1 Chapter 8 Competitive Firms and Markets Key topics 1. competitive firm is a price taker 2. profit maximization 3. competition in short run (SR) 4. competition in long run (LR) 5. competitive firms earn zero LR profit Major question facing a firm "How much output should we produce?" Optimal output to pick profit-maximizing level of output, firm must consider • its cost function • how much it can sell at a given price (demand) • market structure • number of firms in the market • ease of enter and exit • firm’s ability to differentiate its product from its rivals’ Why start with competition • frequently observed market structure • has desirable properties, so it is useful to compare other market structure to competition Competition • consumers believe that all firms sell identical products • firms freely enter and exit market • buyers and sellers know the prices charged by firms • transaction costs are low 2 Price taking • if all 4 conditions hold each firm is a price taker: firm cannot affect market prices • even if some of conditions don't hold, firms may be price takers • for example, if entry of new firms is limited but there are many firms, no firm can successfully raise its price Meaning of “competitive firms” • to most people: firms that are rivals for the same customers • to economists: • firm is a price taker • competitive firm ignores individual rival’s behavior in deciding how much to produce Why would a competitive firm be a price taker? • answer: it has no choice • competitive firm faces a demand curve that is horizontal at the market price Figure 8.1 Residual Demand Curve p, $ per metal chair 93 4340 0 500527 q, Thousand metal chairs per year Q, Thousand metal chairs per year 66 100 63 66 100 63 S o D p, $ per metal chair (a) Firm (b) Market D r Profit maximization • economists assume that a firm maximizes its profit • competitive firm that did not profit maximize would lose money and be driven out of business Profit p = R – C • firm's revenues, R • its cost, C • if profit is negative, p < 0, firm makes a loss 3 Business vs. economic profit • business profit: revenue minus business cost (only explicit cost) • economic profit: revenue minus economic cost (explicit + implicit cost: opportunity cost) • because explicit cost „ economic cost, business profit „ economic profit • we always use economic profit Example: Own your own firm • you pay explicit costs (wages, materials, ) • you do not pay yourself a salary • you receive a business profit of $20,000 per year • your opportunity cost is $25,000, • so you have an economic loss of $5,000 Profit function p(q) = R(q) - C(q) • profit varies with output Two steps to maximizing profit to maximize its profit, any firm (not just competitive firms) must answer two questions: • output decision: if the firm produces, what output level, q*, maximizes its profit or minimizes its loss? • shut-down decision: is it more profitable to produce q* or to shut down and produce no output? Figure 8.2 Maximizing Profit π, Profit ∆ π > 0 ∆ π < 0 q* Quantity, q, Units per day Profit 1 1 π* 0 3 equivalent output rules set output where • p is maximized [peak of profit curve] • marginal profit (extra profit from selling one more unit of output, ∆p/∆q) = 0 [slope of profit curve is flat] • marginal revenue, MR, equals marginal cost, MC: MR(q) = MC(q) 4 Why output rules are equivalent • marginal revenue:MR = extra revenue from selling one more unit of output: ∆R/∆q, where ∆R is the change in revenue • marginal profit(q) = MR(q) - MC(q) • therefore, marginal profit = 0 implies MR = MC Interpreting output rules • does it pay for a firm to produce one more unit of output? • If MR(q) > MC(q), • firm's marginal profit is positive: marginal profit(q) = MR(q) - MC(q) > 0, • so it pays to increase output Calculus • Choose q to max p(q) = R(q) - C(q) • differentiate profit with respect to q and set the derivative equal to zero: 0 ddRdC MRMC dqdqdq π =−=−= Shut-down rules • apply to all firms in SR and LR • firm produces if it can make a profit • should it shut down if it makes a loss? answer: “it depends" Equivalent shut-down rules • Rule 1: firm shuts down only if it can reduce its loss by doing so • Rule 2: firm shuts down only if its revenue is less than its avoidable cost • by shutting down, firm eliminates avoidable costs: • variable costs • fixed costs that are not sunk Example 1 • R = $2,000 • VC = $1,000 • F = $3,000 (sunk) • p = R - VC - F = $2,000 - $1,000 - $3,000 = -$2,000 • firm does not shut down 5 Example 2 • R = $500 • VC = $1,000 • F = $3,000 (sunk) • p = R - VC - F = $500 - $1,000 - $3,000 = -$3,500 • firm shuts down Short run vs. long run • SR: firm compares its revenue to only its avoidable (variable) cost - ignores sunk fixed costs • LR: all costs are avoidable • firm can eliminate them by shutting down • therefore, firm shuts down if LR profit is negative: p < 0 SR competitive output decision • because competitive firm is a price taker, • market price, p, does not change if firm increases output • because competitive firm's revenue, R = pq, • MR = p • competitive firm maximizes profit by setting output where MC = p Figure 8.3 How a Competitive Firm Maximizes Profit Cost, revenue, Thousand $ 284140 0 q me per year 2,272 4,800 426 1,846 100 –100 (a) 1 MR = 8 π* = $426,000 π* π (q ) Cost, C Revenue p, $ per ton e 2841400 q , Thousand metric tons of lime per year 8 6.50 6 10 (b) p = MR π * = $426,000 AC MC , Thousand metric tons of li Solved problem • specific tax of t is collected from only one competitive firm • how should that firm change its output level to maximize its profit • how does its maximum profit change? Solved Problem 8.1 p, $ per umit q 1 q 2 e 1 τ τ e 2 q, Units per year p p = MR AC 1 MC 1 MC 2 = MC 1 + τ AC 2 = AC 1 + τ AC 2 (q 2 ) AC 1 (q 1 ) A B 6 SR shut-down decision • after choosing best output level • firm decides whether to operate or shut down • shuts down if p < AVC • (market price < minimum of its short-run average variable cost curve) • may operate even if p < 0 (p < AC) Figure 8.4 The Short-Run Shutdown Decision p, $ per ton 10050 140 q, Thousand metric tons of lime per year AVC AC MC p a e b 0 5.14 5.50 6.00 6.12 5.00 A=$62,000 B =$36,000 SR competitive firm supply curve • shift in market price traces out firm's supply curve • SR supply curve is MC above the minimum of AVC curve Figure 8.5 How the Profit-Maximizing Quantity Varies with Price p, $ per ton q 3 = 215 q 4 = 285q 1 = 50 q 2 = 140 e 1 e 2 e 3 e 4 p 2 p 1 p 3 p 4 0 q, Thousand metric tons of lime per year 6 7 8 5 AVC MC AC S Factor prices and SR firm supply curve • increase in factor prices causes the production costs of a firm to rise, shifting the firm's supply curve to the left • if all factor prices double, costs double • if only one factor price rises, costs rise less than in proportion Figure 8.6 Effects of an Increase in the Cost of Materials on the Vegetable Oil Supply Curve p, $ per ton e 1 e 2 0 100 178145 q, Hundred metric tons of oil per year 7 8.66 12 AVC 1 MC 1 AVC 2 S 1 S 2 MC 2 p 7 Solved problem interpret: In the 1994-95 growing season, bad weather caused the price of wine grapes to increase substantially. A newspaper article stated that the wine business is too competitive for [wineries] to simply pass a 100% cost increase directly to consumers. SR market supply; identical firms • market supply curve is horizontal sum of the supply curves of all the individual firms • maximum number of firms in a market, n, is fixed in SR • market supply curve at any price is n times the supply of an individual firm • larger n (more identical firms), the flatter (more elastic) the SR market supply curve at each price Figure 8.7 Short-Run Market Supply with Five Identical Lime Firms p, $ per ton 14050 175 q, Thousand metric tons of lime per year 6.47 6.47 6 7 p, $ per ton 7 5 0 AVC (a) Firm MC 200 150 100 50 250 700 Q, Thousand metric tons of lime per year 6 5 0 (b) Market S 3 S 4 S 5 S 2 S 1 S 1 SR market supply; firms differ • relatively low-cost firms enter first • more (differing) firms, more kinks in supply curve Figure 8.8 Short-Run Market Supply with Two Different Lime Firms p, $ per ton 100 140 165 215 315 45025 50 S 2 SS 1 0 q, Q, Thousand metric tons of lime per year 6 7 8 5 SR competitive equilibrium intersection of SR market supply curve and market demand curve determines the SR competitive equilibrium 8 Figure 8.9 Short-Run Competitive Equilibrium in the Lime Market p, $ per ton q 1 = 215q 2 = 50 Q 1 = 1,075Q 2 = 2500 q, Thousand metric tons of lime per year Q, Thousand metric tons of lime per year 6.97 6.20 6 5 0 5 6 7 8 7 8 e 2 e 1 E 2 S E 1 p, $ per ton (a) Firm (b) Market AVC AC D 2 S 1 D 1 A C B Effect of a specific tax on SR equilibrium • specific tax t applied to all firms in market • shifts the market supply curve up by t • alters the SR equilibrium: • lower equilibrium quantity • higher equilibrium price Figure 8.10 Short-Run Effect of a Specific Tax in the Lime Market p, $ per unit τ τ e 1 e 2 p 2 p 1 q 2 q 1 q, Units per year Q 2 = nq 2 Q 1 = nq 1 q , Units per year AVC AV C + τ MC + τ MC S 1 + τ S + τ S 1 S D p 1 + τ (a) Firm p, $ per unit E 1 E 2 (b) Market τ τ LR competitive profit maximization • LR output decision: • set output at q* where p = LR MC(q*) LR shut-down decision • operate only if revenue ‡ variable cost • all costs are variable in the LR, so • operate only if revenue ‡ cost • or p ‡ AC (minimum of AC curve) LR firm supply curve • LR MC above the minimum of LR AC curve (all costs are variable in LR) • firm chooses its capital in LR, so LR supply curve may differ from SR supply curve 9 Figure 8.11 The Short-Run and Long-Run Supply Curves p, $ per unit 50 110 q, Units per year 25 24 28 35 20 0 p SRAC LRMC LRAC SRMC SRAVC B A S SR S LR LR market supply curve • market supply curve = horizontal sum of firms' supply curves in both SR and LR to get more market output • LR market supply differs from SR because of differences in number of firms and input prices Number of firms • in SR, each firm must produce more because the number of firms, n, is fixed • in LR, firms can produce more and/or more firms can produce Input prices • to construct LR market supply curve, we need to know how input prices vary with output • as market expands or contracts, changes in factor prices may shift firms' cost and supply curves • LR effect of changes in input prices > SR effect because market output can change more dramatically in LR LR market supply • LR market supply curve is flat at the minimum long-run average cost if • free entry and exit • an unlimited number of firms have identical costs • input prices are constant • “many firms" = 10 firms in the vegetable oil market p, $ per unit 150 LRAC LRMC (a) Firm q, Hundred metric tons of oil per year 10 S 1 0 p, $ per unit (b) Market Q , Hundred metric tons of oil per year Long-run market supply 10 0 10 Role of entry and exit • firm enters if it can make LR profit: p > 0 • firm exits to avoid a LR loss: p < 0 • entry and exit of firms determines number of firms in a market in LR • higher barriers to entry reduce number of firms • in markets with free entry (no barriers or fixed costs to entry): can have hit-and-run entry and exit Exit cost and shut-down decision • if firms incur a cost to exit a market they may not shut down in SR even if R < VC • stay in operation for a while, to delay incurring exit costs Application: Steel trap • for decades, many U.S integrated steel mills (produce steel from iron ore) operated at losses – why? • U.S firms stopped being competitive in 1950s and 1960s: foreign firms • had lower labor costs • had modern plants • found new sources of rich iron ore U.S. firms slow to leave the market • not until late 1970s did Youngstown Sheet & Tube and U.S. Steel Corporation at Youngstown close • next closing not until 1982 • firms continued to operate aging, inefficient, and unprofitable plants Big shut-down costs • pay to dismantle mill and terminate contracts • union contracts: • workers severance pay • supplemental unemployment benefits • make payments to cover additional future pensions and insurance benefits • generally, union members eligible for pensions when age + years of service = 75 • workers laid off due to plant closings are eligible for a pension when age + years of service = 70 U.S. Steel Corp's closing costs • in 1979 were $650 million ($415 million labor related, or $37,000 per laid-off worker) • rose at least 45% since then [...]... good also rises: 2 3 4 5 6 6.8 Cotton, billion kg per year • in a decreasing-cost market, LR market supply curve is slopes down 11 Figure 8.13 Long-Run Market Supply in an Increasing-Cost Market (a) Firm (b) Market p, $ per unit Figure 8.14 Long-Run Market Supply in an Decreasing-Cost Market p, $ per unit (a) Firm (b) Market p, $ per unit MC 2 MC 1 MC 1 AC 2 AC 1 S AC 1 p2 p1 p , $ per unit MC 2 AC... national product of • competitive market with free entry: • profits are driven to zero in LR • any firm that did not profit maximize would make losses • thus, firms that survive in a competitive market must profit maximize • Grenada (100,000 people): $215 million • Kiribati: $51.1 million • Bhutan: $234 million 13 1 Competition • competitive firms are price takers • markets are likely to be competitive if... LR • competitive firm maximizes profit by setting q so that p = SR MC • it shuts down if p < minimum AVC • competitive firm's SR supply curve: its MC curve above the minimum of its AVC • with identical firms, SR market supply curve is flat at low output levels and upward sloping at larger levels • SR competitive equilibrium is determined by the intersection of the market demand curve and the SR market. ..Why LR market supply curve slopes Pricing • because they avoided shutting down since 1970s, U.S steel mills sold at prices below AC or AVC • 1986: • limited Entry • firms have different costs • input prices very with output • AVC of hot-rolled sheets per ton = $305 • AC = $406 • price = $273 LR market supply; entry limited LR market supply; firms differ • number of firms in a market is limited... 12 Solved Problem 8.3 LR competitive profit is zero with free entry (b) Market (a) Firm p, $ per unit MC p, $ per unit AC 2 + • LR supply curve is horizontal if /q AC 1 e2 p2 p E2 p2 e1 p 1 S2 E1 S1 1 D q1 q2 q , Units per year Q 2 = n 2 q2 Q 1 = n1 q 1 Q, Units per year • firms are free to enter the market • firms have identical cost • input prices are constant • all firms in market operate at minimum... if • if firms differ: • firms with relatively low minimum LR AC enter the market at lower prices than others, so • LR market supply curves slope up if firms differ • government restricts • scare resource • only way to get more output is for existing firms to produce more • because individual firms' supply curves slope up, the market supply curve slopes up • LR supply curve slopes up only if amount that... Long-Run Supply Curve for Cotton LR market supply; input prices vary with output Price, $ per kg Iran 1.71 United States 1.56 Nicaragua, Turkey 1.43 Brazil 1.27 1.15 1.08 0.71 0 S Australia Argentina • increasing-cost market • LR supply curve slopes up Pakistan 1 • nonconstant input prices: • if market buys most of total sales of a factor, factor price may vary with market output • if price of an input... fixed factors Competition in LR (cont.) • LR market supply curve is horizontal if • all firms are identical • entry and exit is easy • input prices are constant • LR market supply curve is flat at minimum AC • LR supply curve slopes if • firms differ • entry is difficult or costly, or • input prices vary with output, 5 Competitive firms earn zero profits in LR • competitive firms may make profits or losses... slight upward slope • supply elasticity is 5.5 Þ 1% increase in price leads to a 5.5% increase in quantity • intersection of LR market supply and demand curves determines LR competitive equilibrium • with identical firms, constant input prices, and free entry and exit, • LR market supply is horizontal at minimum LR AC • so equilibrium price = LR AC • shift in demand curve affects only equilibrium quantity... earn zero profits in LR • competitive firms may make profits or losses in SR • in LR, economic profit = 0 • prices of scarce inputs adjust to ensure that competitive firms make zero long-run profits • only competitive firms that maximize profit can survive 14 . competitive equilibrium intersection of SR market supply curve and market demand curve determines the SR competitive equilibrium 8 Figure 8.9 Short-Run Competitive Equilibrium in the Lime Market. losses • thus, firms that survive in a competitive market must profit maximize 14 1 Competition • competitive firms are price takers • markets are likely to be competitive if • firms sell identical. increasing-cost market • LR supply curve slopes up • in a decreasing-cost market, LR market supply curve is slopes down 12 Figure 8.13 Long-Run Market Supply in an Increasing-Cost Market p, $ per