College of Business Management

Institute of Business Management

ECO 101 - Principles of Microeconomics

Faculty Name: Ms. SABEEN ANWAR

Chapter 14: Firms in competitive markets

A competitive market

A competitive market is a market with many buyers and sellers trading identical products so
that each buyer and seller is a price taker.

In addition to the above mentioned characteristic we usually have the free entry and exit of
firms into or from the market.

Average revenue is defined as total revenue divided by the quantity sold. Marginal revenue
is defined as the change in total revenue from an additional unit sold.

The revenue of a competitive firm can be easily calculated by multiplying the price which is
given with the quantity sold. This implies that the price, the average revenue and the
marginal revenue stay the same.

Profit maximization and the competitive firm’s supply curve

Usually firms try to maximize profits which implies the maximization of the difference
between total revenue and total costs.

As long as the additional revenue is higher than the additional cost for producing and selling
an extra unit of output, it makes sense for the firm to increase the output because it increases
the profit.

The firm maximizes its profits by producing the quantity at which marginal cost equals
marginal revenue.

Because the firm’s marginal-cost-curve determines the quantity of the good the firm is willing
to supply at any price, it is the competitive firm’s supply curve.

The Firm’s short-run decision to shut down

A shut-down refers to a short-run decision not to produce anything during a specific period.
Exit refers to a long-run decision not to produce anymore.

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A firm shuts down if the revenue that it would get from producing is less than its variable
costs of production. Because of this, we can define the relevant short-run supply-curve as
the part of a firm’s marginal-cost curve that lies above average variable cost.

Sunk costs

Sunk cost is defined as “ a cost that has already been committed and cannot be recovered”. In
making production decisions, sunk costs are irrelevant once the expense took place.

The Firm’s Long-Run Decision To Exit Or Enter A Market

In the long run, a firm stays in the market only when revenue are higher than total costs.
Hence, we can state: as long as average revenue is higher than average cost, it is profitable to
enter the market or not to exit it. Because the average revenue is equal to the price, we have as
a rule: p ►ATC, it is profitable to produce.

Hence, a competitive firm’s long-run supply curve is the portion of its marginal cost curve
that lies above average total cost.

Because Profit = (Price – Average total cost) x Quantity, we can graphically show the profit
as in figure 14-5.

The Supply Curve In A Competitive Market

We can derive the market supply curve by just adding the supply curves of all the firms in the
market.

When market entry is easy, new firms will enter the market when price and cost conditions
allow profits. This is the case when prices are above the average total cost. New entries will
take place as long as prices are above this level.

“In a market with free entry and exit, profits are driven to zero in the long run. In this long-run
equilibrium, all firms produce at the efficient scale, price equals the minimum of average total
cost, and the number of firms adjusts to satisfy the quantity demanded at this price.

However, this equilibrium level implies that firms seem to make no profit. However, the
calculation of economic profit allowed for opportunity costs of capital and labor. So these
categories are covered.