Competitive Markets
Lesson 9

Pure Competitive

Purely Competitive Firms - accepts the market price in order to sell their products. They are also called price takers .
- Characteristics:
  - All firms produce an identical product (homogeneous).
    - Consumers do not care where they buy the product
  - Many sellers and buyers are in the market
    - Each firm supplies only a small portion to the market
    - One firm or buyer cannot influence the price of the market
  - No barriers to entry or exit exist
    - Example: If one firm earns economic profit, then rival firms can easily enter the market and try to earn profits
    - If firms are earning a loss, then some firms will leave the market
    - Economic profits are driven to zero as firms enter / leave a market
  - The firms maximize profit by adjusting production level, but cannot influence market price.
Why study price takers?
- Understand why competition is important
- Clarifies differences between price-takers and other firm types
- Agricultural markets, retail, some service markets, and stock markets tend to be price takers

Output in the Short Run

1. Marginal Revenue (MR) - is the change in total revenue when output increases by one unit.

Refer to graph
The farmer only sees the market price.
- If the farmer sells 1 bushel, he receives $2 (MR). The farmer sells another bushel, he receives another $2 (MR)
- If the farmer raises his price of corn above the market price, then nobody buys it.
  - Consumers buy the bushel from competitors for $2
- If the farmer sells his corn below the market price, then he lowers his revenue (loses money)
- Thus, he can sell all his corn at the market price, so MR = P* = $2.

Price Taker's Demand Curve
A Farmer	The Market
Price	Price

Quantity	Quantity

2. Profit maximization - the price taker will expand output in the short run until:

P* = MR = MC

Note: The market price is P* and marginal cost is MC. Further, the MR = MC maximizes profits for monopolies, oligopolies, and monopolistically competitive firms, while MR = P* is only valid for price takers.

	This rule maximize the firm's profits (or minimize its losses)
	Example: If MR = $3 and MC = $2. MR > MC, the firm will collect $3 for selling that last "additional" unit that only costs $2 to produce. Profit increases by $1. If MR = $3 and MC = $5. MR < MC, the firm will collect $3 for selling that last unit that costs $5 to produce. The firm should reduce production by 1 unit to increase profits.

Price takers earn profits by maximizing total revenue (TR) and minimizing total costs(TC)
- Total Revenue (TR) = P * q
- Profits = TR - TC
- Taking vertical slices (adjusting output q) until TR -TC is maximized, which is shown below:

Firm
Price / Per-unit costs

The point where profit is maximized is at the production level q when MC = MR = P*

Quantity

Using the marginal cost, market price, and average total cost, we can show a competitive firm earning a profit.
- Firm earns a profit when Market Price > ATC
- The "green" rectangle is firm's profit
The derivation is:

Profit = Total Revenue - Total Cost

Profit = P q - ATC q = (P - ATC) q

Firm
Price / Per-unit costs

Quantity

3. Losses and going out of business.

Short-run.
- A firm experiencing losses, but covering its average variable costs, will operate in the short run
- Example: AVC = $10 per product, AFC = $10, and the firm produces where MR = MC.
  - Competitive market: P* = MR
    - If P* = $5; firm cannot cover its variable costs, so it shuts down; it still pays its fixed costs
    - If P* = $10; firm covers its variable costs, but earns a loss
    - If P* = $15; firm still earns a loss, but also covers some of its fixed costs
    - If P* = $20; firm breaks even
    - If P* > $20; firm earns an economic profit
- Shutdown - temporary halt in the production or operation of a business.
  - A firm shuts down when P* < AVC
  - The firm still pays fixed costs during the shutdown.
  - Motels, restaurants, and theme parks shutdown during off seasons
Long-run.
- A firm will "go out of business" in the long run whenever P < ATC.
- Going out of business - firm permanently exits the market and avoids paying fixed costs.
  - If P = $0.25 for a generic soda and the ATC = $0.50
  - This firm cannot continue to operate for a long time with losses.

	A Firm
	Price / Per-unit costs
Firm produces quantity q where MC = MR = P ATC > Market Price, the firm is earning a loss or *profit is negative* . Profit = Total Revenue - Total Cost Profit = P q - ATC q The loss = "The red area"
	Quantity

4. A firm maximizes profits when it produces at P* = MC. A firm's short-run supply curve is its marginal cost curve above average variable cost. Firm produces if the market price exceeds its average variable costs.

Law of Supply - as the price of a product increases, firms will increase quantity supplied.

A Firm's Cost Curves	A Firm's Supply Curves
Price / Per-unit costs	Price / Per-unit costs

Quantity	Quantity

Output Adjustments in the Long Run

In the long-run, firms earn zero economic profit
- A normal rate of return, i.e. accounting profit
If P* > ATC, firms earn an economic profit
- New firms enter the market
- SR Supply increases while the price decreases until it equals P = ATC
- Economic profit = 0
If P* < ATC, firms earn a loss
- Some firms leave the market
- SR supply decreases, while the price increases until it equals P = ATC
- Economic profit = 0
Long-run equilibrium
- The market determines the price and quantity of milk
  - P* = $2 and market quantity = 10 (thousand)
- Each firm supplies q quantity of milk
  - Earn zero economic profit
  - P* = ATC = $2

A Milk Firm's Long-Run Cost Curve	The Milk Market
Price / Per-unit costs	Price / Per-unit costs

Quantity	Quantity (in thousands)

Example: The U.S. Gov. says drinking milk does the body good
- Consumers start buying more milk (tastes and preferences)
  - The demand curve shifts right.
    - New market price is P ₂
    - Quantity supplied and sold is Q ₂
- Firms expand output to q ₂
  - Earn economic profits (P ₂ > ATC)
- Long-run equilibrium
  - New firms enter the milk market
  - Short-run supply increases
  - Price decreases, until P ₁ = ATC again
- Result:
  - Same market price, P ₁
  - More milk produced and sold, Q ₃
  - More firms are in the market and all earn zero economic profit

A Milk Firm's Long Run Cost Curve	The Milk Market
Price / Per-unit costs	Price / Per-unit costs

Quantity	Quantity

Economic losses and exit
Example: Consumers' income increases and rice is an inferior product
- The original demand & supply curves are D ₁ & S ₁
- Demand curve shifts left.
  - New market price is P ₂
  - Quantity supplied and sold is Q ₂
- Firms contract output to q ₂
  - Earn economic losses (P ₂ < ATC)
- Long-run equilibrium
  - Some firms leave the rice market
  - Short-run supply decreases
  - Price increases, until P ₁ = ATC again
- Result:
  - Same market price, P ₁
  - Less rice produced and sold, Q ₃
  - Less firms are in the market and all earn zero economic profit

A Firm Producing Rice	The Rice Market
Price / Per-unit costs	Price / Per-unit costs

Quantity	Quantity

Long run supply - the minimum price which firms will supply various production levels when all factors of production can be adjusted. The long-run supply is the black lines in the milk and rice markets

Constant-cost industry - industry were resource prices remain unchanged as market output is expanded
- Long-run market supply curve is horizontal (perfectly elastic)
- Illustrated above in milk and rice markets
- An expanding/contracting industry has no impact on the resource markets, because it is a small industry
Increasing-cost industry - industry were factor prices rise as market output is expanded
- Long-run market supply curve is upward-sloping
- Most common type of industry
- Example: If automobile factory expands production, then resource prices will increase: skilled labor, steel, plastics, etc.
Decreasing-cost industry - industry were factor prices decline as market output is expanded
- Long-run market supply curve is downward-sloping
- Rare type of industry
- Example: Electronic industry. As more and more transistors are etched onto chips, then cost of chips, computers, etc. keep decreasing

Automobile Firm - Increasing Costs	Computer Chip Firm - Decreasing Costs
Price	Price

Quantity	Quantity

P ₁ and Q ₁ are the original demand and supply curves for both markets. Consumer demand more cars and electronics, because of higher incomes. The new market price is P ₂. Both industries earn economic profits, which cause them to expand.

As car industry expands, the resource prices increase (skilled labor, steel, etc.), causing the long-run price and quantity to be P ₃ and Q ₃.

As the electronic industry expands, the resources prices decrease (computer chips), causing long-run price and quantity to be P ₃ and Q ₃.

Competitive Process and Role of Profits

Profit is a reward for increasing the value of resources.
- total revenue (consumers' valuation) > total costs (firm's costs of resources).
  - Minimize costs
  - Operate efficiently
  - Innovate
  - Weeds out inefficient firms
  - Satisfy consumers
Losses are a penalty imposed on firms that reduce the value of resources.
- Firm will either leave the market, restructure, or bankrupt.
Competitive market is efficient
- Allocative efficiency - businesses transfer resources to profitable industries that consumers want
  - P* = MC
- Productive efficiency - businesses produce products for the lowest price
  - P* = min ATC
- Social welfare is maximized
  - Consumer plus producer welfares are maximized
New products
- Microwave ovens
- Personal computers
- DVDs / Blue Ray

Competitive markets and profits create wealth and direct resources to produce highly-valued goods.

Terminology

purely competitive firms
price taker
total revenue
marginal revenue
break-even point
P* = MR=MC
shutdown
going out of business