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Microeconomics
Tutorial 7

Olga Petranevskaya
Perfectly competitive market 2
 » The industry is fragmented. It consists of many
buyers and sellers. Each buyer’s purchases are so
small that they have an imperceptible effect on
market price.

Characteristics of PCM 3
 » Firms produce undifferentiated products. That is,
consumers perceive the products to be identical
no matter who produces them

Characteristics of PCM 4
 » Consumers have perfect information about prices
all sellers in the market charge.

Characteristics of PCM 5
» The industry is characterized by equal access to
resources. All firms—those currently in the industry,
as well as prospective entrants—have access to the
same technology and inputs. Firms can hire inputs,
such as labor, capital, and materials, as they need
them, and they can release them from their
employment when they do not need them.

Characteristics of PCM
» The market is fragmented—implies that sellers
and buyers act as price takers. That is, a firm takes
the market price of the product as given when
making an output decision, and a buyer takes the
market price as given when making purchase
decisions.

Implications for How 7

PCM works
» Firms produce undifferentiated products and
consumers have perfect information about prices—
implies a law of one price: Transactions between
buyers and sellers occur at a single market price.
Because the products of all firms are perceived to be
identical and the prices of all sellers are known, a
consumer will purchase at the lowest price available in
the market.

Implications for How 8

PCM works
» Equal access to resources—implies that the industry is
characterized by free entry. That is, if it is profitable for
new firms to enter the industry, they will eventually do
so.

Implications for How 9

PCM works
Profit maximization 10
accounting profit = sales revenue + accounting costs

economic profit = sales revenue + economic costs

Profit maximization 11
 economic profit = sales revenue + economic costs

economic profit is the difference between a firm’s sales

revenue and the totality of its economic costs,
including all relevant opportunity costs

economic profit 12
Profit-maximizing
output choice for
price-taking firm. 13
π= TR(Q) – TC(Q)

TR(Q)=P*Q
TC(Q)=VC+FC

Profit 14
Price-taker company takes the market price
P as given. Its goal is to choose a quantity of
output Q to maximize its total profit

Profit 15
Total Revenue, Cost, and Profit for a Price- 16

taking Rose Producer

»  

For any firm (price taker or not), the rate at

which total revenue changes with respect
to a change in output

MR=

Marginal revenue 17
»  

MR=

» For a price-taking firm, each additional unit sold

increases total revenue by an amount equal to the
market price—that is, =P. Thus, for a price-taking
firm, marginal revenue is equal to the market price,
or MR=P.

Marginal revenue 18
»  

MC=

» Increasing the quantity in this range increases

total revenue faster than total cost: > , or
P>MC.

Marginal costs 19
 P=MC
a price-taking firm maximizes its profit when it
produces a quantity Q* at which the marginal
cost equals the market price

Marginal costs 20
 21
Profit Maximization by a Price-Taking Firm
 » P =MC.
» MC must be increasing

Price-maximization conditions
for price-taking firm: 22
»   STC(Q)=

Price-taking firm’s short run

cost structure 23
» VC(Q) represents total variable costs. Total variable
costs are zero if the firm produces zero output and
thus are examples of nonsunk costs.
» SFC represents the firm’s sunk fixed costs. A sunk fixed
cost is a fixed cost that a firm cannot avoid if it
temporarily suspends operations and produces zero
output.
» NSFC represents the firm’s nonsunk fixed costs. A
nonsunk fixed cost is a fixed cost that must be incurred
if the firm is to produce any output, but it does not
have to be incurred if the firm produces no output.

Price-taking firm’s short run 24

cost structure
 when all fixed costs are sunk—that is, NFSC =0 and thus TFC = SFC

short-run supply curve tells us how its profit-maximizing output

decision changes as the market price changes.

SHORT-RUN SUPPLY CURVE FOR A PRICE-

TAKING FIRM WHEN ALL FIXED COSTS ARE 25

SUNK
 SHORT-RUN SUPPLY CURVE FOR A PRICE-
TAKING FIRM WHEN ALL FIXED COSTS ARE 26

SUNK
The firm is better off cutting its losses by temporarily
shutting down if the market price P is less than the
average variable cost AVC(Q*) at the output level Q* at
which P equals short-run marginal cost, or P <AVC(Q*).

• A profit-maximizing price-taking firm, if it produces

positive output, produces
where P=SMC and SMC slopes upward.
• A profit-maximizing price-taking firm never produces
where P<AVC.

SHORT-RUN SUPPLY CURVE FOR A PRICE-

TAKING FIRM WHEN ALL FIXED COSTS ARE 27

SUNK
If the market price is less than the minimum level of AVC
—a level we denote by Ps the firm will supply zero
output (i.e., Q =0).

Ps - the firm’s shutdown price, the price below which it

produces a quantity of zero in the short run.

If the market price is greater than PS, the firm will

produce a positive amount of output, and its short-run
supply curve will coincide with its short-run marginal
cost curve.
SHORT-RUN SUPPLY CURVE FOR A PRICE-
TAKING FIRM WHEN ALL FIXED COSTS ARE 28

SUNK
Task 1 29
In each of the following situations, do you think the
industry described will be perfectly competitive or not?

Dozens of designers sell high - fashion clothes. Each

designer has a distinctive style and a loyal clientele.
In each of the following situations, do you think the
industry described will be perfectly competitive or not?

There are many baseball teams in the United States,

one or two in each major city and each selling tickets to
its hometown events.
»  

» Optimal output rule: MR=MC

» Price-taking firm’s optimal output rule P=MC
Profit is equal to total revenue minus total cost, TR −
TC. This means:

» If the firm produces a quantity at which TR > TC, the

firm is profitable.
» If the firm produces a quantity at which TR = TC, the
firm breaks even.
» If the firm produces a quantity at which TR < TC, the
firm incurs a loss
We can also express this idea in terms of revenue and
cost per unit of output.
Profit/Q = TR/Q − TC/Q
TR/Q is average revenue, which is the market price.
TC/Q is average total cost.

» If the firm produces a quantity at which P > ATC, the

firm is profitable.
» If the firm produces a quantity at which P = ATC, the
firm breaks even.
» If the firm produces a quantity at which P < ATC, the
firm incurs a loss.
The break - even price of a price - taking firm is the
market price at which it earns zero profit.

A firm will cease production in the short run if the

market price falls below the shut - down price, which is
equal to minimum average variable cost.
 Profitability condition (min Result
ATC=break-even point)
P> min ATC Firm profitable. Entry into industry in the
long run.
P= min ATC Firm breaks even. No entry into or exit
from industry in the long run.
P< min ATC Firm unprofitable. Exit from industry in the
long run.

Profitability condition (min Result

AVC= shut-down price)
P> min AVC Firm produces in the short run. If P <
minimum ATC, firm covers variable cost and
some but not all of fixed cost. If P >
minimum ATC, firm covers all variable cost
and fixed cost.
P= min AVC Firm indifferent between producing in the
short run or not. Just covers variable cost.
P< min AVC Firm shuts down in the short run. Does not
cover variable cost.
Task 2
Kate’s Katering provides catered meals, and the catered meals
industry is perfectly competitive. Kate’s machinery costs $100 per
day and is the only fixed input. Her variable cost consists of the
wages paid to the cooks and the food ingredients. The variable
cost per day associated with each level of output is given in the
accompanying table.
Quantity of meals (Q) VC

0 0
10 200
20 300
30 480
40 700
50 1000

a. Calculate the total cost, the average variable cost, the

average total cost, and the marginal cost for each quantity of
output.
Kate’s Katering provides catered meals, and the catered meals
industry is perfectly competitive. Kate’s machinery costs $100 per
day and is the only fixed input. Her variable cost consists of the
wages paid to the cooks and the food ingredients. The variable
cost per day associated with each level of output is given in the
accompanying table.
Quantity of meals (Q) VC

0 0
10 200
20 300
30 480
40 700
50 1000

b. What is the break-even price? What is the shut-down

price?
Kate’s Katering provides catered meals, and the catered meals
industry is perfectly competitive. Kate’s machinery costs $100 per
day and is the only fixed input. Her variable cost consists of the
wages paid to the cooks and the food ingredients. The variable
cost per day associated with each level of output is given in the
accompanying table.
Quantity of meals (Q) VC

0 0
10 200
20 300
30 480
40 700
50 1000

c. Suppose that the price at which Kate can sell catered meals
is $21 per meal. In the short run, will Kate earn a profit? In
the short run, should she produce or shut down?
Kate’s Katering provides catered meals, and the catered meals
industry is perfectly competitive. Kate’s machinery costs $100 per
day and is the only fixed input. Her variable cost consists of the
wages paid to the cooks and the food ingredients. The variable
cost per day associated with each level of output is given in the
accompanying table.
Quantity of meals (Q) VC

0 0
10 200
20 300
30 480
40 700
50 1000

d. Suppose that the price at which Kate can sell catered meals
is $17 per meal. In the short run, will Kate earn a profit? In
the short run, should she produce or shut down?
Kate’s Katering provides catered meals, and the catered meals
industry is perfectly competitive. Kate’s machinery costs $100 per
day and is the only fixed input. Her variable cost consists of the
wages paid to the cooks and the food ingredients. The variable
cost per day associated with each level of output is given in the
accompanying table.
Quantity of meals (Q) VC

0 0
10 200
20 300
30 480
40 700
50 1000

e. Suppose that the price at which Kate can sell catered meals
is $13 per meal. In the short run, will Kate earn a profit? In
the short run, should she produce or shut down?
Task 3
Suppose that a firm has a short-run total cost curve given by
STC =100 + 20Q + Q(^2). The corresponding short-run
marginal cost curve is SMC = 20 + 2Q.
All of the fixed cost is sunk.

Problem
(a) What is the equation for average variable cost (AVC)?
(b) What is the minimum level of average variable cost?
(c) What is the firm’s short-run supply curve?

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Task 4 45
Firms in a perfectly competitive market are said to be
“price takers”—that is, once the market determines an
equilibrium price for the product, firms must accept this
price. If you sell a product in a perfectly competitive
market, but you are not happy with its price, would you
raise the price, even by a cent?

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Task 5 47
The AAA Aquarium Co. sells aquariums for $20 each.
Fixed costs of production are $20. The total variable costs
are $20 for one aquarium, $25 for two units, $35 for the
three units, $50 for four units, and $80 for five units. In
the form of a table, calculate total revenue, marginal
revenue, total cost, and marginal cost for each output
level (one to five units).

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The profit maximizing level of output is 4 aquariums,
with a profit of $10. Producing more or less than this
amount results in lower profits.

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What is the profit-maximizing quantity of output? On one
diagram, sketch the total revenue and total cost curves.
On another diagram, sketch the marginal revenue and
marginal cost curves.

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Task 6 51
A computer company produces affordable, easy-to-use
home computer systems and has fixed costs of $250. The
marginal cost of producing computers is $700 for the first
computer, $250 for the second, $300 for the third, $350
for the fourth, $400 for the fifth, $450 for the sixth, and
$500 for the seventh.
Create a table that shows the company’s output, total
cost, marginal cost, average cost, variable cost, and
average variable cost.

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» At what price is the zero-profit point? At what price is
the shutdown point?
» If the company sells the computers for $500, is it
making a profit or a loss? How big is the profit or loss?
Sketch a graph with AC, MC, and AVC curves to
illustrate your answer and show the profit or loss.

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» If the firm sells the computers for $300, is it
making a profit or a loss? How big is the profit or
loss? Sketch a graph with AC, MC, and AVC curves
to illustrate your answer and show the profit or
loss.

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