Firms in Competitive Markets

00:01 Hello. Welcome back to your online presentation on Microeconomics.

00:05 My name is James DeNicco.

00:06 In this presentation, we're gonna be talking about Firms in Competitive Markets.

00:11 So we're gonna learn about what a competitive market is.

00:14 Here we're gonna assume perfect competition.

00:17 When should a firm in a competitive market contemplate shutting down or exiting the market? We'll learn about that.

00:24 And we'll also learn about the implications of a competitive market for profits in the short run and the long run.

00:31 So first, what is a competitive market? A competitive market is a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.

00:41 There's free entry and exit into a competitive market and anyone can decide to enter or leave.

00:48 What's gonna result here is zero profit, economic profit in the long run.

00:54 You're gonna have so many firms competing for market share, they're gonna keep lowering the price to try to get market share until they hit as low as they can go without losing profits, so no firm is gonna be able to raise their price because their identical product, somebody will just go buy the product from somebody else.

01:13 Firms can't lower their prices anymore because they'll be making losses then they'll have to exit the market.

01:19 So, here, let's look at the revenue of a competitive market.

01:23 So they're price takers. They have no market power. They can't control the price.

01:28 So what you're gonna see here is that prices are gonna stay the same no matter how much they sell.

01:34 So here we have -- this is gallons of water, let's say.

01:38 So the first gallon of water they can sell for $6, the second gallon of water they can only sell each one for $6 no matter how much they're producing or how much they're selling, the price can't change.

01:50 This is a little different than our downward sloping demand curve, right? As we lower prices we can sell more.

01:56 Like I said, in the competitive market you have so many people competing they get that price so low, you can't lower your price anymore without losing profits, you can't raise your price cuz you'll lose all your market share. It will go to somebody else.

02:09 So what's our revenue? It's just the quantity sold times our price, so we sell one, 1 times 6 is $6.

02:16 We sell two, 2 times 6 is $12, all the way down to 8 times 6 is $48.

02:22 So what we're gonna see, our average revenue is gonna stay the same because the price stays the same, alright? So our average revenue, our revenue divided by quantity, 6 divided by 1 is 6, 12 divided by 2 is 6.

02:37 So the average revenue just equals our price.

02:40 It's also our marginal revenue.

02:43 The marginal revenue, the additional revenue that we get from selling one more unit, it's just the $6 price because we can't change our prices. We're price takers, alright? We're price takers cuz we have no market power so the price is the same no matter how much you sell.

02:59 Alright, let's expand on our example a little bit here of our perfect competition, alright? So in our example here, we have the quantity of gallons of water being sold.

03:09 We have our total revenue, our average revenue, our total cost, our profit, our marginal revenue, our marginal cost, and our change in profits, alright? So everything is the same as was before the slide but the revenue slide.

03:21 So our total revenue is just our gallons times our price.

03:24 Our average revenue, right, that's just the total amount we -- or is our revenue divided by our quantity; so you'll see that the average revenue is just the price cuz the price doesn't change; and then we get to our total cost, alright? Now, we have our total cost.

03:40 We see -- we put a zero.

03:42 We have a cost of $3, that must be our fixed cost, right, cuz our fixed cost doesn't change as our quantity changes, our variable cost does, so anything after that $3 is variable cost.

03:54 Now what are our profits? That's our total revenue minus our total cost, so zero minus 3 is negative 3; 6 minus 5 is 1; 12 minus 8 is 4; and on down the line.

04:05 Our marginal revenue, that's the increase in revenue that we get from selling an additional unit.

04:11 It's just the price, the price doesn't change.

04:14 So we sell one unit we get $6, we sell our second unit we get another $6 and on down the line.

04:19 Our marginal cost, that's the difference in cost that we incur from producing another unit so it's just our total cost for producing one -- 5. 5 minus 3 is 2.

04:30 The second unit, the total cost is 8, 8 minus 5 is 3, the additional cost we incur from producing an additional unit.

04:38 Now, the change in profits, alright, we go to our profit.

04:41 The first one brings us $1: $1 minus negative 3 is 4; $4 minus 1 is $3 and on down the line.

04:49 So in order to maximize profit, firms want their marginal cost to equal to marginal revenue, so let's think about what that means.

04:59 Marginal revenue, that's the additional revenue you get from producing another unit.

05:03 Marginal cost that's the cost you incur from producing another unit.

05:06 You don't want the cost for making another unit to be larger than the revenue you earn or you're earning a loss, right, you're making a loss at that point, so if you produce a unit it brings in more than it cost, you want it.

05:20 At the indifference point, that's when we say the marginal revenue equals the marginal cost, you're not making any profit, but you're not making any losses so you'll produce that unit.

05:29 You don't go beyond that because now producing one more unit, the cost is greater than the revenue.

05:35 So here our marginal revenue is constant, our marginal cost is increasing, that's because of our diminishing returns of production.

05:43 Go back to labor, think about labor as our variable cost so you hire one more person production increases, but the size of the increase in production is diminishing because of coordination issues.

05:54 So later on, as you're hiring more people, if you wanna increase the quantity by the same amount, you need to hire more people to get there so it's more costly, so our marginal cost rises, alright? So we're gonna wanna produce again where our marginal revenue equals our marginal cost.

06:12 So you see our change in our profits.

06:14 The first one we sell we get $4, the second one we sell we get $3, the third one we sell we get $2, the fourth one we get $1, the fifth one zero dollar but we're not losing any on that unit, so we'll take it.

06:26 After that, if you produce another unit, it's gonna cost more than it brings in, in revenue, so you wanna stop.

06:34 So what are our total profits here: 4 plus 3 plus 2 plus 1, alright? But the marginal profit, that's what you're looking at, so you don't wanna go beyond that because then you'll start to have losses.

06:46 So now let's take a look at the picture, alright, how does this all look in a picture, we've seen this cost curves before in our cost of production presentation.

06:53 So what we have here we have a constant price, right, price equals average revenue equals marginal revenue.

07:00 Average revenue, that's just revenue divided by quantity.

07:04 We sell each unit for the same price so the price equals our average revenue.

07:09 Our marginal revenue that equals the price as well, each unit we sell we get another $6 so it's just gonna be straight across, alright.

07:18 We see a rising marginal cost here.

07:21 We see it intersects our average total cost at the efficient scale right at the minimum because if the marginal cost is below average total cost it brings it down.

07:31 If the marginal cost or the cost of the next unit we sell is above the average, it will bring the average up. And here we have our average variable cost, it goes down at first and then it starts to rise, alright.

07:44 So in this graph, the firm is gonna maximize again as they always do where marginal cost equals marginal revenue.

07:51 So we see our marginal revenue here is our price, this is our marginal cost, so this is where we wanna produce, this is the profit maximizing quantity of production, alright? So what happens if prices go up? Alright, if prices go up that means the marginal revenue goes up, so as marginal revenue goes up you wanna increase your production, always where marginal revenue equals marginal cost, right, that's where we maximize profits.

08:19 We don't wanna go beyond that points cuz the marginal cost is greater than marginal revenue, so if prices go up, you increase the quantity you produce.

08:28 So now you see that if your price is greater than your average total cost, you're making a profit, alright? So the price, that's what you earn per unit that you sell; the average total cost, that's the cost per unit to make, so if the price per unit that you get is greater than the cost per unit to produce you're making a profit.

08:46 So you see what is our profit? It's the price minus the average total cost times the quantity sold, alright.

08:53 So in the short run, you can have firms in the profit, you can have firms in the profit.

08:58 In the long run, that profit will go away because of entry.

09:02 Now what a losses look like? In the short run you can have losses as well.

09:05 So a loss that's when you're average total cost is greater than your price, so the cost per unit of production is greater than the revenue that you're bringing in per unit.

09:17 Average revenue just equals price cuz the price isn't changing.

09:21 So here we see a loss. What is that loss? It's the cost minus the price times the quantity sold.

09:27 So this brings us to an interesting point when firms need to decide whether they're gonna shut down or whether they're gonna exit.

09:35 They're two entirely different things, alright? A shutdown, that's a short run decision not to produce anything during a specific time period due to current marketing conditions.

09:44 Exit, that's a long run decision just to get out, close shop and never come back, okay? So how do firms decide whether they're gonna shutdown or whether they're gonna exit? So this decision is gonna depend on what we call sunk cost.

09:57 Sunk cost are costs that's been committed that can't be recovered.

10:01 So this can helps us explains some things, why an empty restaurant stays open or why a mini golf course in a summer resort stays open even when it isn't the summer, alright, because you've already committed these sunk cost.

10:14 Let's take a look at how this works, alright? So here we have our competitive firm.

10:21 So in the short run, firms produce on the marginal cost curve if price is greater than average variable cost, so the average variable cost where price equals average variable cost, that's your shutdown point in the short run.

10:34 So you can make losses in the short run and still stay open.

10:39 You've committed to pay for these sunk cost so you're the restaurant, you're the empty restaurant, you've already paid for your lease, you've committed to this lease you can't get out of it, alright? So you've already incurred those cost, so, yeah, you're losing money, alright, nobody's in your restaurant, you're earning less than it cost for those fixed cost, for those sunk cost.

11:00 However, you can eat away at some of those losses if you stay open, if the price is greater than your average variable cost, so you spent $30,000 on the lease, that's gone, okay? You can't make up the money to have profits right now because you're not getting enough business, but you're making more money than you pay your labor, the waitresses.

11:24 You're earning more than you pay your waitresses, so you're earning more than your average variable cost.

11:30 What that does is it eats away at some of your losses.

11:33 If you just shut down completely, you're earning nothing, right? So that total sunk cost you're gonna have to pay for all $30,000 of it, but if you stay open and earn more than your average variable cost, maybe you earn $5000 more than your average variable cost, will then, you eat away at some of your losses so you don't shut down until your price is below your average variable cost, alright, because then at that point, yeah, there's no reason to stay open, you're just losing more money.

12:04 You lose the $30,000 and you make less than you pay your labor so you're losing even more money.

12:11 At that point, you shut down until things get better.

12:13 That's your short run shutdown point, that's your short run decision.

12:16 Now, in the long run it's a little different.

12:19 In the long run you can get out of some of those sunk cost, you can get out of your lease, the lease is for a year, next year you can end the lease and you can be done with those sunk cost.

12:29 So in the long run, if you're price is less than your average total cost, you exit, you get out of there cuz that means you're making loses, alright, you have losses in the long run.

12:40 If your average total cost is above your price, your cost per unit is above your revenue per unit, and you get out of there.

12:46 The short run decision is a little different, but the long run decision if you're making losses, you exit.

12:52 Alright, now the short run of an individual firm versus the market.

12:56 So here we have our identical firms so everybody is the same.

13:00 So what you're gonna see is the market supply is gonna look exactly like the individual firm supply, it's just gonna be larger.

13:07 So here we have a quantity of one hundred, say we have a thousand firms, the quantity is just gonna be a thousand, the scale is just gonna be larger, alright? All the firms are identical that's one of our assumptions in perfect competition.

13:20 So the market just looks like a -- just looks like the individual, just much larger.

13:26 So you have also differences between the short run and the long run.

13:29 In the short run firms can make some profit, alright, but in the long run they can't make any profit, they can also make losses in the short run but in the long run economic profit is gonna be zero; so if there's some short run economic profit what's gonna happen? Firms are gonna enter. its gonna increase supply and lower the price, alright, the price will get back down to where people don't wanna lower it anymore cuz then they'll be making losses.

13:52 In the short run, if there's losses, if there's too many firms, well then firms are gonna exit, supply will decrease and prices will go back up.

13:59 In the long run, what you're gonna see is your supply here is just gonna be a horizontal line, it's just gonna be straight across.

14:07 In the short run, the marginal cost can be upward slopping, your marginal cost is your supply here, so, yes, as prices go up prices go down, you're gonna wanna change the amount that you produce, but in the long run, the prices are always gonna get back to marginal cost, you're gonna be at your efficient scale, your efficient scale, that's where your marginal cost intersects your average total cost.

14:30 Here your price equals your marginal cost equals your average total cost at that efficient scale, that's the zero profit condition, that's where you're gonna be in the long run so you see this horizontal supply curve.

14:44 Now, why would a firm stay in business if they're making zero profits? Well, cuz this is economic profit, remember. So we have the explicit and the implicit cost.

14:53 So accounting profit might actually be positive, alright? So accounting just takes into consideration the explicit cost so what this is saying, economic profit is zero, it's saying your cost of business and your implicit cost, what you could be doing with your time other than that, those cost add up to equal your revenue so that profit equals zero, but in accounting terms, you might be actually making some money, you could have some profit cuz they just look at the explicit side of it, they don't look at the implicit side of it.

15:25 They don't worry about what else you could be doing with your time, so you might actually be making $80,000 a year in accounting profit, but, if you consider the time you could be spending somewhere else, you could probably be earning that $80,000 doing something else so that your economic profit is zero.

15:43 That's why firms stay in business even though their economic profits are zero, they're still making money. They're still making money.

15:50 They're making money doing this or in this $80,000 instead of doing something else.

15:56 Alright, so now let's take a look at the short run versus the long run in a perfectly competitive market.

16:03 So we're at a long run right here, alright.

16:06 Supply equals demand and then here's our price, alright, our price is determined where our supply equals our demand, we draw right across here and we're gonna see that our price equals our average total cost, right? So the market begins in long run equilibrium with the firm earning zero profit.

16:23 Our price equals our average total cost where at our efficiency scale or efficient scale where the marginal cost intersects the average total cost curve.

16:32 Then, say, something happens to increase the demand, alright? People have a craving for that product, all of sudden that product becomes more popular, a change in taste and there's a shift in demand to the right, so all of a sudden what you're gonna see is there's more demand, that price goes up.

16:47 Now in the short run, you're actually earning profit.

16:50 You take a look over here to the right and you see that your price is greater than your average total cost.

16:55 In the short run that's great, right? You're getting profits.

16:58 However, identical firms, they're gonna see that free entry and exit, firms are gonna enter to get some of that profit so what's gonna happen is demand shifted to the right, now supply is gonna shift to the right.

17:12 There's gonna be more firms entering as the supply increases that brings the price back down to the average total cost restoring your long run equilibrium so that you're earning zero economic profit.

17:25 So what have we learned here? We understand the meaning of a competitive market.

17:29 We know when a firm in a competitive market to contemplate shutting down or exiting.

17:34 We understand the implications of a competitive market for profits in the short and long run.

17:39 As to your presentation on firms as a competitive market. Thank you.