ECON 101:

Introduction to
Microeconomics
Lesson 18
Chapter 14: Firms in Competitive Markets

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Objectives
By the end of this lesson, students will be able to answer the
following questions:
• What is a perfectly competitive market?
• What is marginal revenue? How is it related to total and
average revenue?
• How does a competitive firm determine the quantity that
maximizes profits?
• When might a competitive firm shut down in the short run?
Exit the market in the long run?

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Rationale
• In previous lessons, we learned about the costs of production.
Now, we will explore the production decisions of firms in
competitive markets and the production outcomes under
different price and cost combinations.

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Prior Knowledge
An understanding of:
• Production function and marginal function and how they are
related
• Various costs and how they are related to each other and to
outputs
• How costs are different in the short run versus the long run
• “Economies of scale”

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Introduction: A Scenario
• Three years after graduating, you run your own business.
• You must decide how much to produce, what price to charge, and
how many workers to hire.
• What factors should affect these decisions?
• Your costs (studied in preceding chapter)
• How much competition you face
• We begin by studying the behavior of firms in perfectly competitive
markets.

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WHAT IS A COMPETITIVE MARKET?
• A competitive market has many buyers and sellers trading
identical products so that each buyer and seller is a price taker.
– Buyers and sellers must accept the price determined by the
market.

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The Meaning of Competition
• A perfectly competitive market has the following characteristics:
• There are many buyers and sellers in the market.
• The goods offered by the various sellers are largely the same.
• Firms can freely enter or exit the market.
• Which means that the government does not restrict the
number of firms in the market

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The Meaning of Competition
• As a result of its characteristics, the perfectly competitive market
has the following outcomes:
• The actions of any single buyer or seller in the market have a
negligible impact on the market price.
• Each buyer and seller takes the market price as given.

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The Revenue of a Competitive Firm
• Total revenue for a firm is the selling price times the quantity sold.

• TR = (P  Q)

• Total revenue is proportional to the amount of output.

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The Revenue of a Competitive Firm
• Average revenue tells us how much revenue a firm receives for
the typical unit sold.

• Average revenue is total revenue divided by the quantity sold.

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The Revenue of a Competitive Firm
• In perfect competition, average revenue equals the price of the
good.
Total revenue
Average Revenue=
Quantity
Price  Quantity
=
Quantity

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The Revenue of a Competitive Firm
• In perfect competition, average revenue equals the price of the
good.

= Price

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The Revenue of a Competitive Firm
• Marginal revenue is the change in total revenue from an additional
unit sold.
∆TR
MR =
∆Q

• For competitive firms, marginal revenue equals the price of the

good.

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The Revenue of a Competitive Firm
• Total revenue (TR) TR = P x Q

TR
• Average revenue (AR) AR = =P
Q

• Marginal Revenue (MR): ∆TR

The change in TR from MR =
∆Q
selling one more unit.

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ACTIVE LEARNING 1: Revenue Exercise
Fill in the empty spaces of the table.

Q P TR AR MR

0 $10 n.a.

1 $10 $10

2 $10

3 $10

4 $10 $40
$10
5 $10 $50
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Short Answer: Revenue Exercise
What is the marginal revenue of the 1st unit?

Type your response

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Short Answer: Revenue Exercise
What is the marginal revenue of the 4th unit?

Type your response

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Whiteboard: Revenue Exercise

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MR = P for a Competitive Firm
• A competitive firm can keep increasing its output without affecting
the market price.
• So, each one-unit increase in Q causes revenue to rise by P,
i.e., MR = P.

MR = P is only true for

firms in competitive markets.

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PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
• The goal of a competitive firm is to maximize profit.
• This means that the firm will want to produce the quantity that
maximizes the difference between total revenue and total
cost.

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Poll: Marginal Cost
Refer to the table

What is the marginal cost of

producing of the 4th unit?
A. $10
B. $18
C. $20
D. $82

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Whiteboard: Marginal Cost

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Profit Maximization
• What Q maximizes the firm’s profit?
• To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
• If MR > MC, then increase Q to raise profit.
• If MR < MC, then reduce Q to raise profit.

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Profit Maximization
Profit =
At any Q with Q TR TC Profit MR MC
MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

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The Marginal Cost-Curve and the Firm’s
Supply Decision
• Profit maximization occurs at the quantity where marginal revenue
equals marginal cost.
• When MR > MC, increase Q
• When MR < MC, decrease Q
• When MR = MC, profit is maximized.

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Poll: Units
Refer to the table

Assume that the firm can sell any

output at the market price of $21. To
maximize profit or minimize loss, the
firm will produce
A. 3 units
B. 4 units
C. 5 units
D. 6 units
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Whiteboard: Units

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Marginal Cost and the Firm’s Supply
Decision
Rule: MR = MC at the profit-maximizing Q.

At Qa, MC < MR. Costs

So, increase Q MC
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit. P1 MR

At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q 1 Qb
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Marginal Cost and the Firm’s Supply
Decision
Costs
If price rises to P2, MC
then the profit-maximizing P2 MR2
quantity rises to Q2.
The MC curve determines the
firm’s Q at any price. Hence, P1 MR

The MC curve is the

firm’s supply curve. Q
Q1 Q2

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Figure 1: Profit Maximization for a Competitive Firm
Costs
and The firm maximizes Suppose the market price is P.
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue.
If the firm produces
MC2 Q2, marginal cost is
MC2.
ATC
P = MR1 = MR2 P = AR = MR
AVC

MC1 If the firm

produces Q1,
marginal cost is
MC1.

0 Q1 QMAX Q2 Quantity
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Figure 2: Marginal Cost as the Competitive Firm’s Supply
Curve As P increases, the firm will
Price select its level of output
So, this section of the along the MC curve.
firm’s MC curve is
also the firm’s supply MC
curve.
P2

ATC
P1
AVC

0 Q1 Q2 Quantity 31
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Shutdown Versus Exit
• Shutdown:
A short-run decision not to produce anything because of market
conditions.
• Exit:
A long-run decision to leave the market.

• A firm that shuts down temporarily must still pay its fixed costs. A
firm that exits the market does not have to pay any costs at all,
fixed or variable.

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The Firm’s Short-Run Decision to Shut Down
• The firm shuts down if the revenue it gets from producing is less
than the variable cost of production.
• Shut down if TR < VC
• Divide both sides by Q:
• Shut down if TR/Q < VC/Q
• Therefore,
• Shut down if P < AVC

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Figure 3: The Competitive Firm’s Short-Run
Supply Curve
Costs
Firm’s short-run
If P > ATC, the firm supply curve MC
will continue to
produce at a profit.

ATC

If P > AVC, firm will

continue to produce AVC
in the short run.

Firm
shuts
down if
P < AVC
0 Quantity
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Spilt Milk and Other Sunk Costs
• The firm considers its sunk costs when deciding to exit but ignores
them when deciding whether to shut down.
• Sunk costs are costs that have already been committed and
cannot be recovered.
• FC is a sunk cost: The firm must pay its fixed costs whether it
produces or shuts down.
• So, FC should not matter in the decision to shut down.

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The Firm’s Short-Run Decision to Shut Down
• The portion of the marginal cost curve that lies above average
variable cost is the competitive firm’s short-run supply curve.

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A Competitive Firm’s Short-Run Supply Curve
The firm’s SR
supply curve is Costs
the portion of MC
its MC curve
above AVC. If P > AVC, then
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

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The Firm’s Long-Run Decision to Exit or
Enter a Market
• In the long run, the firm exits if the revenue it would get from
producing is less than its total cost.
• Exit if TR < TC
• Again, divide both sides by Q:
• Exit if TR/Q < TC/Q
• Therefore,
• Exit if P < ATC

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The Firm’s Long-Run Decision to Exit or
Enter a Market
• A firm will enter the industry if such an action would be profitable.
• Enter if TR > TC
• Again, divide both sides by Q:
• Enter if TR/Q > TC/Q
• Therefore,
• Enter if P > ATC

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Figure 4: The Competitive Firm’s Long-Run
Supply Curve
Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity
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ACTIVE LEARNING 2A: Identifying a Firm’s
Profit
A competitive firm
Determine this firm’s Costs, P
total profit. MC
Identify the area on the P = $10 MR
graph that represents ATC
the firm’s profit. $6

Q
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Whiteboard: Identifying a Firm's Profit

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ACTIVE LEARNING 2B: Identifying a Firm’s
Profit or Loss
A competitive firm

What is this firm’s Costs, P

profit or loss? MC

ATC

$5
P = $3 MR

Q
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Short Answer: Identifying a Firm’s Profit or
Loss

Refer to the graph:

What is this firm’s

profit or loss?

Type your response

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Whiteboard: Identifying a Firm's Profit or Loss

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Market Supply: Assumptions
1) All existing firms and potential entrants have identical costs.
2) Each firm’s costs do not change as other firms enter or exit the
market.
3) The number of firms in the market is
• Fixed in the short run
(due to fixed costs)
• Variable in the long run
(due to free entry and exit)

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1-MINUTE RESPONSE

What was the most important thing you learned today

and what did you understand the least?
Respond in the online classroom.

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Summary of this Lesson
• Because a competitive firm is a price taker, its revenue is
proportional to the amount of output it produces.
• The price of the good equals both the firm’s average revenue and
its marginal revenue.
• To maximize profit, a firm chooses the quantity of output such
that marginal revenue equals marginal cost.
• This is also the quantity at which price equals marginal cost.
• Therefore, the firm’s marginal cost curve is its supply curve.
• In the short run, when a firm cannot recover its fixed costs, the
firm will shut down temporarily if the price of the good is less than
average variable cost.
• In the long run, when the firm can recover both fixed and variable
costs, it will exit if the price is less than average total cost.
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Post-work for Lesson 18
• After the Live Lecture, please review your notes and reflect on
the lesson content. Then, go to the online classroom for details
about the required resources.

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To Prepare for the Next Lesson
• Complete the post-work for Lesson 18
• Complete the pre-work for Lesson 19
• Read the required readings for Lesson 19

Go to the online classroom for details.

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