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Chapter 14: Competitive Markets, Pages 290-293

I. What Is A Competitive Market: Also called perfectly competitive market, competitive market has two primary characteristics, (1) many buyers & sellers in the market, and (2) the goods offered by sellers are essentially the same.

a. Both buyers and sellers are price takers and have little impact on price because of the above factors. b. Gas and milk are price taker products. There are many consumers of both products and many suppliers that

they have very little influence on the price. If one supplier increases their price, consumers will just go elsewhere. If oneseller lowers the price, all others will follow eliminating any advantage for any of the sellers. Price is eliminated as acompetitive edge for sellers.

c. Another condition of competitive markets, is firms can easily enter and leave the market. The investment often inot large, the customer base is a constant, and the losses are not large.

II. The Revenue of a Competitive Firm: Table 1 shows that a specific quantity of milk (Q) is sold at the market price(P). Total revenue (TR ), will be PxQ….see Quantity 2 and ata price of $6 per gallon the TR is $12 at Q level 2.

a. Because the quantity of milk produced in Table 1the price will not depend on the quantity produced and sold, but by the market conditions. Total revenue is proportional tothe amount of output.

b. Just as with cost analysis, the concepts of averageand marginal are useful with revenue.

c. The key questions answered by average and

marginal prices are, “what is the revenue for a gallon of milk ”and “how much additional revenue will earned for eachadditional gallon produced.”

d. The last two columns in Table 1 have the answers.The average revenue (AR ) is the total revenue divided by thequantity produced or (AR=TR/Q) and the marginal revenue(MR ) is the change in total revenue divided by the change inquantity, or (MR=ΔTR/ΔQ).

e. A key factor to remember: with all firms, and market conditions, the AR will always equals the price of the good because dividing the total revenue by by the total quantity (TR/Q) will always yield the price per single output. (P=AR )

f. Because the price is fixed by overwhelming market demand, for perfectly competitive firms only, marginal reven(MR ) will always equal the price (P)of the good.

III.Profit Maximization & the Competitive Firm’s Supply Curve a. The number one goal of a firm is to maximize profit. b. At quantity level 1, TR is $6, TC is $5, P is $1,

MR is $6, MC is $2, ΔP is $4.c. The profit maximizing level of production can be

found by comparing the marginal cost (MC) with themarginal revenue (MR ).

d. The fifth and sixth columns in Table 2 computeMR & MC from the changes in TR & TC, and thelast column shows the change in profit for each additionalgallon produced

e. Notice how the change in profit decreases with

every quantity of production and the marginal costincreases at each quantity of production.

f. As long as the MR exceeds MC, increasing thequantity produced raises profit.

g. When MC=MR , profit maximization has beenachieved. This occurs at quantity levels 4 and 5 with a profitof $7.

h. A major point of economics can be illustrated by this concept…..rational people think at the margin, what benefits me the most will drive my decision-making.

I. If I stop production before MC=MR , I have not achieved my maximum profit, and if I produce beyond MC=MR

my profit will decrease, and I will also not achieve my goal of profit maximization.

Table 1 Total, Average, and Marginal Revenue for a

Competitive Firm

Table 2 Profit Maximization: A Numerical Example



IV. The Marginal-Cost Curve and the Firm’s Supply Decision: Figure 1 features the MC and ATC curves withthe MC crossing at the minimum ATC point (1). It also shows the perfectly elastic market price line, that of a price taker,which is also the average revenue line (AR ), and the marginal revenue line (MR ). The price is constant regardless of Q.

a. We use Figure 1 to find the quantity of output thatmaximizes profit.

b. At Q1 MR 1>MC1. There is still considerable growth potential to reach maximum profit at Qmax, where MC=MR.

c. One can see visually that at Q1 and P the profit asindicated by where Q1 crosses the ATC and intersects the P line

is less than where Qmax crosses the ATC and intersects the Priceline.d. The Profit x Q at Qmax is much greater than Profit x Q at Q1.e. Lessons Learned: (a) If MR is greater than MC, the firm

should increase output to increase profit, (b) if MC is greater than MR, the firm should decrease its output to increase profit, (3) and at the profit maximizing level of output,MR=MC.

V. Marginal Cost as the Competitive Firm’s Supply Curve: Because a P.C. firm is a price taker, its MR equals the mar

ket price. For any given price, the P.C. firm’s profit maximizing quantity of output is found by looking at the intersection othe price with the marginal-cost curve. In Figure 1 that quantity of output is Qmax.a. Figure 2 shows how a P.C. firm reacts to a price increase. When the price is P1, quantity produced is at Q1, where

Price and Quantity meet on the MC curve. b. When the price rises to P2, MR is now higher than MC at the previous level of output, so the firm increases productionc. Because the firm’s marginal-cost curve determines the quantity of the good the firm is willing to supply at any

price, the marginal-cost curve is also the perfectly competitive firm’s supply curve.

Figure 1 Profit Maximization for a Competitive Firm

Quanti0

Costs

and

Revenue

MC

ATC

AVC

MC 1

Q1

MC 2

Q2

The firm maximizes

profit by producing

the quantity at which

marginal cost equals

marginal revenue.

QMAX

P = MR 1 = MR 2 P = AR = MR

If the firm

produces Q1,marginal cost is

MC 1.

If the firm produces

Q2 , marginal cost is

MC 2 .

Suppose the market price is P.

10 T o t a l R e

v e n u e

s a n d T

o t a l C

o s t s

P e r D a y

( $ )

Q: Recor dable DVD’s per Day

20

30

40

50

60

1 2 3 4 5 6 7 8 9 1110 12

Losses

Losses

Profits

TR=PxQ

TR

TC

TC

Figure A: Profit MaximizationProfit maximization occurs where marginal revenue equals marginal cost.

(MKT Price)

T.Output TC MPr TR TP ATC AVC MC MR0 10 $5 $0 -$10

*$5 *$51 15 5 5 -10 $15.00 $5.00

3 52 18 5 10 -8 9.00 4.00

2 53 20 5 15 -5 6.67 3.33

1 54 21 5 20 -1 5.25 2.75

2 55 23 5 25 2 4.60 2.60

3 56 26 5 30 4 4.33 2.67

4 57 30 5 35 5 4.28 2.86

5 5

8 35 5 40 5 4.38 3.12

6 59 41 5 45 4 4.56 3.44

7 510 48 5 50 2 4.80 3.80

8 511 56 5 55 -1 5.09 4.18

* Placed between rows where quantities occur to indicate a change betweenone rate of output and the next.

-

Figure 2 Marginal Cost as the Competitive Firm’s SupplyCurve

Quantity0

Price

MC

ATC

AVC

P 1

Q1

P 2

Q2

So, this section of thefirm’sMC curve isalso the firm’s supply

curve.

As P increases, the firm will select its level of output along the MC curve.

93-295

Profit-Maximization

Figure B



1X. Calculating the Short-Run Break-Even Price: D1 touches min. point of the ATC=AR=P=MR, which mean

TR=TC, this is the Short-Run break-even price. It is also covering normal rate of return, implicit & explicit costs.

X. Calculating the Short-Run Shutdown Price: The firm will producewhere the MC intersects the demand curve. E1 or E2, but at E2 you are onlycovering variable costs, not fixed costs.

1. At E2, the short-run shutdown price is where the price just coversAVC, just below the intersection of the MC and the AVC. Each unit soldwill addto its losses. You cannot even cover the fixed costs by continuing.

2. This is only for the short run because the firm will be out of business already in the long-run.

VI. The Meaning Of Zero Economic Profits: At E1 on Figure C,the price is equal to ATC. Why produce with no profits?1. Consider that a firm can have zero economic profits and still havepositive accounting profits.2. The ATC includes all economic costs.3. At short-run break-even price they are zero whileaccounting costs are not.

V1. The Firm’s Short-Run Decision to Shut Down: A shut-

down refers to short-run decision not to produce anything during aspecific period because of market conditions. Exit is a long-run de-cision to leave the market.

a. The difference is firm’s cannot avoid their fixed costs inthe short-run but can in the long-run, because they have none.

b. A firm that shuts down temporarily has to pay its fixedcosts but a firm that exits the market does not have to pay either costfactor, fixed or variable. It can sell his fixed costs, land-machines.

c. In the short-run, a firm that is losing money will want tocontinue producing as long as their total revenue exceeds their vari-able costs (TR>VC). Why? Because a firm can modify its variablecosts with layoffs and reducing non-essential expenses, but it is stillobligated to pay their fixed costs.

d. Therefore, if a firm earns more than their variable costs, they will have less debt by being able to pay for their variable costs and have some left over to apply to their fixed costs. If TR is less than VC, (TR< VC), the firm shuts down

e. In the long-run, all costs are variable, therefore, a firm will better be able to manage its expenses and if it cannomake a profit it can just shutdown because its expenses are variable, therefore easy to eliminate while exiting an industry.

Figure 3 The Competitive Firm’s Short-Run Supply Cur

MC

Quan

ATC

AVC

0

Costs

Firm

shuts

down if

P < AVC

Firm’ s short-run

supply curve

If P > AVC, firm will

continue to producein the short run.

If P > ATC , the firm

will continue to produce at a profit.

P=MR=AR

1 P r i c e a n d C o s t s p e r U n i t ( $ )

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3

4

5

6

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Losses

MC

d1

7 8 9

Figure B: Short Run Losses

78

9

AT

d2

P=MR=A


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2

3

4

5

6

1 2 3 4 5 6

Losses

MC

d

7 8 9

Figure C: Short Run Shutdown/Break-even P

7

8

9

AT

E2

E1

A

SR B rea k -eve n

poi nt

SR S h utdo w n poi nt

AV

Page 295-297

VI1. Short Run Losses: In Figure B, d1 shifts to d2 because supply or demand changes. Price falls from $5 to $3. MC crosses between $5 & $6and the firm is not profitable because cost is > than price. However, thefirm is minimizing losses because MC + MR.

VII1. The Short-Run Shutdown Price: The firm is sustaining

economic losses in Figure B.1. In the long-run it will go out of business. See the MC & ATC going upwhile price stays the same.2. A firm is out of business when it sells its assets, it is shut down when itstops producing.3. The cost of staying in business in the short-run is the total variable

cost, it will disappear if you shut-down, your fixed costs continue rent,leases, etc.EXAMPLE: A price of $8 @ output of 100=$800 in TR. ATC per unit is$9 x 100 for a cost of $900, (AVC is $700 & FC is $200)=a loss of $100.If the firm continues to produce it has losses of $100, if it shuts down, ithas losses of $200, the sum of the fixed costs.



The Meaning Of Zero Economic Profits

19. At E1 on Figure B, the price is equal to ATC. Why produce with no profits? Consider that a firm can have zero economic prof

and still have positive accounting profits. The ATC includes all economic costs. At short-run break-even price they are zero whileaccounting costs are not.

20. When a competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue?The price of output stays the same because of perfect competitive market conditions and the fact the product is small in its production compared with the world market, and the total revenueoutput doubles.

The Firm’s Short-Run Decision to Shut Down (Figure 3)1. What is a business shutdown? refers to short-run decision not to produceanything during a specific period because of market conditions.2. What is an Exit by a firm? is a long-run decision to leave the market.3. What is the the difference between a shutdown and an exit? is firm’s cannotavoid their fixed costs in the short-run but can in the long-run. A firm that shutsdown temporarily has to pay its fixed costs but a firm that exits the market doesnot have to pay either cost factor, fixed or variable.4. Why will a firm want to continue producing in the short-run when TR>VC?a firm that is losing money will want to continue producing as long as their totalrevenue exceeds their variable costs (TR>VC). Why? Because a firm can modifyits variable costs with layoffs and reducing non-essential expenses, but it is still

obligated to pay their fixed costs. Therefore, if a firm earns more than their variablecosts, they will have less debt by being able to pay for their variable costs and havesome money left over to pay towards fixed costs.5. What should a firm do if TR is less than VC, (TR< VC), and why? The firmshuts down because its losses will be lower when it eliminates its variable costs.6. Why is it easier and less painful for a firm to shut down in the long-run? In the long-run,all costs are variable, therefore, a firm will better be able to manage its expenses and if itcannot make a profit it can just shutdown because its expenses are variable, therefore easy to eliminate while exiting an industry.

Figure 3 The Competitive Firm’s Short-Run Supply Cu

MC

Quan

ATC

AVC

0

Costs

Firmshuts

down if

P < AVC

Firm’ s short-run

supply curve


continue to produce

in the short run.


will continue to

produce at a profit.

D=P=MR=AR


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2

3

4

5

6

1 2 3 4 5 6

MC

d1

7 8 9


78

9

AT

d2

Page 295-297

Short Run Loss (Figure B) 7. What is the total revenue at d1? $5 x $7,500=$37,5008. What is the total profit at d1? .50x7,500 = $3,750

9. What is the total cost at d1? $4.50x7,500=$33,750

10. A determinant occurs and d1 shifts to d2, what is the new

TR? $3x5,500=$16,500 11. What is the total profit and/or loss at d2? 0 profit, loss of $26,125-$16,500=$9,625.00

12. What is the total cost at d2? $4.75x5,500=$26,125.0013. Why is the firm not profitable? because TC is > than price14. Why would E2 be the short run shutdown point? BecauseAVC is at or above d2

15. Why would production continue if TC produced a loss? If TR exceeded AVC production would continue in the short run. Thecost of staying in business in the short-run is the total variable

cost, it will disappear if you shut-down, your fixed costs continue

rent, leases, etc.EXAMPLE: A price of $8 @ output of 100=$800 in TR. ATC per unit is $9 x 100 for a cost of $900, (AVC is $700 & FC is $200)=a loss of $100.16. What in Figure B indicates this business will fail in the long

run without corrective interventions? In the long-run it will goout of business. See the MC & ATC going up while price staysthe same.17. When is a firm is out of business? When it sells its assets.18. When is a business shutdown? It is shut down when it stops producing.

E1

E2

AVC




19. At E1 on Figure B, the price is equal to ATC. Why produce with no profits? Consider that a firm can have zero economic prof

and still have positive accounting profits. The ATC includes all economic costs. At short-run break-even price they are zero whileaccounting costs are not.

20. When a competitive firm doubles the amount it sells, what happens to the price of its output and its total revenue?The price of output stays the same because of perfect competitive market conditions and the fact the product is small in its production compared with the world market, and the total revenueoutput doubles.

The Firm’s Short-Run Decision to Shut Down (Figure 3)1. What is a business shutdown? refers to short-run decision not to produceanything during a specific period because of market conditions.2. What is an Exit by a firm? is a long-run decision to leave the market.3. What is the the difference between a shutdown and an exit? is firm’s cannotavoid their fixed costs in the short-run but can in the long-run. A firm that shutsdown temporarily has to pay its fixed costs but a firm that exits the market doesnot have to pay either cost factor, fixed or variable.4. Why will a firm want to continue producing in the short-run when TR>VC?a firm that is losing money will want to continue producing as long as their totalrevenue exceeds their variable costs (TR>VC). Why? Because a firm can modifyits variable costs with layoffs and reducing non-essential expenses, but it is still

obligated to pay their fixed costs. Therefore, if a firm earns more than their variablecosts, they will have less debt by being able to pay for their variable costs and havesome money left over to pay towards fixed costs.5. What should a firm do if TR is less than VC, (TR< VC), and why? The firmshuts down because its losses will be lower when it eliminates its variable costs.6. Why is it easier and less painful for a firm to shut down in the long-run? In the long-run,all costs are variable, therefore, a firm will better be able to manage its expenses and if itcannot make a profit it can just shutdown because its expenses are variable, therefore easy to eliminate while exiting an industry.

Figure 3 The Competitive Firm’s Short-Run Supply Cu

MC

Quan

ATC

AVC

0

Costs

Firmshuts

down if

P < AVC

Firm’ s short-run

supply curve


continue to produce

in the short run.


will continue to


D=P=MR=AR


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2

3

4

5

6

1 2 3 4 5 6

MC

d1

7 8 9


78

9

AT

d2

Page 295-297

Short Run Loss (Figure B)

7. What is the total revenue at d1?

8. What is the total profit at d1?

9. What is the total cost at d1?

10. A determinant occurs and d1 shifts to d2, what is the new

TR?

11. What is the total profit and/or loss at d2?


13. Why is the firm not profitable?

14. Why would E2 be the short run shutdown point?

15. Why would production continue if TC produced a loss?

16. What in Figure B indicates this business will fail in the long

run without corrective interventions?

17. When is a firm is out of business?

18. When is a business shutdown?

E1

E2

AVC



IX. Sunk Costs: A cost that has already been committed and cannot be recovered.a. A firm does not stop production because of fixed costs in the short run, but because of variable costs. b. A firm is obligated to its fixed costs because of contracts and/or other agreements, but a firm can eliminatevariable costs.c. If a firm has $1 million in total costs with fixed costs of $300,000 and variable costs of $700,000 with a totalrevenue of $800,000, it makes economic sense to continue producing in the short-run.d. This is because you have enough revenue to pay for your variable costs and have $100,000 left over to apply tothe fixed costs, or, to pay for your fixed costs and have $500,000 left over to pay part of your variable costs.

e. If total revenue was less than the variable costs of $700,000, shutdown would be the best decision because nowyou cannot pay all of your variable costs or fixed costs.f. Two primary options left to save the business would be to slash your variable costs to $500,000, or less, with-out reducing total revenue, or a combination of renegotiating your fixed costs and reducing variable costs to reach profitability. Two other potential options would be to increasetotal revenue via new customers or seek a merger with a com- petitor.

X. The Firm’s Long-Run Decision to Exit or Enter a Mar-ket: A firm’s shutdown decision in the Long-Run is similar toits exit decision.

a. Remember, all fixed costs are variable in the long-run,so a firm will shut down and exit the market if the revenue itwould get from producing is less than the total costs.

(TR<TC), (TR/Q<TC/Q, or(P<ATC) b. In this case the firm exits the market because it will

save both its variable costs and its fixed costs.c. A firm will enter the market if it can achieve a profit

by the price exceeding the average total cost. (P>ATC) d. In Figure 4, we see in the long-run that the supply

curve is the portion of its marginal cost curve that lies aboveATC.

e. If the price is lower than ATC, it will exit the market.

XI. Measuring profit for the Competitive Firm: Remember, profit equals total revenue minus total cost. (P=TR-TC)a. Other ways to determine profit are:

(TR/Q - TC/Q) x Q or, (P - ATC) x Q

b. Panel A of Figure 5 shows a firm earning a profit.c. The shaded rectangle is P-ATC and the width is Q.d. So, the profit is (P-ATC) x Q. If P was $50, ATC was $45,and Q was 1 million, the profit would be $5 million.e. Panel B of Figure 5 shows a firm with losses. It can also be

seen as minimizing losses because MC=MR, which is themaximum revenue attainable given this production scenario.f. The shaded rectangle shows ATC-P with a width of Q.g. This is a loss because the ATC is above the Price indicatingcosts are more than revenues.h. So, the loss is (ATC - P) x Q.

i. So, the loss is (ATC – P) x Q. If P was $50, ATC was $55,and Q was 1 million, the loss would be $5 million.

The firm would then exit the market.

CH 14: Page 297-300

Figure 4 The Competitive Firm’s Long-Run Supply Curve

MC = long-run

Firm

exits if

P < ATC

Quantity

ATC

0

Costs

Firm’ s long-run

supply curve

Firm

enters if

P > ATC

7

Figure 5 Profit as the Area between Price and Average Tot

Cost(a) A Firm with Profits

Quantity0

Price

P = AR = MR

ATC MC

P

ATC

Q

(profit-maximizing quantity)

Profit

7

Figure 5 Profit as the Area between Price and Average Tot

Cost(b) A Firm with Losses

Quantity0

Price

ATC MC

(loss-minimizing quantity)

P = AR = MR P

ATC

Q

Loss



The Firm’s Short-Run Decision to Shut Down (Figure 3)

1. What is a business shutdown?

2. What is an Exit by a firm?

3. What is the the difference between a shutdown and an exit?

4. Why will a firm want to continue producing in the short-run when TR>VC?

5. What should a firm do if TR is less than VC, (TR< VC),

and why?

6. Why is it easier and less painful for a firm to shut down in the long-run?

Short Run Loss (Figure B)

7. What is the total revenue at d1?

8. What is the total profit at d1?


10. A determinant occurs and d1 shifts to d2, what is the new TR?

11. What is the total profit and/or loss at d2?


13. Why is the firm not profitable?

14. Why would E2 be the short run shutdown point?

15. Why would production continue if TC produced a loss?

16. What in Figure B indicates this business will fail in the long run without corrective interventions?

17. When is a firm is out of business? .

18. When is a business shutdown?


19. At E1 on Figure B, the price is equal to ATC. Why produce with no profits?

Figure 3 The Competitive Firm’s Short-Run Supply Cur

MC

Quan

ATC

AVC

0

Costs

Firmshuts

down if

P < AVC

Firm’ s short-run

supply curve

If P > AVC, firm will continue to producein the short run.

If P > ATC , the firmwill continue to


D=P=MR=MC=AR

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5

6

1 2 3 4 5 6

MC

d1

7 8 9


7

8

9

ATC

d2

Page 295-299

E1

E2

AVC



Page 301-303 Figure 6 Short-Run Market Supply

(a) Individual Firm Supply

Quantity (firm)0

Price

MC

1.00

100

$2.00

200

(b) Market Supply

Quantity (market)0

Price

Supply

1.00

100,000

$2.00

200,000

If the industry has 1000 identical firms, then at each market price, industry output will be 1000 times larger than the representative firm’s output.

Figure 7 Long-Run Market Supply

(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

(b) Market Supply

Quantity (market)

Price

0

P = minimum ATC

Supply

MC

ATC

The Short Run: Market Supply with a Fixed Number of Firms1. For any given price, each firm supplies a quantity of output so that its MC equals price.2. When the demand increases so does the price, as seen in panel a.3. The market supply curve reflects the individual firms’ marginal cost curves. 4. As long as the price is above the AVC, each firm’s marginal cost curve is its supply curve because the firm will increase produc-

tion.5. To derive the market supply curve, we add the quantity supplied by each firm in the industry.6. Since there are 1,000 firms, as seen inn panel b, on average, the average quantity supplied by the market is 1,000 times the QS

by each firm.

The Long Run Market Supply With Entry & Exit

1. Firms will enter or exit the market until profit is driven to zero.2. In the long run, price equals the minimum of ATC.3. The long run market supply is horizontal at this price.4. At the end of the process of entry and exit, firms that remain must be making zero economic profit5. The process of entry and exit ends only when price and ATC are driven to equality.

Why do competitive firms stay in business if they make zero profit?

6. Profit equals TR -TC, TC includes the implicit opportunity costs of the firm.7. In the zero- profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the

business going via the implicit costs. Remember, implicit costs reduce the taxable profit on paper, but in fact the business makesa profit while paying taxes only on the TR — TC.8. The firm which only has accounting costs to claim, and has a profit on paper, will pay a profit tax and the firm with 0 economic profit will pay no taxes.

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Figure 1 Economists versus Accountants

Revenue

Total

opportunity

costs

How an Economist

Views a Firm

How an Accountant

Views a Firm

Revenu

Economic

profit

Implicit

costs

Explicit

costs

Explicit

costs

Accounting

profit



G. Over time, the profit in this market encouragesnew firms to enter.

H. As the number of firms grows, the short-run supplycurve shifts to the right from S1 to S2 in panel c.

I. The shift causes the price to fall to equal the ATC on theP1 demand curve, with zero economic profits, but at the

new long-run equilibrium the quantity produced hasincreased to D3.

H. New firms will stop entering the market at the lower equilibrium price.

A. As more firms use a specific resource in their production, the increase in demand for the resource raises

the cost to all firms, which creates a new higher price.B. The result is a long-run market supply curve that is upward sloping.

A. Costs vary because each worker has a different productivity level in terms of the speed of their production, better useof time, and fewer mistakes in the workplace. Those firms with lower costs are more likely to enter the market thanthose with higher costs.

B. For the firms with higher costs to be profitable if they enter the market, prices must rise. The higher demand andquantity supplied will provide the profit margins some new firms need to remain in the market.

FACT : Because firms can enter and exit more easily in the long run than in the short run, the long-run supply curve is

typically more elastic than the short-run supply curve.

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Figure 8 An Increase in Demand in the Short Run and Long

Run

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

S Short-run supply, 1

P 1

ATC

Long-runsuppl y P 1

1Q

A

MC

A market begins in long runequilibrium.

And firms earn zero profit.

-


Run

Market Firm

(b) Short-Run Response

Quantity (firm)0

Price

P 1

Quantity (market)

Long-run

supply

Price

0

D1

D2

P 1

S 1

P 2

Q1

A

Q2

P 2

B ATC MC

An increase in market demand…

…raises price and output.

The higher P encourages firms to produce

more……and generates short -run profit.

-


Run

P 1

Firm

(c) Long-Run Response

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P 1

P 2

Q1 Q2

Long-run

supply

B

D1

D2

S 1

AS 2

Q3

C

Profits induce entry and market supply increases.

The increase in supply lowers market price. In the long run market price is restored, but market supply is greater.

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A Shift in Demand in the Short Run andLong Run

• An increase in demand raises price and quantity

in the short run.

• Firms earn profits because price now exceeds

average total cost.

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Why the Long-Run Supply Curve MightSlope Upward

• Some resources used in production may be

available only in limited quantities.

A. Because firms can enter and exit in the long

run but not in the short run , the response of amarket to a change in demand depends on thetime horizon.

B. In panel a the equilibrium point is A, the quan-tity sold is Q1 and the price is P1.

C. A massive increase in demand shifts D1 to D2in panel b and the short-run equilibriummoves from point A to point B, Q1 rises to Q2and P1 rises to P1.

D. All of the existing firms respond to the higher price by producing more.

E. Because each firm’s supply curve reflects its

marginal-cost curve, how much they increase production is determined by the marginal-costcurve.

F. In the new short-run equilibrium, the price ex-ceeds the ATC so firms are making a positive profit.

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Why the Long-Run Supply Curve MightSlope Upward

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• Firms may have different costs.

- The marginal firm exits

1.

2.the market if the Price were any lower.



Summary

• Because a competitive firm is a price taker, its

revenue is proportional to the amount of output

it produces.

• The price of the good equals both the firm’saverage revenue and its marginal revenue.

Summary

-

• To maximize profit, a firm chooses the

quantity of output such that marginal revenue

equals marginal cost.

• This is also the quantity at which price equals

marginal cost.

• Therefore, the firm’s marginal cost curve is its

supply curve.

Summary

-

• In the short run, when a firm cannot recover its

fixed costs, the firm will choose to shut down

temporarily if the price of the good is less than

average variable cost.• In the long run, when the firm can recover both

fixed and variable costs, it will choose to exit

if the price is less than average total cost.

Summary

• In a market with free entry and exit, profits are

driven to zero in the long run and all firms

produce at the efficient scale.

• Changes in demand have different effects over

different time horizons.

• In the long run, the number of firms adjusts to

drive the market back to the zero-profit

equilibrium.

chapter 14.open.1

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