Firms in Compe,,ve

Markets

Chapter 14
 LEARNING OBJECTIVES
By the end of this chapter, you should be able to:
• Define key concepts (perfectly compe,,ve market,
price taker, average revenue, marginal revenue,
profit-maximizing rules, break-even price, shut-down
price)
• Iden,fy the characteris,cs of the firms in
compe,,ve market
• Calculate profit-maximizing output given profit
maximizing rule
• Use an appropriate diagram to show how short run
profit or loss is eliminated under perfect compe,,on
by market entry or exit
 Perfectly Compe,,ve Market
Characteris,cs of a Compe,,ve Market:

1. A market with many buyers and sellers

2. Products are iden,cal

3. Each buyer and seller is a “price taker” (buyers

and sellers cannot influence the market price)

4. Firms can freely enter or exit the market

 Total Revenue, Total Cost, and Profit

• A firm in a compe,,ve market tries to

maximize profit.
• Total Revenue
– The dollar amount a firm receives from the sale of
its output.
• Total Cost
– The market value of the inputs a firm uses in
produc,on.
• Profit = Total revenue - Total cost
 Average Revenue, and Marginal Revenue

• Average Revenue
P ⇥Q
– Revenue per unit sold: AR = =P
Q

• Marginal Revenue
– The extra revenue (ΔTR) arising from an extra
unit sold (ΔQ) TR
MR =
Q
• Under perfect compe;;on:
MR = AR = P
Compe,,ve Firm
 Quick Quiz

ü When a competitive firm doubles the

amount it sells, what happens to the price of
its output and its total revenue?
 Profit-Maximizing Rules

• A firm maximizes its economic profit when it:

1. Produces output at a level such that marginal
revenue [MR] equals marginal cost [MC]
MR = P = MC
2. Ensures that total revenue [TR] exceeds total
variable cost [TVC] at the output where MR = MC
TR > TVC
If rule 2 is not met, the firm should cease produc,on
[i.e. “shut-down”]
Profit-Maximizing: A Numerical Example
 Ra,onal People Think at the Margin

• One of the ten principles of economics in

Chapter 1 is that ra,onal people think at the
margin.
• If MR > MC, then increase the output.
• If MR < MC, then decrease the output.
• If MR = MC, now the firm is maximizing the
profit.
Cost Curves for a Compe,,ve Firm
Compe,,ve Firm’s Decision in the Short-Run
and Long-Run
• Under some circumstances, a firm will decide to shut
down and not produce anything at all.
• Shutdown versus exit:
– A shutdown refers to a short-run decision not to
produce anything during a specific period of ,me
because of current market condi,ons.
– An exit refers to a long-run decision to leave the
market.
• The short-run and long-run decisions differ because
most firms cannot avoid their fixed costs in the short
run but can do so in the long run.
Compe,,ve Firm’s Decision in the Short-Run
and Long-Run
• Firm’s shutdown decision?
– If the firm shuts down, it loses all the revenue
from the sale of its product.
– At the same ,me, it saves the variable costs of
making its product (but must s,ll pay the fixed
costs).
– Thus, the firm shuts down if the revenue that it
would earn from producing is less than its variable
costs of produc,on.
 Shut-down Price
Shut-down price: a price at which profit maximiza,on
[MR=MC] implies total revenue just equals total
variable cost, Since TR = VC occurs when price is just
equal to minimum average variable cost, shut-down
price is equivalent to minimum AVC.

Shut down if T R < V C

TR VC
Shut down if <
Q Q

Shut down if P < AV C

 Break-even Price
Break-even price: a price at which profit
maximiza,on [MR=MC] implies zero economic profit.
Since zero economic profit occurs when price is just
equal to minimum average total cost, break-even
price is equivalent to minimum ATC.
Compe,,ve Firm’s Short-Run Supply Curve
Compe,,ve Firm’s Long-Run Decision to Exit

• If the firm exits, it will lose all revenue from the

sale of its product, but it saves on both fixed and
variable costs of produc,on.
• The firm exits the market if the revenue it would
get from producing is less than its total costs.
• The exit price coincides with the minimum point
on the average-total-cost curve.
-Exit if TR < TC -Enter if TR > TC
-Exit if TR/Q < TC/Q -Enter if TR/Q > TC/Q
-Exit if AR < ATC -Enter if P> ATC
Compe,,ve Firm’s Long-Run Supply Curve
MEASURING PROFIT FOR THE
COMPETITIVE FIRM

Profit = T R TC
✓ ◆
TR TC
Profit = ⇥Q
Q Q

Profit = (P AT C) ⇥ Q
Compe,,ve Firm’s Profit/Loss (the Area
between Price and Average Total Cost)
 Quick Quiz

ü How does the price faced by a profit-

maximizing competitive firm compare to
its marginal cost? Explain.
ü When does a profit-maximizing
competitive firm decide to shut down?
ü When does a profit-maximizing
competitive firm decide to exit a market?
AcCve Learning: IdenCfying a Firm’s Profit

• Determine this firm’s total profit.

• Identify the area
on the graph that
represents the
firm’s profit.
Answer: IdenCfying a Firm’s Profit
AcCve Learning: IdenCfying a Firm’s Profit

• Determine this firm’s total loss, assuming AVC

< $3.
• Iden,fy the area
on the graph that
represents the
firm’s loss
Answer: IdenCfying a Firm’s Profit
 Supply Curve in a Compe,,ve Market
• Let’s discuss the supply curve for a market.
• There are two cases to consider:
1. Iden,cal Producers
ØAll producers have the same opportunity costs-
zero economic profit for all in the long run)
ØFor any given price, each firm supplies a
quan,ty of output so that its marginal cost
equals the price.
2. Producers have different opportunity costs
Supply Curve in a Compe,,ve Market for
Iden,cal Producers
Supply Curve in a Compe,,ve Market for 100
Producers with Different Opportunity Costs
 Long-Run Equilibrium
• The long-run equilibrium of a compe,,ve
market with free entry and exit must have
firms opera,ng at their efficient scale (zero
economic profit).
• In the zero-profit equilibrium, economic profit
is zero, but accoun,ng profit is posi,ve.
Long-Run Equilibrium
 The effect of an increase in the market demand on
the compe,,ve firm

(b) Short-Run Response

Firm Market
Price Price

Profit MC ATC S1
B
P2 P2
A
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Quantity (market)

 Long Run Equilibrium

(c) Long-Run Response

Firm Market
Price Price

MC S1
ATC B S2
P2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market)

 Quick Quiz

ü In the long run with free entry and exit, is

the price in a market equal to marginal
cost, average total cost, both, or neither?
ü Explain with a diagram.
 Classroom AcCvity: A Profitable
Opportunity
As a recent graduate of this college, you have landed
a job in produc,on management for Universal Clones
Inc. You are responsible for the en,re company on
weekends.
Your costs are shown below.
Quan,ty Average Total Cost
500 200
501 201
Your current level of produc,on is 500 units. All 500
units have been ordered by your regular customers.
 Classroom AcCvity: A Profitable
Opportunity
The phone rings. It’s a new customer who wants
to buy 1 unit of your product. This means you
would have to increase produc,on to 501 units.
Your new customer offers you $450 to produce
the extra unit.
a. Should you accept this offer?
b. What is the net change in the firm’s
profit?
 Summary
• Because a compe,,ve firm is a price taker, its
revenue is propor,onal to the amount of output it
produces.
• The price of the good equals both the firm’s average
revenue and its marginal revenue.
 Summary
• To maximize profit, a firm chooses the
quan,ty of output such that marginal revenue
equals marginal cost.
• This is also the quan,ty at which price equals
marginal cost.
• Therefore, the firm’s marginal cost curve is its
supply curve.
 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 its
costs, it will choose to exit if the price is less
than average total cost.
 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 ,me horizons.
• In the long run, the number of firms adjusts to
drive the market back to the zero-profit
equilibrium.