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• Quiz next Thursday (March 15)

• Problem Set given next Tuesday (March 13)– Due March 29

• Writing Assignment given next Tuesday (March 13)– Due April 3

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ECON 102.004 – Principles of Microeconomics

S&W, Chapter 7

The Competitive Firm

Instructor:

Mehmet S. Tosun, Ph.D.

Department of Economics

University of Nevada, Reno

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Lecture Outline

• Revenue, costs and profit maximization

• Entry and exit decisions

• Market supply curve

• Long-run and short-run supply curves

• Accounting vs. Economic profits

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Competition

• Many firms do business in industries with a great deal of competitive pressure. – The flower seller at the local farmer’s market– A chip manufacturer in China or South Korea– A large firm such as Microsoft

• All face stiff competition in their industries.

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Revenue

• A firm's income or total revenue, TR = pQ.– Marginal Revenue: the extra revenue a firm

earns from selling one extra unit• MR = ∆TR/∆Q = slope of the total revenue curve

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Costs

• Total costs are made up of variable costs (costs that vary with output) and fixed costs (or sunk costs which have already been paid and cannot be recovered).– Total costs = variable costs + fixed costs– TC = VC + FC

• Marginal Cost: the extra cost of producing one additional unit of output– MC = ∆TC/∆Q = slope of the total cost curve

• Average Cost: the cost per unit of output – Can also be decomposed into variable and fixed categories– Average costs = average variable costs + average fixed costs– AC = AVC + AFC

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• Firms produce where the difference between total revenue and total cost is greatest.– This occurs where the slope of TR and the slope of TC

are equal.• The slope of the TR curve is MR.

• The slope of the TC curve is MC.

• Profits are at a maximum where MR = MC.– Here the revenue earned on the last unit sold equals the

cost of making the last unit.

MC = MR (b)

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• Many buyers and sellers of a homogeneous product• Information is good, if not perfect.• Firms can enter and exit the market.• These conditions imply

– Competitive firms are small compared to the large market they sell in so they are price takers.

– MR = price; the firm can always sell the next unit at the going market price.

• Competitive firms maximize profits where MR = MC, or p = MC.– This means that the marginal cost curve is the supply curve for the

firm since the MC curve gives the profit maximizing quantity supplied for any price.

Competitive Markets

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Entry (a)

• When should a firm not currently in the market enter the market?– Answer: when it can make a profit.

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Average Cost Curves

• Different firms may have different average cost curves.• Due to:

– Differences in scale– Differences in management– Different locations– And so on

• These firms will enter the market at different prices; the more efficient firms will enter first.

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Exit (a)

• What causes a firm in an industry to leave an industry?– A firm leaves the industry if leaving is the best option.– That is, if the firm loses less when shut than when producing.

• When a firm exits or goes out of business, it loses its sunk costs.• If its losses when producing exceed its sunk costs, the firm shuts

down.• Shut if Loss > FC or if TC – TR > FC

– Shut if TC = VC + FC > FC + TR (cancel FC from both sides)– Shut if VC > TR or if VC > pQ (now divide by Q)– Shut if AVC > p

• Operate if p >= AVC

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Looking Beyond the Basic Model: Sunk Costs, Entry, and Competition

• The basic model of competition assumes that an industry has many firms.

• Even without a large number of firms, competition may still hold.– The theory of contestable markets: the mere threat of

entry may be sufficient to keep prices to competitive levels.

• If sunk costs are low, any significant price increase over minimum average cost will induce entry and lower prices.

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Long‑Run Supply versus Short‑Run Supply• Also entry and exit are more of a factor in the long run than in the short

run.

• So long‑run supply will be more elastic just because of entry and exit.

• The long‑run supply curve may be horizontal.

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Why Do Firms Produce If in the Long Run Profits Are Zero?

• Firms produce to make profits, but under competition, economic profits are eventually driven to zero.– Most people define profits as the excess of

income over expenses.– Economists define profits as income net of all

costs including the opportunity costs, especially the opportunity costs of the owner's capital.

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Owners Opportunity Costs and Economic Profit

• Firms must be owned just as they must be staffed by workers.– Workers are paid a wage to compensate them for the

opportunity cost of their time; this is a cost to the firm.– Likewise, owners are paid to compensate them for the

opportunity cost of their capital and this is also a cost to the firm.

– Owners can earn the rate of interest at the bank so a firm must pay owners at least this return.

– If firms pay owners returns above the return paid by banks the extra is called economic profit.

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Opportunity Costs (b)

• Suppose the interest rate is 5% but the firm yields an 8% return to its owners.– The additional 3% is economic profit, or above normal profit.

• In the long run, competition drives economic profit to zero.– So owners get just the return they could get from the bank.– This means there is no reason for firms to exit or enter.– If there were economic profits in the long run then other firms

would enter.– The market supply would increase and prices would fall reducing

profits.– This process continues until economic, or above normal, profit is

competed away to zero.

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Economic Rent

• For most people, rent is the payment for the use of land or buildings.

• For economists, rent is the extra return on an input resulting from its qualitative superiority and scarcity, rather than its marginal cost.

• In a competitive industry, the marginal firm makes no profit.– Other firms earn profits that should be called economic rents.– If all firms have the same technology and face the same input

prices, they will all make a zero profit in competitive equilibrium.– Some firms have a technological advantage over others or have

lower input prices; they earn an economic rent.