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Things to know about all market Things to know about all market systemssystems

1. A1. An n equilibriumequilibrium is where no one has an is where no one has an incentive to change their production. incentive to change their production.

In market systems: In market systems: if a firm can increase their profit by changing if a firm can increase their profit by changing

the price or quantity of their goods, they will. the price or quantity of their goods, they will. They will stop changing these factors when They will stop changing these factors when

they have reached the maximum amount of they have reached the maximum amount of profit they possibly can achieve, given the profit they possibly can achieve, given the current conditions of the market. current conditions of the market.

This profit maximizing output and price is the This profit maximizing output and price is the equilibrium. equilibrium.

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Things to know about all market Things to know about all market systemssystems

2. Firms will produce where MC=MR2. Firms will produce where MC=MR Recall, Marginal Cost (MC) is the additional cost Recall, Marginal Cost (MC) is the additional cost

of producing one more unit of output.of producing one more unit of output. Marginal Revenue (MR) is the additional Marginal Revenue (MR) is the additional

revenue acquired by producing (and as we revenue acquired by producing (and as we assume selling) one more unit of output. assume selling) one more unit of output. MR= TR/ Q = (TR1-TR2)/(Q1-Q2)MR= TR/ Q = (TR1-TR2)/(Q1-Q2) MR=P in a competitive market (we will talk about this MR=P in a competitive market (we will talk about this

more later)more later) MR<P in a monopoly (we will talk about this more MR<P in a monopoly (we will talk about this more

later)later)

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Things to know about all market Things to know about all market systemssystems

2. Firms will produce where MR=MC: we prove this by eliminating all 2. Firms will produce where MR=MC: we prove this by eliminating all other possibilitiesother possibilities

If MC<MR, a firm can make a higher profit by increasing their If MC<MR, a firm can make a higher profit by increasing their output.output. The additional revenue from selling one more unit is more than the extra The additional revenue from selling one more unit is more than the extra

cost to produce that unit. cost to produce that unit. So, a firm’s profit will increase if output increases, therefore the firm So, a firm’s profit will increase if output increases, therefore the firm

producing where MC<MR has an incentive to change their price and/or producing where MC<MR has an incentive to change their price and/or output.output.

If MC>MR, a firm can make a higher profit by decreasing their If MC>MR, a firm can make a higher profit by decreasing their output. output. The additional revenue from selling one more unit is less that the extra The additional revenue from selling one more unit is less that the extra

cost to produce that unit. cost to produce that unit. So, a firm’s profit will increase if output decreases, therefore the firm So, a firm’s profit will increase if output decreases, therefore the firm

producing where MC>MR has an incentive to change their price and/or producing where MC>MR has an incentive to change their price and/or output.output.

If MC=MR, a firm is making the highest profit possible.If MC=MR, a firm is making the highest profit possible. At this point, each firm does not have a way to increase profit more, so At this point, each firm does not have a way to increase profit more, so

they have no incentive to change their price and/or output.they have no incentive to change their price and/or output.

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Competitive MarketsCompetitive Markets

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By the end of this Section, You By the end of this Section, You should be able to:should be able to:

Define Competitive Market and describe Define Competitive Market and describe its propertiesits properties

Know and use the properties of a Know and use the properties of a competitive firm’s profit maximizing competitive firm’s profit maximizing quantity and pricequantity and price

Determine LR and SR choice to enter or Determine LR and SR choice to enter or exit the marketexit the market

Display the competitive markets in SR and Display the competitive markets in SR and LRLR

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Perfectly Competitive MarketsPerfectly Competitive Markets

A perfect competition is a market structure A perfect competition is a market structure in which the decisions of individual buyers in which the decisions of individual buyers and sellers has no effect on the market.and sellers has no effect on the market. Each firm and consumer is such a small part Each firm and consumer is such a small part

of the market, a change in one firm or one of the market, a change in one firm or one consumer’s behavior won’t effect the price consumer’s behavior won’t effect the price

Price is set by market forces (invisible hand)Price is set by market forces (invisible hand)

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Perfectly Competitive Market Perfectly Competitive Market AssumptionsAssumptions

1.1. A competitive firm takes the price as A competitive firm takes the price as given or they are a given or they are a price takerprice taker..

2.2. Products sold by the firms in a Products sold by the firms in a competitive industry homogenous (the competitive industry homogenous (the same). They are perfect substitutes.same). They are perfect substitutes.

3.3. Any firm can enter/exit the market Any firm can enter/exit the market without serious impediments.without serious impediments.

4.4. Both Buyers and Sellers have equal Both Buyers and Sellers have equal access to information.access to information.

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Perfectly Competitive Firms Perfectly Competitive Firms Maximize Profits in the SRMaximize Profits in the SR

Note, because the firm is a price taker, a Note, because the firm is a price taker, a Competitive Firm maximizes profits by Competitive Firm maximizes profits by choosing the optimal amount to produce.choosing the optimal amount to produce.

The Profit Maximizing Quantity is The Profit Maximizing Quantity is determined by using one of two strategies:determined by using one of two strategies:

1. TR>TC1. TR>TC Profit maximizing output is where TR exceeds Profit maximizing output is where TR exceeds

TC the most.TC the most. 2. MC=MR=P2. MC=MR=P

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Economic ProfitMR = P

MCMR = MC

ATC

Applying MR=MC Rule Applying MR=MC Rule GraphicallyGraphically

LO: 7-3

Price/Costs

Quantity

P

Q*

ATC

Economic Profit = BH = (Q*)(P-ATC)

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Entering and Exiting the Market in Entering and Exiting the Market in the Short Runthe Short Run

In the short run, In the short run, A firm enters the market by providing output to sellA firm enters the market by providing output to sell a firm can not exit the industry as a whole but can shut down, or a firm can not exit the industry as a whole but can shut down, or

not manufacture the good for a period of timenot manufacture the good for a period of time

If the firm enters the market in the short run:If the firm enters the market in the short run: Profit = TR – VC – FCProfit = TR – VC – FC

In the short run, a firm will ALWAYS incur fixed costs.In the short run, a firm will ALWAYS incur fixed costs. Fixed costs in this case are called sunk costs. Fixed costs in this case are called sunk costs. Sunk costsSunk costs are are

costs already committed to.costs already committed to.

If a firm shuts down (exits the market) in the SR: If a firm shuts down (exits the market) in the SR: Profit = 0 – 0 – FCProfit = 0 – 0 – FC They produces 0 output and incurs a loss equal to its fixed They produces 0 output and incurs a loss equal to its fixed

costs.costs. Shutting down prevents them from losing any more profit.Shutting down prevents them from losing any more profit.

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LR Competitive EquilibriumLR Competitive Equilibrium

The long run competitive equilibrium is The long run competitive equilibrium is where economic profit = 0. where economic profit = 0. Called the Zero Profit ConditionCalled the Zero Profit Condition Note this is economic profit.Note this is economic profit.

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LR Competitive Equilibrium LR Competitive Equilibrium GraphicallyGraphically

LR Competitive Equilibrium is where “everything is equal”.

Price

Quantity

LRAC MC

SRAC

P*

Q*

Notice, where the set market price (or MR) crosses the MC where the SRAC and the LRAC are at their minimum. This also follows MC=MR=P.

MR

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Entering and Exiting the Market in Entering and Exiting the Market in the Long Runthe Long Run

In the long run, In the long run, A firm enters the market by choosing to provide the A firm enters the market by choosing to provide the

good to sell.good to sell. A firm will enter the market as long as the current firms are A firm will enter the market as long as the current firms are

making a positive profit.making a positive profit. A firm exits the industry by choosing to not produce a A firm exits the industry by choosing to not produce a

good to sell any more. good to sell any more. Once firms stop making a positive profit, firms will no longer Once firms stop making a positive profit, firms will no longer

choose to enter the market.choose to enter the market. If firms are making a negative profit, firms will exit the If firms are making a negative profit, firms will exit the

market.market. They will exit the market until LR profits = 0.They will exit the market until LR profits = 0.