CHAPTER+14+.+FIRMS+IN+COMPETITIVE+MARKETS+;)

=Firms in Competitive Markets =

= =  **Basic terms**

Average Revenue: total revenue divided by the quantity sold Marginal Revenue: the change in total revenue from an additional unit sold Sunk Cost: a cost that has already been committed and cannot be recovered


 * Competitive Market**: A market is competitive if each buyer and seller is small compared to the size of the market and therefore has little ability to influence market prices.


 * Perfectly Competitive Market**:
 * Many buyers and sellers
 * Homogeneous products
 * The firm is the price taker
 * Price = Marginal Revenue = Average revenue
 * Total revenue is proportional to the price and amount of output
 * Free Entry&Exit in Market (No barrier)
 * At profit maximizing point, Price = Marginal Cost
 * At profit maximizing point, Price = Average Total Cost

(The Price and the Marginal Revenue and the Average Revenue are all $6)

Why is the "Profit Maximizing Point" at Marginal Revenue = Marginal Cost ?

When we say marginal 'something', we can get the graph easily by getting the derivative graph of the 'something'. For example, the graph of the marginal cost would be the derivative graph of total cost (or variable cost, since the two graphs has the same shape which makes the derivative function similar).

Since "Profit" is calculated by Total Revenue - Total Cost, if we get the derivative function of the equation, it becomes

Profit ' = Total Revenue ' - Total Cost ' (the ' sign means the derivative function) Profit Maximizing point is where the derivative function equals 0, so

Total Revenue ' - Total Cost ' = 0 is where profit is maximized. Total Revenue ' => Marginal Revenue Total Cost ' => Marginal Cost

Therefore Total Revenue ' - Total Cost ' = 0 = Marginal Revenue - Marginal Cost

Then if we move the Marginal Cost to the 0 side, Marginal Revenue = Marginal Cost is where the profit is maximized.

**Economic Profit**
Since the firms in a completely competitive market are "Price Takers", they take the price that is decided by the supply and demand curve of the market. And if we combine the Marginal Cost graph, Average Total Cost graph, Average Variable Cost graph all together, it looks like the graph below. As shown in the graph, the firm should produce at the point where Marginal Revenue meets Marginal Cost. Since the price is higher than the average total cost, there is an economic profit. If marginal revenue is greater than marginal cost, the firm should increase its output. If marginal cost is greater than marginal revenue, the firm is overproducing and should decrease its output.

Economic Loss
If the average total cost is higher than the price, there is an economic loss. But the firms should still produce where MR = MC because this will minimize the loss. However, there are different situations where the firm has to shutdown, keep producing although it is a loss, and exit the market.

A firm should shutdown in the shortrun when price is lower than average variable cost.
 * ===ShutDown - a temporal state of "not producing" (thus, no variable cost) (*Shortrun)===

A firm should keep producing in the shortrun although it is a loss when the price is lower than the average total cost, but higher than the variable cost.
 * ===Producing - the state of producing outputs although it is a loss (*Shortrun)===

In the long run, when the price is lower than the average total cost, the firm should exit the market. This is because if the price is lower than the average total cost in a long time scale, it means an economic loss for a long time. Firms cannot stay in the market for a long time when the price is lower than the average total cost and is making an economic loss.
 * ===Exit - exiting the market (*Longrun)===

Longrun Equilibrium
In a longrun, firms reach a state called equilibrium where they make zero economic profit, or normal profit. This is because of the repetition of entering and exiting of the firms. If there is a economic profit, firms would enter the market. Then supply would go up, and as price goes down, economic loss will occur, thus reducing the number of firms again. Then the supply curve will go down, and increase the price. Then firms will come in again. As this process continues for a long time, the firms will reach a condition where Marginal Revenue = Marginal Cost = Average Total Cost = Price. At this certain state, the economic profit is 0. But this does not mean that there is no profit. What this means is that the firm is earning just as much as its second option, or the opportunity cost.