Professional Documents
Culture Documents
Rashwan
Principles of
Economics Arab World Edition
Chapter 14
Firms in Competitive
Markets
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In this chapter,
look for the answers to these questions:
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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, how many workers to hire, etc.
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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Characteristics of Perfect Competition
1. Many
1. Many buyers
buyers and
and many
many sellers.
sellers.
2. The
2. The goods
goods offered
offered for
for sale
sale are
are largely
largely the
the same.
same.
3. Firms
3. Firms can
can freely
freely enter
enter or
or exit
exit the
the market.
market.
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The Revenue of a Competitive Firm
Total revenue (TR) TR = P x Q
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ACTIVE LEARNING 1
Calculating TR, AR, MR
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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ACTIVE LEARNING 1
Answers
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n/a
$10
1 $10 $10 $10
Notice that $10
2 $10
Notice
$20
that$10
MR
MR == PP $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
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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.
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Profit Maximization
What Q maximizes the firm’s profit?
To find the answer, “think at the margin.”
If we 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
(continued from earlier exercise)
Q TR TC Profit MR MC
Profit =
At any Q with 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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MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
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MC and the Firm’s Supply Decision
If price rises to P2,
then the profit- Costs
maximizing quantity MC
rises to Q2.
P2 MR2
The MC curve
determines the firm’s
Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2
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Shutdown vs. Exit
Shutdown:
A short-run decision not to produce anything
because of market conditions.
Exit:
A long-run decision to leave the market.
A key difference:
If shut down in SR, must still pay FC.
If exit in LR, zero costs.
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A Firm’s Short-run Decision to Shut Down
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A Competitive Firm’s SR Supply Curve
The firm’s SR supply
curve is the portion of
its MC curve above AVC. Costs
MC
If P > AVC, then
firm produces Q ATC
where P = MC.
AVC
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The Irrelevance of Sunk Costs
Sunk cost: a cost that has already been
committed and cannot be recovered.
Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
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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A Firm’s Long-Run Decision to Exit
Cost of exiting the market: revenue loss = TR
Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
So, firm exits if TR < TC
Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ATC
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A New Firm’s Decision to Enter Market
In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC
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The Competitive Firm’s Supply Curve
The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC
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ACTIVE LEARNING 2
Identifying a firm’s profit
A competitive firm
Questions:
Costs, P
1. Determine this
MC
firm’s total profit.
P = $10 MR
2. Identify the
ATC
area on the graph
that represents $6
the firm’s profit.
Q
50
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ACTIVE LEARNING 2
Answers
A competitive firm
Costs, P
Profit per unit MC
P = $10 MR
= P – ATC ATC
= $10 – 6 profit
= $4 $6
Total profit
= (P – ATC) x Q
= $4 x 50 Q
50
= $200
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ACTIVE LEARNING 3
Identifying a firm’s loss
Q
30
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ACTIVE LEARNING 3
Answers
A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR
Q
30
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CONCLUSION:
The Efficiency of a Competitive Market
Profit-maximization: MC = MR
Perfect competition: P = MR
So, in the competitive equilibrium: P = MC
Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
So, the competitive equilibrium is efficient,
maximizes total surplus.
In the next chapter we look at monopoly: pricing and
production decisions, deadweight loss, regulation.
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S U M MA RY