Economics Chapter on Competitive Firms

Competitive Firms and Price-Taking

• A competitive firm is a price taker because it faces a horizontal demand curve at the market price.
• This means the firm can sell as much as it wants at the market price, but cannot sell anything if it raises the price.
• It has no incentive to lower its price because it can sell all it wants at the current price.
• Perfect competition is characterized by many buyers and sellers, homogenous goods, easy entry and exit, and perfect information.

Perfect Competition Assumptions

• Price-taking: Individual firms have no impact on the market price due to their small size.
• Product homogeneity: All firms produce identical goods, making price differences difficult to sustain.
• Free entry and exit: Firms can enter or exit the market without significant barriers or costs, leading to a more competitive landscape.

Barriers to Entry

• High start-up costs can delay entry and limit competition.
• Brand loyalty can make it difficult for new firms to gain market share.
• Government restrictions can limit competition and protect incumbent firms.

Profit Maximization

• Firms aim to maximize profit by optimizing their output decision and shutdown decision.
• Output decision: Determining the output level that maximizes profit or minimizes losses.
• Shutdown decision: Whether to produce or shut down based on profit potential.

Output Rules

• Firms use three key rules to determine output levels:
  • Profit maximization: Setting output where profit is highest.
  • Zero marginal profit: Setting output where marginal profit is zero.
  • Equality of marginal revenue and marginal cost: Setting output where marginal revenue (MR) equals marginal cost (MC).

Revenue in a Perfectly Competitive Market

• Average revenue (AR): Total revenue divided by the quantity sold.
• Marginal revenue (MR): Change in total revenue from selling one more unit.
• In a perfectly competitive market, MR is equal to the market price.

Profit Maximization in the Short Run

• A firm maximizes profit by producing at the output level where MR = MC.
• The second-order condition ensures that the firm is at a maximum point, not a minimum.

The Demand Curve for a Perfectly Competitive Firm

• A perfectly competitive firm faces a horizontal demand curve.
• This means it can sell any quantity at the market price but cannot sell anything above it.
• It can sell as much as it wants at the given market price.

Shutdown Decision in the Short Run

• A firm will shut down in the short run if the price (P) is less than the average variable cost (AVC).
• This is because the firm cannot cover its variable costs, and shutting down minimizes losses.

Short-Run Supply Curve

• A firm's short-run (SR) supply curve is the portion of its marginal cost (MC) curve above the average variable cost (AVC) curve.
• It represents the quantity the firm will supply at each market price.

Sunk Costs

• Sunk costs are already incurred and cannot be recovered, so they should not influence decisions.
• Fixed costs are an example of sunk costs in the short run.
• Shutdown decisions should be based on covering variable costs, not fixed costs.

Long-Run Decision to Exit the Market

• A firm should exit the market in the long run if the price (P) is less than the average total cost (ATC).
• This indicates that the firm cannot cover its total costs, making it more profitable to exit.

Long-Run Decision to Enter the Market

• A firm should enter the market in the long run if the price (P) is greater than the average total cost (ATC).
• This indicates that the firm can cover its total costs and earn a profit, making entry desirable.

Illustrating Profit or Loss

• Profit is calculated as total revenue minus total cost (TR - TC).
• It can also be expressed as the difference between price (P) and average total cost (ATC) multiplied by the quantity (Q) sold: (P - ATC) x Q.
• Profit is positive when P > ATC, zero at P = ATC, and negative when P < ATC.

Market Supply Assumptions

• All firms have identical costs, including potential entrants.
• Costs remain stable regardless of entry or exit.
• The number of firms is fixed in the short run (due to fixed costs) and variable in the long run (due to free entry and exit).

Short-Run Market Supply Curve

• At prices above AVC, each firm will produce its profit-maximizing quantity where MR = MC.
• The market supply is the sum of all individual firm supplies at each price.