Perfectly Competitive Markets

The amount of good or service a firm supplies to a market depends on

• firm’s goals (profit maximization)
• firm’s technology (firm’s production/cost function)
• market structure

We now examine firm behaviour and outcomes in perfectly competitive markets

A perfectly competitive market has the following characteristics

1. many firms selling identical products to many buyers
2. sellers and buyers are well informed about prices
3. established firms have no advantage over new firms
4. firms are free to enter and/or exit market in the long run

Lecture 9: page 1

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Firm Demand and Marginal Revenue
In a perfectly competitive market
• there are many independent sellers, each of which accounts for only a small portion of the quantity
exchanged
• there are many independent buyers, each of which accounts for only a small portion of the quantity
exchanged

Hence, the decisions of individual sellers and individual buyers cannot influence the market price; ie, the
sellers and buyers are price takers

Price of Market Price of Firm

wheat wheat
($/MT) ($/MT)
S

260 260 D

0 0
0 770 Wheat 0 10 20 30 40 Wheat
(106 MT/yr) (103 MT/yr)

Since the firm sells every unit it produces at the market price, the firm’s total revenue (TR) is the
market price, p, times the firm’s output, q:

TR = p × q

The firm’s marginal revenue (MR) is

∆TR
MR = =p
∆q

Lecture 9: page 2

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Profit Maximization
Although firms in competitive markets are price takers, they must choose how much to produce

We assume all firms set output level, q, to maximize economic profit

ı = TR − TC

where ı is the firm’s profit, TR is the firm’s total revenue, and TC is the firm’s total cost

Can think of firms using a two-step process to determine their profit-maximizing output level
Step 1: determine which positive output level (ie, q > 0) maximizes the firm’s profit
Step 2: check if q = 0 generates more profit than producing the output level determined in Step 1

In Step 1 firm compares its marginal revenue to its marginal cost

• if MR > MC, increasing q by one unit will increase ı
• if MC > MR, decreasing q by one unit will increase ı

If q > 0, firm must operates at an output level where MR = MC to maximize profit

The figure below shows a typical U-shaped marginal cost curve for a firm operating in a perfectly
competitive market

$/unit MC

p̄

0 q
0 q1 q2

If the market price is p̄, there are two output levels, q1 and q2 , at which MR = MC

REMARK To maximize profit, a firm must operate to an output level where MR = MC and MC is
increasing. For a firm in a perfectly competitive market, MR = p. Therefore, a profit-maximizing firm
in a perfectly competitive market should operate at an output level where p = MC and MC is increasing

Lecture 9: page 3

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Firm Supply in the Short Run
In the short run, a firm should either
• produce q > 0, where p = MC and MC is increasing
• produce q = 0

REMARK In the short run, if a firm shuts down and produces q = 0, the firm remains the market
and must cover its fixed costs. Shutting down is not the same as exiting a market, which is something
a firm can only do in the long run when all inputs are variable

If the firm produces where q > 0, p = MC and MC is increasing, the firm’s short-run profit is

ı = TR − (TVC + TFC)

On the other hand, if the firm shuts down (ie, q = 0), it generates no revenue (ie, TR = 0) and incurs
no variable costs (ie, TVC = 0), so the firm’s short-run profit is

ı = −TFC

The firm should shut down if doing so generates a profit greater than the alternative; ie, the firm should
shut down if

−TFC > TR − TVC − TFC

which we can express as

TVC > TR ⇒ TVC > pq ⇒ TVC=q > pq=q

So the firm should shut down if

AVC > p

But since the firm’s AVC depends of its output level, the firm should shut down if

AVCmin > p

Lecture 9: page 4

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The figure below shows a competitive firm’s short-run cost curves and its profit-maximizing output level
for different market prices

$/unit
MC

ATC
p5

p4 AVC

p3
p2
AVCmin
p1

0 q
0 q1 q2 q4
q3 q5

The short-run supply curve of a firm operating in a competitive market comprises the segment of the
y-axis below its minimum AVC and the segment of its MC curve that sits above the its minimum AVC

$/unit
MC
S = MC

AVC

AVCmin

0 q
0 q̄

Lecture 9: page 5

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Firm Profit in the Short Run
For a firm in a competitive market

ı = TR − TC
= pq − TC
„ «
pq TC
=q −
q q
= q(p − ATC)

$/unit
MC

ATC
p∗
AVC
∗
ATC

0
0 q∗
Output

$/unit
MC

ATC

AVC
∗
ATC
p∗

0
0 q∗
Output

Lecture 9: page 6

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 $/unit
MC

ATC

AVC
∗
p∗ = ATC ATCmin

0 Output
0 q∗

So, in the short run, a competitive firm with a positive output level may have positive, negative, or zero
economic profit depending on how the market price compares to the firm’s average total cost
• profit is positive if p > ATC
• profit is negative if p < ATC
• profit is zero if p = ATC

Lecture 9: page 7

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Market Supply in the Short Run
In the short run, at least one input needed for production is fixed, which implies
• the number of firms in the market is fixed
• the aggregate quantity supplied at any given price is just the sum of quantities supplied by those
firms

To illustrate, assume the market contains 50 identical firms that have access to the same production
technologies and inputs at the same prices, and therefore have identical costs and supply curves

P P
One firm S 50 firms
S
40 40

30 30

20 20

10 10
4 4
q Q
3 6 11 16 21 150 300 550 800 1050

Lecture 9: page 8

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Firm Supply in the Long Run
In the long run, a firm should either
∆MC LR
• produce q > 0, where p = MC LR and >0
∆q
• produce q = 0

In the long run, a firm that produces no output (ie, q = 0) lays off all of its workers, liquidates all of its
assets, and exits the market

∆MC LR
If the firm produces where q > 0, p = MC LR and > 0, the firm’s long-run profit is
∆q
ı = TR − TC

On the other hand, if the firm exits the market (ie, q = 0), it generates no revenue (ie, TR = 0) and
incurs no costs (ie, TC = 0), so the firm’s long-run profit is zero
ı=0

The firm should exit the market if doing so generates a profit greater than the alternative; ie, the firm
should exit if
0 > TR − TC ⇒ TC > TR ⇒ TC > pq ⇒ TC=q > pq=q

So the firm should exit if

ATC > p

But since the firm’s long-run ATC depends of its output level, the firm should exit if
LR
ATCmin >p

$/unit
MC LR = S LR

ATC LR

LR
ATCmin

0 q
0 q∗

Lecture 9: page 9

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Equilibrium in the Long Run
In a competitive market in the long run, new firms are free to enter market and incumbent firms are free
exit the market

A firm’s economic profit, ı, is defined as

ı = TR − TC

where ı is the firm’s profit, TR is the firm’s total revenue, and TC is the firm’s total cost, where those
costs reflect the opportunity costs of the firm’s inputs

If ı > 0 for firms in the market, one or more new firms will enter the market, which will
• increase supply in the market
• drive down the market price
• decrease the profit of firms in the market
So a competitive market where firms enjoy positive economic profit (ie, ı > 0) cannot be in long-run
equilibrium

If ı < 0 for firms in the market, one or more firms will exit the market, which will
• decrease supply in the market
• drive up the market price
• increase the profit of firms in the market
So a competitive market where firms suffer economic losses (ie, ı < 0) cannot be in long-run equilibrium

If ı = 0 for firms in the market

• no new firms will enter the market
• no incumbent firms will exit the market
So a competitive market where firms earn zero economic profit (ie, ı = 0) can be in long-run equilibrium

Hence, for competitive market in long-run equilibrium, the profit of all incumbent firms must be zero
“ ”
ı = q p − ATC LR = 0 ⇒ p = ATC LR

Lecture 9: page 10

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 $/unit
MC LR = S LR

ATC LR

LR
ATCmin

0 q
0 q∗

CONCLUSION The requirement that firm profit be zero in long-run equilibrium implies: (1) every firm
must be operating at the minimum point on its ATC LR curve (ie, operating at the efficient scale of
LR
production); and (2) the equilibrium market price in the long run must equal ATCmin

Lecture 9: page 11

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Market Supply in the Long Run
We now derive the long-run market supply curve by examining how a competitive market in long-run
equilibrium would respond to an increase in demand

Market Firm
Price $/unit

MC SR
S0SR
S1SR ATC LR
b ATC SR
48 48
a c
34 34

D0 D1
0 Q 0 q
0 600 700 0 10
660 11

The market is initial long-run equilibrium at point (a) where

• the market price is $34
• the quantity exchanged in the market, Q, is 600 units
• each firm is earning zero economic profit (ı = 0) and operating at the efficient scale of production,
with q = 10)
• there are n = Q=q = 600=10 = 60 firms in the market
• supply curve S0SR is the aggregate supply of the 60 firms in the short-run

If something causes demand to increase from D0 to D1 , the market transitions to a short-run equilibrium
at point (b) where
• the market price is $48
• the quantity exchanged in the market, Q, is 660 units
• each firm is earning a positive economic profit (ı > 0) and producing q = 11
• there are still n = Q=q = 660=11 = 60 firms in the market

Lecture 9: page 12

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 Market Firm
Price $/unit

MC SR
S0SR
S1SR ATC LR
b ATC SR
48 48
a c
34 34

D0 D1
0 Q 0 q
0 600 700 0 10
660 11

The positive profits of incumbent firms results in the entry of new firms in the long run, increasing supply
and driving down price

New firms enter until the profit of incumbent firms is driven back to zero; so the entry of new firms
drives the price back to $34

Eventually, a new long-run equilibrium is established at point (c) where

• the market price is $34
• the quantity exchanged in the market, Q, is 700 units
• each firm is earning zero economic profit (ı = 0) and operating at the efficient scale of production,
with q = 10)
• there are n = Q=q = 700=10 = 70 firms in the market
• supply curve S1SR is the aggregate supply of the 70 firms in the short-run

Lecture 9: page 13

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By definition, the market long-run supply curve is the relationship between the market price p and the
aggregate quantity supplied in the long run

The above analysis identified two points on long-run market supply curve, each of which corresponds to
a long-run market equilibrium
• point a: p = $34 and Q = 600
• point c: p = $34 and Q = 700

Market Firm
Price $/unit

MC SR
S0SR
S1SR ATC LR
b ATC SR
48 48
a c
34 S LR 34

D0 D1
0 Q 0 q
0 600 700 0 10
660 11

Lecture 9: page 14

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