Lesson 9

Competitive Market

Learning Competencies
At the end of the period, the students should be able to:
1. examine the behaviors of competitive firms;
2. determine which among a firm’s many types of costs are most relevant for its supply
decisions; and
3. examine how firms make production decisions in competitive markets.

Here’s the idea

Pure competition is commonly known as perfectly competitive market. It is a market

structure with many buyers and sellers trading identical products so that each buyer and seller
is a price taker (Manapat and Pedrosa, 2014).

Characteristics of Competitive Market:

1. There are many buyers and sellers in the market.

2. The goods offered by the various sellers are largely the same. As a result of the
condition, the action of any single buyer or seller in the market  has a negligible
impact on the market price. Each buyer or seller takes the price as given and are
said to be price takers.

3. Firms can freely enter of exit in the market.

Revenue of a Competitive Market

Table 8: Revenue of a Competitive Firm

Quantity  Pric Total Average Marginal Revenue 

(in e Revenue  Revenue
gallon)
1 6 6 6 6
2 6 12 6 6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
6 6 36 6 6
7 6 42 6 6
8 6 48 6 6
 Table 8 presents the revenue of a competitive firm. Mankiw (2009) explains that the
fourth column shows the average revenue, which is total revenue divided the amount of output.
Average revenue tells us how much revenue a firm receives for the typical unit sold. Total
revenue is the price multiplied with the quantity (TR= P x Q). Average revenue is the total
revenue divided the quantity (AR= TR/Q). Therefore, for all firms, average revenue equals the
price of goods.
The fifth column shows the marginal revenue, which is the change in total revenue from
the sale of each additional unit of output. Price is fixed for a competitive firm. Therefore, when
quantity rises by one unit, total revenue rises by a peso. So, for competitive firm, marginal
revenue equals the price of the goods.

Profit Maximization for a Competitive Market

Table 9: Profit maximization in a competitive market
Quantit Total Revenue Total Profit Marginal Revenue Marginal Cost
y Cost
0 0 3 -1 6
1 6 5 1 6 2
2 12 8 4 6 3
3 18 12 6 6 4
4 24 17 7 6 5
5 30 23 7 6 6
6 36 30 6 6 7
7 42 38 4 6 8
8 48 47 1 6 9

Table 9 presents the profit maximization in a competitive firm. The third column shows
the total cost which include the fixed cost, which is 3 in this example and the variable costs
depends on the quantity produced.
The fourth column shows the firms profit, which is computed by subtracting total cost
from the total revenue. If it produces nothing it has a loss of 3, the fixed cost.
To maximize profit, you have to choose the quantity that makes profit as large as
possible. Another way is to find the profit-maximizing quantity by comparing the marginal
revenue and marginal cost from each unit produced. 
As long as revenue exceeds the marginal cost, increasing the quantity produced raises
profit. If marginal revenue is less than the marginal cost, you should decrease the production.

Cost/Revenue             MC
                                      MC 2     ATC

                                                            Loss       P=AR=MR

  Profit
    MC 1

                            AVC

     Q 1     Q
max          Q 2                   Quantity
Figure 23: Profit maximization for a competitive firm 
 These cost curves have three features:
1. The marginal cost curve (MC) is upward sloping.
2. The average total cost curve (ATC) is U-shaped.
3. The marginal cost curve crosses the average total cost curve at the minimum of
average total cost.
Figure 23 shows the horizontal line at the market price (P). Mankiw (2009) describes
price as the line which is horizontal because the firm is a price taker. The price of the firm’s
output is the same regardless of the quantity that the firm decides to produce. Take note: for a
competitive firm, the firm’s price equals both its average revenue (AR) and its marginal revenue
(MR).
At Q the marginal revenue is greater than marginal cost. If the firm raised its level of
1,

production and sales by one unit the additional revenue (MR ) would exceed additional costs
1

(MC ) profit would increase. At Q , firm can increase profit by increasing the production.
1 1

At Q marginal cost is greater than marginal revenue. If the firm reduced production by
2

one unit the cost saved (MC ) would exceed revenue lost (MR ). At Q the firm can increase
2 2 2

profit by reducing production.

Regardless of whether the firm begins with production at low level (Q ) or at high level
1

(Q ) the firm will eventually adjust production until the quantity produced reaches Q . This
2 max

analysis shows the general rule for profit maximization: Marginal revenue is exactly equals
marginal cost. Since, a competitive firm is a price taker, its marginal revenue equals the price.
This analysis shoes the general rule for profit maximization: Marginal revenue is exactly equals
marginal cost.

Marginal Cost as the Competitive Firm’s Supply Curve

       Price MC

                                               P 2
                P 1                         ATC

         
AVC
    Quantity

Q 1    Q 2

Figure 23: Marginal cost as the competitive firm’s supply curve

Moreover, Mankiw (2009) discusses how the competitive firm responds to an increase in
the price. When the price is P , the firm produces quantity Q , which is the quantity that equates
1 1

marginal cost to the price. When the price rises to P the firm finds the marginal revenue is now
2

higher that the marginal cost at the previous level of output, so the firm increases production.
The new profit maximizing quantity is Q at which, marginal cost equals new higher price. In
2

essence, 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.

Short-run Decision to Shutdown

Shutdown  refers to a short-run decision not to produce anything during a specific period
of time because of current market condition. On the other side, exit refers to a long-run decision
to leave the market (Case, Fair and Oster, 2017).
The long-run and short-run decisions differ because most firms cannot avoid their fixed
cost in the short-run but can do so in the long-run. A firm that shuts down temporarily still has to
pay its fixed costs. A firm that exits the market saves both its fixed and variable costs.
If the firm shuts down, it loses all revenue from the sale of its product and saves the
variable costs of making its product. The firm shuts down if the revenue that it would get from
producing is less than its variable costs of production.  Shutdown if total revenue is less than
the variable costs. This can be further simplified total revenue divided by quantity is average
revenue and it is simply the goods price. So, shutdown if price is less than the average variable
cost. The firm chooses to shutdown if the price of the good is less than the average variable
cost of production.
 The competitive firm’s short-run supply curve is the portion of its marginal cost curve that
lies above the average variable cost. Figure 24 shows the illustration.

        Cost             MC
           supply curve

  ATC

            AVC
Firm shuts down if
      P<AVC
  Quantity
Figure 24: Competitive firm’s short-run supply curve

Long-run Decision to Exit or Enter

If the firm exits it will loss all revenue all revenue from the sale of its product but it saves
both fixed and variable costs of production. Thus, the firm exists the market if the revenue it
would get from producing is less than its total costs. Exit if total revenue is less than total cost or
exit if price is less than the average total cost (Mankiw, 2009).
The firm will enter the market if the action would be profitable, which occurs if the price
of the good exceeds the average total cost of production. Enter if price is greater than the
average total cost. The firm is in the market if marginal costs equals the price.
In the long-run the competitive firm’s supply curve is the portion of its marginal cost
curve that lies above the average total cost. If the price falls below the average total cost, the
firm is better of existing the market
        Costs         MC

  long-run supply curve

    ATC
                   Firm exits if
          P<ATC
    Quantity

Figure 25: Competitive firm’s long-run supply curve

Measuring Profit and Loss

Profit is determine by subtracting total cost from total revenue. The firm maximizes profit
by producing the quantity at which the price equals marginal cost (Mankiw, 2014). 
      Price         MC
 ATC

     

    P       P=AR=MR

                    Profit
    ATC

   Q 1    Quantity
  Table 26: Competitive firm with profits 
Table 26 presents the competitive firm with profits. On the shaded rectangle, the height
of the rectangle is the difference between price and average total cost. Q is the profit-1
maximizing quantity. The width is the quantity to produced. The area of the rectangle is (P-ATC)

x Q which is the firm’s profit. 

      Price           MC       ATC

     
           

  ATC

                                           loss   
       P     P=AR=MR

    Q   Quantity

    Table 27: Competitive firm with losses

Maximizing profit means minimizing losses, a task accomplished once by producing the
quantity at which price equals marginal cost. The height of the rectangle is average total cost
less the price and the width is the quantity. The area is (ATC-P) x Q, which is the firm’s loss.
Because the firm in this situation is not making enough revenue to cover its average total cost,
the firm would choose to exit the market. Table 27 illustrates the competitive firm with losses.