Chapter 7 The Competitive Firm

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Chapter 7The Competitive Firm
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Competition

• Many firms do business in industries with a great
  deal of competitive pressure.
• The flower seller at the local farmers market
• A chip manufacturer in China or South Korea
• A large firm such as Microsoft
• All face stiff competition in their industries.

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Revenue

• A firm's income or total revenue, TR pQ.
• Marginal Revenue the extra revenue a firm earns
  from selling one extra unit
• MR ?TR/?Q slope of the total revenue curve

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Revenue
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Costs

• Total costs are made up of variable costs (costs
  that vary with output) and fixed costs (or sunk
  costs which have already been paid and cannot be
  recovered).
• Total costs variable costs fixed costs
• TC VC FC
• Marginal Cost the extra cost of producing one
  additional unit of output
• MC ?TC/?Q slope of the total cost curve
• Average Cost the cost per unit of output
• Can also be decomposed into variable and fixed
  categories
• Average costs average variable costs average
  fixed costs
• AC AVC AFC

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MC MR. (a)

• Production decisions are made at the margin.
• The firm wishes to maximize profits.
• Profit total revenue - total costs pQ - TC
  pQ - (TVC TFC).

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MC MR (b)

• Firms produce where the difference between total
  revenue and total cost is greatest.
• This occurs where the slope of TR and the slope
  of TC are equal.
• The slope of the TR curve is MR.
• The slope of the TC curve is MC.
• Profits are at a maximum where MR MC.
• Here the revenue earned on the last unit sold
  equals the cost of making the last unit.

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Competitive Markets

• Many buyers and sellers of a homogeneous product
• Information is good, if not perfect.
• Firms can enter and exit the market.
• These conditions imply
• Competitive firms are small compared to the large
  market they sell in so they are price takers.
• MR price the firm can always sell the next
  unit at the going market price.
• Competitive firms maximize profits where MR MC,
  or p MC.
• This means that the marginal cost curve is the
  supply curve for the firm since the MC curve
  gives the profit maximizing quantity supplied for
  any price.

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Entry (a)

• When should a firm not currently in the market
  enter the market?
• Answer when it can make a profit.

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Entry (b)

• Profit total revenue - total costs.
• Dividing by the quantity, profit per unit p -
  cost per unit p - AC.
• Profits are positive, and entry will occur if the
  price gt the minimum average cost.

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Average Cost Curves

• Different firms may have different average cost
  curves.
• Due to
• Differences in scale
• Differences in management
• Different locations
• And so on
• These firms will enter the market at different
  prices the more efficient firms will enter first.

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Exit (a)

• What causes a firm in an industry to leave an
  industry?
• A firm leaves the industry if leaving is the best
  option.
• That is, if the firm loses less when shut than
  when producing.
• When a firm exits or goes out of business, it
  loses its sunk costs.
• If its losses when producing exceed its sunk
  costs, the firm shuts down.
• Shut if Loss gt FC or if TC TR gt FC
• Shut if TC VC FC gt FC TR (cancel FC from
  both sides)
• Shut if VC gt TR or if VC gt pQ (now divide by Q)
• Shut if AVC gt p
• Operate if p gt AVC

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Exit (b)

• Put another way, a firm need not cover its fixed
  costs since it will lose these anyway if it shuts
  down.
• A firm that is operating must cover its
  operating, or variable, costs.
• If it cannot cover its variable costs, it shuts
  down.
• That is, if the price lt the minimum of the AVC,
  the firm shuts down.
• If the price fails to cover the minimum of the
  AVC, the firm is losing all of its variable costs
  and some part of its fixed costs if it operates,
  so it is better to shut down and just lose its
  fixed costs.

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The Firm's Supply Curve

• The firm's supply curve is that part of its
  marginal cost curve above the shutdown point
• Its shutdown point is the minimum of the AVC.

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The Market Supply Curve

• The market supply curve is the horizontal sum of
  the individual firms' supply curves
• The market supply curve is upward sloping for two
  reasons.
• First, each firm will produce more at higher
  prices.
• Second, more firms will join the industry at
  higher prices.

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Looking Beyond the Basic Model Sunk Costs,
Entry, and Competition

• The basic model of competition assumes that an
  industry has many firms.
• Even without a large number of firms, competition
  may still hold.
• The theory of contestable markets the mere
  threat of entry may be sufficient to keep prices
  to competitive levels.
• If sunk costs are low, any significant price
  increase over minimum average cost will induce
  entry and lower prices.

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Long-Run Supply versus Short-Run Supply

• Adjustments to market conditions take time.
• It is more difficult to change output in the
  short run than in the long run the long-run
  supply curve will be flatter than the short-run
  supply curve.

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Long-Run Supply versus Short-Run Supply (cont.)

• Also entry and exit are more of a factor in the
  long run than in the short run.
• So long-run supply will be more elastic just
  because of entry and exit.
• The long-run supply curve may be horizontal.

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Why Do Firms Produce If in the Long Run Profits
Are Zero?

• Firms produce to make profits, but under
  competition, economic profits are eventually
  driven to zero.
• Most people define profits as the excess of
  income over expenses.
• Economists define profits as income net of all
  costs including the opportunity costs, especially
  the opportunity costs of the owner's capital.

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Owners Opportunity Costs and Economic Profit

• Firms must be owned just as they must be staffed
  by workers.
• Workers are paid a wage to compensate them for
  the opportunity cost of their time this is a
  cost to the firm.
• Likewise, owners are paid to compensate them for
  the opportunity cost of their capital and this is
  also a cost to the firm.
• Owners can earn the rate of interest at the bank
  so a firm must pay owners at least this return.
• If firms pay owners returns above the return paid
  by banks the extra is called economic profit.

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Opportunity Costs (b)

• Suppose the interest rate is 5 but the firm
  yields an 8 return to its owners.
• The additional 3 is economic profit, or above
  normal profit.
• In the long run, competition drives economic
  profit to zero.
• So owners get just the return they could get from
  the bank.
• This means there is no reason for firms to exit
  or enter.
• If there were economic profits in the long run
  then other firms would enter.
• The market supply would increase and prices would
  fall reducing profits.
• This process continues until economic, or above
  normal, profit is competed away to zero.

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Economic Rent

• For most people, rent is the payment for the use
  of land or buildings.
• For economists, rent is the extra return on an
  input resulting from its qualitative superiority
  and scarcity, rather than its marginal cost.
• In a competitive industry, the marginal firm
  makes no profit.
• Other firms earn profits that should be called
  economic rents.
• If all firms have the same technology and face
  the same input prices, they will all make a zero
  profit in competitive equilibrium.
• Some firms have a technological advantage over
  others or have lower input prices they earn an
  economic rent.