Lecture 6 notes - Competitive Firms and Markets: Chapter...

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BE 530 Page 1 of 4 Lecture 6 Competitive Firms and Markets: Chapter Review Introduction In this chapter, we examine the behavior of competitive firms—firms that do not have market power . Firms that have market power can influence the market price of the goods they sell. The cost curves developed in the previous chapter shed light on the decisions that lie behind the supply curve in a competitive market. What is a Competitive Market? A competitive market has two main characteristics: There are many buyers and sellers in the market. The goods offered for sale are largely the same. The result of these two conditions is that each buyer and seller is a price taker . A third condition sometimes thought to characterize competitive markets is: Firms can freely enter or exit the market. Firms in competitive markets try to maximize profits, which equals total revenue minus total cost. Total revenue ( TR ) is P x Q . Since a competitive firm is small compared to the market, it takes the price as given. Thus, total revenue is proportional to the amount of output sold—doubling output sold doubles total revenue. Average revenue ( AR ) equals total revenue ( TR ) divided by the quantity of output ( Q ) or AR = TR / Q . Since TR = P x Q, then AR = ( P x Q )/ Q = P . That is, for all firms, average revenue equals the price of the good . Marginal revenue ( MR ) equals the change in total revenue from the sale of an additional unit of output or MR = Δ TR / Δ Q . When Q rises by one unit, total revenue rises by P dollars. Therefore, for competitive firms, marginal revenue equals the price of the good . Profit Maximization and the Competitive Firm’s Supply Curve Firms maximize profit by comparing marginal revenue and marginal cost. For the competitive firm, marginal revenue is fixed at the price of the good and marginal cost is increasing as output rises. As long as marginal revenue exceeds marginal cost, increasing the quantity produced raises profit. Profit is maximized when
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BE 530 Page 2 of 4 Lecture 6 firms produce output up to the point where marginal cost equals marginal revenue . Assume that we have a firm with typical cost curves. Graphically, marginal cost ( MC ) is upward sloping, average total cost ( ATC ) is U-shaped, and MC crosses ATC at the minimum of ATC . If we draw P = AR = MR on this graph, we can see that the firm will choose to produce a quantity that will maximize profit based on the intersection of MR and MC . That is, the firm will choose to produce the quantity where MR = MC . At any quantity lower than the optimal quantity, MR > MC and profit is increased if output is increased. At any quantity above the optimal quantity, MC > MR and profit is increased if output is reduced. If the price were to increase, the firm would respond by increasing production to the point where the new higher P = AR = MR is equal to MC . That is, the firm moves up its MC curve until MR = MC again. Therefore, because the firm’s marginal-cost curve determines how much the firm is willing to supply at any price, it is the competitive firm’s supply curve .
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This note was uploaded on 07/15/2011 for the course ACC 360 taught by Professor Marshallhunt during the Spring '09 term at University of Michigan-Dearborn.

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Lecture 6 notes - Competitive Firms and Markets: Chapter...

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