Chapter+14+Emily+K

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How do competitive firms make decisions?
 = = In this chapter, you will learn about the behaviors of a competitive firm. All firms want to maximize profit. But how do they achieve that? With the knowledge you have gained from the previous chapter about all the different costs of a firm, you will determine how a firm makes its decisions regarding production, and even non-production. In this chapter, we get to incorporate individual firms to the entire market in which they belong, and compare how firms respond to market changes. By the end of this chapter, you will know exactly where a firm needs to produce in order to maximize its profit, what a firm needs to do if it is facing loss, and ultimately, how each individual firm earns profit in the long run.

= =  A **competitive market** has two characteristics:  For competitive firms, marginal revenue equals the price of the good. A firm maximizes profit when it produces at a quantity where marginal cost equals marginal revenue.  
 *  There are many buyers and many seller in the market
 *  The goods produced by different firms are homogenous.

In reality...
<span style="font-family: Verdana,Geneva,sans-serif;"> There is no market that is perfectly competitive. This is because the products produced by within a market virtually cannot be homogeneous. They are all different, whether that comes from the product's physical difference, or the consumers' perceived difference. For physical difference, think about the difference between a pair of Nike Air running shoes and some cheap tennis shoes from an unknown brand. The difference of the actual qualities of the shoes is immense. On the other hand, perceived difference comes from what consumers believe to be true. For example, there should not be too big of a difference in quality between a JanSport bag and a regular schoolbag without a brand name. However, consumers tend to think that JanSport backpacks are superior, leading to the higher prices of those bags. This leads us to the argument that the more non-homogeneous a product is, the more control the firm (that produces such a product) has. This will eventually lead to a monopoly, which you'll learn more next chapter.

<span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">How Price is Related to Average Revenue and Marginal Revenue
<span style="font-family: Verdana,Geneva,sans-serif;">Total revenue of a competitive firm is calculated by multiplying price by quantity. The average revenue is then calculated dividing the total revenue by quantity. This means that average revenue is the same as price. Now let's look at marginal revenue. Marginal revenue is the amount that a firm raises by selling an extra unit of product. The important part is that the price of a competitive firm is fixed, so every time there is one extra unit of product sold, the revenue becomes the price of the product. Thus, in competitive firms, marginal revenue equals the price of the good.

<span style="font-family: Verdana,Geneva,sans-serif;">How a Firm Maximizes Profit
<span style="font-family: Verdana,Geneva,sans-serif;">Now, with the knowledge that we now have, we can identify how a competitive firm decides what quantity to produce. A firm wants to gain as much profit, so it will naturally eventually produce at the profit maximizing point. If the marginal revenue is greater than marginal cost, then the firm is not using enough of the resources to maximize profit. Thus, the firm should (and will) increase the quantity of its output. When the marginal cost is greater than marginal revenue, that means that the firm is losing money for producing too much. Thus, in this case, the firm should reduce its quantity output. (GRAPH!!!!) <span style="font-family: Verdana,Geneva,sans-serif;">

<span style="font-family: Verdana,Geneva,sans-serif;">Firms Adjust to Price
<span style="font-family: Verdana,Geneva,sans-serif;">A competitive firm is a price taker, rather than a price maker. Thus, it responds to prices, rather than it deciding the prices itself. Given a specific price, the firm will react to it and determine the ideal quantity output that should be produced at the particular price. The firm can determine this because of what we have just learned, profit maximization. The firm knows that it can maximize profit at the point where marginal revenue equals marginal cost. Marginal revenue is price, as discussed before, so the firm produces at the point where quantity touches the marginal-cost graph and makes a rectangle. This is why the marginal-cost curve is also called the supply curve of the firm - it determines how much the firm will produce at a certain price.

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<span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">Firms enter, firms shut down, firms exit...
<span style="color: #008000; font-family: Verdana,Geneva,sans-serif;"> Firms enter the market when they see potential for profit <span style="font-family: Verdana,Geneva,sans-serif;">. In other words, if they see that other firms already in the market are making money, they enter in hopes of also gaining profit. However, when they enter the market and for some reason they realize that the total cost is greater than total revenue, they may choose to shut down, or stop producing. Even still, the <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">firm would have to pay the fixed costs <span style="font-family: Verdana,Geneva,sans-serif;">, because that does not change even if quantity output changes. In the long run, if the situation of cost being greater than revenue continues, the firm may choose to exit the market, meaning leaving the market completely. Firms can only do this in the long run, because exiting a market is not a process that can be done quickly.



For a real life example, think of the computer industry that was booming in the 1980's. Companies such as Apple and Macintosh were thriving, and everyone wanted to join the market because it seemed to have great potential. The result was that too many firms joined, causing the supply to increase greatly and the price to fall. Today, many firms that decided to enter the computer market (including computer mechanics) are struggling from the problem of decreased price. Many choose to exit the market, which is possible now since a long time has passed.

<span style="font-family: Verdana,Geneva,sans-serif;">Shut Down or Exit?
<span style="font-family: Verdana,Geneva,sans-serif;"> If business is not going so well and the firm cannot recover itself, the firm may decide that it is better not to continue the business. When <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">a firm stops its production, it is called a shut-down <span style="font-family: Verdana,Geneva,sans-serif;">. Although the quantity of production is zero, the firm still must pay fixed costs, the cost that exists even when there is no output. Now, that was in the short run. In the long run, if business still (unfortunately) is declining, the <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">firm may choose to leave the market altogether <span style="font-family: Verdana,Geneva,sans-serif;">, which means the firm is out of the market completely. In this case, since there //is// no firm anymore, there is no fixed cost. <span style="font-family: Georgia,serif;">

<span style="font-family: Verdana,Geneva,sans-serif;">When to Shut Down
<span style="font-family: Verdana,Geneva,sans-serif;"> A firm continues its production until it can no longer take the loss. To a point, the firm will actually want to produce, in order to at least pay for the fixed costs, which exist regardless of whether the firm produces or not. However, when the variable cost exceeds the total revenue, the firm decides to shut down altogether and stop producing, because at that point, the firm is worse off by producing. It would not even cover for the fixed costs. total revenue < variable cost price < average variable cost

<span style="font-family: Verdana,Geneva,sans-serif;">When to Exit
<span style="font-family: Verdana,Geneva,sans-serif;"> Generally the same rules apply when a firm is making decisions to exit the market. The firm will exit if the same condition of loss continues. However, the difference is that in the long run, there is no fixed cost, so only variable cost remains. This means that variable cost becomes total cost. Because a firm can exit a market only in the long run, it will exit when the total revenue is less than the total cost. total revenue < total cost price < average total cost

Why A Firm Makes Zero Profit in the Long Run
In the short run, a firm may experience profit or loss. Because firms can enter and exit the market freely in a competitive market, there are frequent shifts in the supply curve, which affect the well-being of the firms within a market. As you learned above, if the market is thriving, other firms will want to join the market. With the increased supply in the market naturally comes a decrease in price. This means that the incumbent firms (those who were already in the market) face a decrease in profit, if not economic loss. Then, when firms face economic loss, they will exit the market. When firms exit, the supply in the market decreases, and price increases. Shifts in demand can also lead to changes in price. For example, if people suddenly stopped eating fast-foods in order to take care of their health, the demand in the fast-food market will decrease, resulting in a fall in price. So you see, prices constantly rise and fall in a market. And in the long run, the rises and falls balance out each other, and the price reaches equilibrium. Thus, firms make zero profit in the long run. You're probably thinking, what? Why would a firm make zero profit in the long run? If it made zero profit, why would it stay in business? Well, one thing you have to remember is that when we say "zero profit," we're talking economic profit. Remember that economic profit includes both financial cost and opportunity cost. So if a firm is making zero opportunity cost, that means it has at least covered up for the opportunity cost. Thus, there is no way the firm could have made more money.

= Conclusion = <span style="font-family: Verdana,Geneva,sans-serif;">In this chapter you have learned that a competitive firm is a price taker that has no market power. For this reason, the demand curve is perfectly elastic, and the price of the product equals the marginal revenue. You have learned how to locate the point where the firm maximizes its profit: a competitive firm always maximizes its profit at the point where marginal revenue equals marginal cost. Thus, when a certain price is given from the market, the firm will adjust to the corresponding quantity for which it can make the most profit. When firms are not doing so well, they choose to shut down. When conditions continue to worsen, the firm eventually exits the market altogether. The firms that decide to stay in the market make zero profit in the long run, and this is attributed to the characteristic of free entry and exit of a competitive market. With the continued phenomenon of firms entering and exiting, price will first fluctuate, but eventually find its equilibrium. This balances out the rises and falls of the price, and the firm in the end is left with zero profit.



Question:How does a firm know what quantity to produce in order to maximize its profit?
Answer: The firm will be able to figure out what quantity to produce by analyzing its graph of costs and price. The firm always wants to produce where the marginal revenue (or the price) equals the marginal cost, because that will maximize its profit. So, if the firm's current marginal cost is lower than the marginal revenue, that means that the firm can make more profit if it increases quantity. In that case, the firm will increase its quantity, and the profit will increase. If the marginal cost is higher than the marginal revenue, then the firm will have to decrease its quantity of output in order to minimize its loss. When a certain price is given from the market, the firm wants to match its quantity so that the marginal cost will equal the marginal revenue.

<span style="color: #800000; display: block; font-family: Verdana,Geneva,sans-serif; font-size: 150%; text-align: center;">[[image:glossary_ek.jpg]]
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 * competitive market:** a market with many buyers and sellers where the product produced by sellers is homogeneous
 * average revenue:** total revenue divided by quantity sold
 * marginal revenue:** change in total revenue from additional unit sold
 * sunk cost:** cost that has already been committed and cannot be recovered