The Meaning of Competition
A competitive
market, sometimes called a perfectly competitive market, has three characteristics:
- There are many buyers and many sellers in the market.
- The goods offered by the various sellers are largely the same.
- Firms can freely enter or exit the market.
At Qa, MC < MR.
So, increase Q to raise profit.
At Qb, MC >
MR. So, reduce Q to raise profit.
At Q1, MC = MR.
Changing Q would lower profit.
A Firm’s
Short-run Decision to Shut Down
If the firm shuts
down temporarily,
revenue falls
by TR
costs fall by
VC
So, the firm
should shut down if TR < VC.
Divide both
sides by Q: TR/Q < VC/Q
So, we can write
the firm’s decision as:
Shut down if P
< AVC
A Firm’s
Long-Run Decision to Exit
If a firm exits
the market,
revenue falls
by TR
costs fall by
TC
So, the firm
should exit if TR < TC.
Divide both sides by Q to rewrite the firm’s decision as
Exit if P < ATC
A competitive
firm's revenue is related to the amount of production it produces since it is a
price taker. The cost of the good is equal to both the average and marginal
revenue of the company.
A company
selects a volume of output so that marginal revenue and marginal cost are equal
to maximize profit. Because a competitive firm's marginal revenue is
equal to the market price, the firm decides on quantity so that the price is
equal to the marginal cost. As a result, the firm's supply curve is its
marginal-cost curve.
If the price of
the good is less than the average variable cost in the short term, a firm that
cannot recover its fixed costs will decide to temporarily close. In the long
run, if the price is less than the average total cost and the company can
recover both fixed and variable costs, it will decide to quit.
Profit is
eventually driven to zero in a market with unfettered entry and exit. In this
long-term equilibrium, all businesses operate at their most productive scale,
the price is set at the average total cost's minimum, and the number of
businesses changes to accommodate the quantity required at this price.
Over various time horizons, variations in demand have distinct implications. In the short run, rising prices and profits result from rising demand, whereas falling prices and losses result from falling demand. However, if businesses are allowed to enter and leave the market, eventually the number of businesses adjusts, and the market returns to the zero-profit equilibrium.
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