q 1 Q 2

S 2

Q 3

A firm begins inlong-run eqm

but then an increasein demand raises P ,leading to SR

profits for the firm.Over time, profits induce entry,shifting S to the right, reducing P

driving profits to zeroand restoring long-run eqm.

AB

C

This slide replicates Figure 8 from the textbook. In edit mode, thetext boxes in the top part of the slide appear to be on top of eachother. But in slide-show mode, the text boxes display one at atime.

If students did not previously understand why the LR marketsupply curve is horizontal, this slide may help.


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.

If either of these assumptions is not true,then LR supply curve slopes upward.

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


1) Firms have different costs As P rises, firms with lower costs enter the market

before those with higher costs. Further increases in P make it worthwhile

for higher-cost firms to enter t he 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.

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


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 landsuitable for farming).

The entry of new firms increases demand for thisinput, causing its price to rise.

This increases all firms costs.

Hence, an increase in P is required to increasethe market quantity supplied, so the supply curveis upward-sloping.

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


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Conclusion: The efficiency of acompetitive market

Profit-maximization: MC = MR Perfect competition: P = MR So, in the competitive eqm: P = MC Recall, MC is cost of producing the marginal unit.

P is value to buyers of the marginal unit. So, the competitive eqm is efficient, maximizes

total surplus. In the next chapter, monopoly: pricing &

production decisions, deadweight loss, regulation.

Recall from Chapter 7: a competitive market equilibrium isefficient. This chapter has shown why: P = MR under perfectcompetition, so P = MC in the competitive market equilibrium.

Reviewing these concepts now sets the stage for the next fewchapters, where firms with market power set their price abovemarginal cost, leading to market inefficiencies and a potential role

for government intervention.


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 firmwill 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 .


profit

A firm with profits

Q

Costs, P

MC

ATC P MR

Q

ATC

profit per unit = P ATC

revenue per unit =

cost per unit =

profit-maximizing quantity

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

The height of the rectangle is P ATC, profit per unit.


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


ATC loss

A firm with losses

Q

Costs, P

MC

ATC

P MR

Q

loss per unitrevenue per unit =

cost per unit =

loss-minimizing quantity

This slide is hidden and will not display in your presentation. Ihave 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 area of the rectangle= height x width= (loss per unit) x (number of units)= total loss.

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Micro Ch14 Lecnotes