Firms in Competitive

Markets

14

WHAT IS A COMPETITIVE
MARKET?
In a perfectly competitive market
There are many buyers
There are many sellers
Firms can freely enter or exit the market, in the long
run.
In the short run, the number of firms is assumed
fixed (constant).

All sellers sell the same product.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

WHAT IS A COMPETITIVE
MARKET?
As a result:
The actions of any single buyer or seller have
a negligible impact on the market price.
That is, the market price is unaffected by the
amount bought by a buyer or the amount sold by a
seller

Therefore, every buyer and every seller takes

the market price as given.
Everybody is a price taker

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Price takers
A firm in a perfectly competitive market cannot stay in
business if its price is higher than what the other firms are
charging
No firm would be able to raise the market price by
reducing production and attempting to create a shortage.
Conversely, there is no danger that a firm would drive the
market price down by producing too much.
Therefore, no firm would want to charge a price lower
than what the others are charging.
In short, each firm takes the prevailing market price as a
givenlike the weatherand charges that price.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Total Revenue of a Competitive Firm

Total revenue for a firm is the selling price
times the quantity sold.
TR = P Q
We saw this in Chapters 5 and 13

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Average Revenue of a Competitive Firm

Total revenue
Average Revenue =
Quantity
Price Quantity

Quantity
Price
Average revenue is the revenue per unit sold
P = AR.
This is simply because all units sold are sold at the
same price.
6

Marginal Revenue of a Competitive Firm

Marginal Revenue is the increase () in
total revenue when an additional unit is
sold.
MR = TR / Q

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

The Revenue of a Competitive Firm

In perfect competition, marginal revenue
equals price: P = MR.
We saw earlier that P = AR
Therefore, for all firms in perfect
competition, P = AR = MR

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Table 1 Total, Average, and Marginal Revenue for

a Competitive Firm

Note:
(a) P = AR = MR
9
(b) P does not fall as Q increases

Demand curves for the firm and the market (industry)

Jones and Peters, a firm

Price

Price

Market

Demand, P = AR = MR

Demand, P = AR
0

Quantity (firm)

The market price is P. No matter

what amount Jones and Peters
produces, the market price will not
change. Therefore, J&P will be
able to sell any feasible output if it
charges the price P.

Quantity (market)

The market demand curve is

negatively sloped, as usual. That
is, the market price, which is the
lowest prevailing price, is
inversely related to the quantity
10
demanded.

Supply
We have just seen
the demand curves
for a firm and for the
entire industry
Next, we need to
work out what the
supply curves look
like

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

11

Supply: short run and long run

The analysis of supply in perfect
competition depends on whether it is the
short run or the long run.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

12

Short run and long run: assumptions

The quantity of a resource used by a firm
may be fixed in the short run but not in the
long run.
Example: If a firm currently has three custom-made
machines and if it takes six months to get new
machines, then the firm is stuck with its three machines
for the next six months.

All fixed costs are sunk costs in the short

run but not in the long run
The number of firms in an industry is fixed
in the short run but not in the long run
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

13

Shut Down and Exit

Before a firm decides how much to supply,
it must decide whether or not to stay in
business
A shutdown refers to a short-run decision to
stop production temporarily, perhaps
because of poor market conditions.
Exit refers to a long-run decision to end
production permanently.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

14

The Firms Short-Run Decision to Shut Down

A firm will shut down (temporarily) if its
variable costs exceed its total revenue, no
matter what quantity it produces
Its fixed costs do not matter!
This is because
Fixed costs are sunk costs in the short run
sunk costs are defined as costs that will have to be
paid even if the firm shuts down.

Therefore, FC cannot affect a firms decision

on whether to stay open or shut down
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

15

Sunk Costs
Sunk costs will have to be paid even when
a firm is in a temporary shutdown.
Examples:
If the firm signs a long-term contract with its
landlord, the rent will have to be paid even when the
firm is temporarily shut down.
Some maintenance costs will have to be incurred
even when the firm is shut down.
The firm may be under contract to provide customer
service to past customers even after it shuts down.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

16

The Firms Short-Run Decision to Shut Down

Total Revenue = $1000 per month

Variable Cost = $800 per month
Fixed Cost = $400 per month
Profit = $200 per month (a loss)
Q: Should this firm stay in business or should it shut
down for the time being?
A: It should stay in business
If it shuts down, the fixed cost (say, rent owed to the landlord)
will still have to be paidbecause it is sunk!and the loss will
then be even higher, $400 per month.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

17

The Firms Short-Run Decision to Shut Down

Total Revenue = $1000 per month

Variable Cost = $1200 per month
Fixed Cost = $400 per month
Profit = $600 per month (a loss)
Q: Should this firm stay in business or should it
shut down for the time being?
A: It should shut down.

The lesson from this and the previous slide

is that
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

18

The Firms Short-Run Decision to Shut Down

A firm shuts down if total revenue is less
than variable cost, no matter what quantity
the firm produces. That is,
A firm shuts down if
TR < VC, no matter what Q is, or
TR/Q < VC/Q, no matter what Q is, or
P < AVC, no matter what Q is.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

19

A Firms Shut Down Decision

$

The firm stays open

because P > Minimum AVC

AVC
PH

Minimum AVC

Minimum AVC

PL

Quantity

0
The firm shuts down
because P < Minimum AVC

20

Table 2 Profit Maximization: A Numerical Example

Is it possible
to figure out
the profitmaximizing
output from
just the MR
and MC
numbers?

Yes, it is where
MR = MC.
21

Figure 1 Profit Maximization for a Competitive Firm

Costs
and
Revenue

The firm maximizes

profit by producing
the quantity at which
marginal cost equals
marginal revenue.

MC

MC2

We have seen before

that, as firms are price
takers in perfect
competition, P = AR =
MR.
We have also seen
that, profit
maximization implies
MR = MC.

ATC
P = MR1 = MR2

P = AR = MR
AVC
Therefore, P = AR =
MR = MC is the
fingerprint of perfect
competition

MC1

CHAPTER 14

Q1

QMAX

Q2

Quantity
22

PROFIT MAXIMIZATION AND THE

COMPETITIVE FIRMS SUPPLY CURVE
Profit maximization occurs at the
quantity where marginal revenue equals
marginal cost.
This is a crucial principle in understanding the
behavior of firms

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

23

PROFIT MAXIMIZATION AND THE

COMPETITIVE FIRMS SUPPLY CURVE
When MR > MC increase Q
When MR < MC decrease Q
When MR = MC Profit is maximized;
stick with this Q.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

24

Recall: The Supply Curve

Price

Supply
P2

P1

Q1

Q2

Quantity

25

Figure 2 Marginal Cost as the Competitive Firms

Supply Curve
Price

P2

This section of the

firms MC curve is
also the firms supply
curve.

MC

ATC

P1
AVC

Q1

Q2

Quantity

26

Figure 3 The Competitive Firms Short Run Supply

Curve
Costs
If P > ATC, the firm
will continue to
produce at a profit.

Firms short-run
supply curve

MC

ATC
If P > AVC, firm will
continue to produce
in the short run.

Firm
shuts
down if
P < AVC

AVC

What can shift the supply

curve to the right?
0

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Quantity
27

The Short Run: Market Supply with a Fixed

Number of Firms
The market supply curve is the horizontal
sum of the individual firms short run supply
curves.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

28

Figure 6 Market Supply with a Fixed Number of Firms

(a) Individual Firm Supply

(b) Market Supply (# of firms fixed)

Price

Price

MC

Supply

$2.00

$2.00

1.00

1.00

100

200

Quantity (firm)

100,000

200,000 Quantity (market)

Q: What is the number of firms?

29
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Short-Run Equilibrium: back where we began!

(a) Individual Firm Supply

(b) Market Supply (# of firms fixed)

Price

Price

MC

Supply

$2.00

$2.00

1.00

1.00

DemandL
0

100

200

Quantity (firm)

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

100,000

DemandH

200,000 Quantity (market)

30

Price = Minimum ATC; profit = zero; demand has no effect on price,

and no effect on the quantity produced by a firm; demand does
affect the quantity produced by the industry, and the number of
firms in the industry

THE LONG RUN

31

The Firms Long-Run Decision to Exit or

Enter a Market
In the long run, the firm exits if it sees that
its total revenue would be less than its total
cost no matter what quantity (Q) it might
produce
That is, a firm exits if
TR < TC, no matter what Q is.
TR/Q < TC/Q , no matter what Q is.
P < ATC , no matter what Q is.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

32

The Firms Long-Run Decision to Exit or

Enter a Market
A new firm will enter the industry if it can
expect to be profitable.
That is, a new firm will enter if
TR > TC for some value of Q
TR/Q > TC/Q for some value of Q
P > ATC for some value of Q

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

33

Entry and Exit of Firms in the Long-Run

$

The number of firms will

stabilize when P = Minimum
ATC. This is the long run price!
New firms will enter
because P > Minimum ATC
ATC

PH
Minimum ATC

PL
0

Minimum ATC
This is the efficient scale output.
This is each firms long-run
equilibrium output!

Existing firms will exit

because P < Minimum ATC

Quantity
34

Figure 4 The Competitive Firms Long-Run Supply

Curve
Costs
Firms long-run
supply curve

Firm
enters if
P > ATC

MC = long-run S

ATC

Firm
exits if
P < ATC

0
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Quantity
35

THE SUPPLY CURVE IN A

COMPETITIVE MARKET
A Firms Short-Run
Supply Curve
The portion of its (short
run) marginal cost curve
that lies above the (short
run) average variable cost
curve.

MC
ATC
AVC

A Firms Long-Run Supply

Curve
The portion of its (long run)
marginal cost curve that
lies above the (long run)
average total cost curve.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

ATC

36

Long-Run Equilibrium
Price

Price

Market
Demand

ATC

$1.50

P = Minimum ATC = $1.50

200
(efficient
scale)

Quantity
(firm)

This is it, as far as long-run equilibrium is concerned!

How many firms are there in long-run equilibrium?
What would happen if demand moves left (decreases)?
What could cause prices to increase?

6,000 Quantity
(industry)
P = AR = MR = MC = ATC is the
fingerprint of perfect competition in
the long run.
37

A Firms Profit
Profit equals total revenue minus total
costs.

Profit = TR TC
Profit/Q = TR/Q TC/Q
Profit = (TR/Q TC/Q) Q
Profit = (P ATC) Q

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

38

Figure 5 Profit as the Area between Price and Average

Total Cost
(a) A Firm with Profits
Price
MC

ATC

Profit
P

ATC

P = AR = MR

Quantity
Q
(profit-maximizing quantity)

39

Figure 5 Profit as the Area between Price and Average

Total Cost
(b) A Firm with Losses
Price

MC

ATC

ATC
P

P = AR = MR
Loss

Q
CHAPTER 14 FIRMS IN COMPETITIVE
MARKETS
(loss-minimizing
quantity)

Quantity
40

The Long Run: Market Supply with Entry and

Exit
Firms will enter or exit the market until profit
is driven to zero.
Price equals the minimum of average total
cost.
The long-run market supply curve is a
horizontal line at this price.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

41

Figure 7 Market Supply with Entry and Exit

(a) Firms Zero-Profit Condition

(b) Market Supply (# of firms variable)

Price

Price

MC
ATC
P = minimum
ATC

Supply

Quantity (firm)

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Quantity (market)

42

Why Do Competitive Firms Stay in Business

If They Make Zero Profit?
Profit = TR TC
Total cost = explicit cost + implicit cost.
Profit = 0 implies TR = explicit cost +
implicit cost
In the zero-profit equilibrium, the firm earns
enough revenue to compensate the owners
for the time and money they spend to keep
the business going.
So, dont feel sorry for the owners!
43

Recap: Economic and Accountants

How an Economist
Views a Firm

How an Accountant
Views a Firm

Economic
profit
Accounting
profit

Revenue

Implicit
costs

Revenue
Total
opportunity
costs

Explicit
costs

Explicit
costs

44

Application
We will now work through what happens
when the demand for a product increases.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

45

Short Run and Long Run Effects of a Shift in

Demand: an application
An increase in demand raises price and quantity
(for each firm and the industry) in the short run.
Firms earn positive profits
because price now exceeds average total cost.

New firms enter

Market supply increases (shifts right)
Price decreases; gradually returns to minimum ATC
Profits decrease; gradually return to zero
So, the long-run effect of an increase in demand is
as follows: the price is unchanged, each firms
output is unchanged, the number of firms
increases, industry output increases.
46

Figure 8 An Increase in Demand in the Short Run and

Long Run

(a) Initial zero-profit long-run equilibrium

Market

Firm
Price

Price

MC

ATC

Short-run supply, S1
A

P1

Long-run
supply

P1

Demand, D1
0

q1

Quantity (firm)

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Q1

Quantity (market)

47

Figure 8 An Increase in Demand in the Short Run and

Long Run
(b) Short-Run Response to an increase in demand
Market

Firm

Price

Price

Profit

MC

ATC

P2

P2

S1

P1

P1
D2

Long-run
supply

D1
0

q1

q2

Quantity (firm)

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

Q1

Q2

Quantity (market)

48

Figure 8 An Increase in Demand in the Short Run and

Long Run
(c) Long-Run Response to positive short-run profits: new firms enter,
pushing the short-run market supply to the right.
Market

Firm
Price

Price

MC

ATC

P2

S1
S2
C

P1

Long-run
supply

P1
D2
D1

q1

Quantity (firm)

Q1

Q2

Q3 Quantity (market)

An increase in demand leads to an increase in price in the short run. But this
price increase will not last. New firms will enter and push the price back to P1,
the minimum ATC. Each firms output will return to q1. The only long-run effect 49
of
demand will be to increase the number of firms.

Any Questions?

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

50

Summary
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 firms
average revenue and its marginal revenue.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

51

Summary
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 firms marginal cost curve is
its supply curve.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

52

Summary
In the short run, when a firm cannot recover
its fixed costs, the firm will choose to 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 choose
to exit if the price is less than average total
cost.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

53

Summary
In a market with free entry and exit, profits
are driven to zero in the long run and all
firms produce at the efficient scale.
Changes in demand have different effects
over different time horizons.
In the long run, the number of firms adjusts
to drive the market back to the zero-profit
equilibrium.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

54