CHAPTER
14
Firms in Competitive Markets
Goals
Learn what characteristics make a market competitive
in this chapter you will
Examine how competitive firms decide how much output to
produce
Examine how competitive firms decide when to shut down
production temporarily
Examine how competitive firms decide whether to exit or enter
a market
See how firm behavior determines a market’s short-run and longrun supply curves
Outcomes
List up to three conditions that characterize a competitive market
after accomplishing
these goals, you
should be able to
Locate the supply curve for a competitive firm on a graph of its
cost curves
Demonstrate why firms temporarily shut down if the price they
receive for their output is less than average variable cost
Demonstrate why firms exit a market permanently if the price
they receive for their output is less than average total cost
Show why the long-run supply curve in a competitive market is
more elastic than the short-run supply curve
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Chapter 14 Firms in Competitive Markets
Strive for a Five
The material covered in Chapter 14 is only tested on the microeconomics test. In recent
years, students have been asked to produce a cost curve model for a perfectly competitive
firm.
More specifically, students are required to understand:
■■ Profit maximization MR=MC rule
■■ Profit maximization for perfectly competitive firms and industry
■■ Short-run supply and shutdown decision
■■ Long-run supply and exit decision
■■ Market behavior in the short and long run
■■ Efficiency of perfect competition
Key Terms
■■
■■
■■
■■
■■
■■
■■
Price takers—Buyers and sellers in a competitive market that must accept the price that
the market determines
Competitive market—A market with many buyers and sellers trading identical products
so that each buyer and seller is a price taker
Average revenue—Total revenue divided by the quantity sold
Marginal revenue—The change in total revenue from an additional unit sold
Shut down—A short-run decision to cease production temporarily during a specific
period of time due to current market conditions
Exit—A long-run decision to cease production permanently and leave the market
Sunk cost—A cost to which one is already committed and is not recoverable
Chapter Overview
Context and Purpose
Chapter 14 is the second chapter in a five-chapter sequence dealing with firm behavior
and the organization of industry. Chapter 13 developed the cost curves on which
firm behavior is based. These cost curves are employed in Chapter 14 to show how
a competitive firm responds to changes in market conditions. Chapters 15 through
17 will employ these cost curves to see how firms with market power (monopolistic,
monopolistically competitive, and oligopolistic firms) respond to changes in market
conditions.
The purpose of Chapter 14 is to examine the behavior of competitive firms—firms that
do not have market power. The cost curves developed in the previous chapter shed light on
the decisions that lie behind the supply curve in a competitive market.
Chapter Review
Introduction In this chapter, we examine the behavior of competitive firms—firms that
do not have market power. Firms that have market power can influence the market price of
the goods they sell. The cost curves developed in the previous chapter shed light on the
decisions that lie behind the supply curve in a competitive market.
What Is a Competitive Market?
A competitive market has two main characteristics:
■■ There are many buyers and sellers in the market.
■■ The goods offered for sale are largely the same.
Chapter 14 Firms in Competitive Markets
The result of these two conditions is that each buyer and seller is a price taker. A third
condition sometimes thought to characterize perfectly competitive markets is:
■■ Firms can freely enter or exit the market.
Firms in competitive markets try to maximize profit, which equals total revenue minus
total cost. Total revenue (TR) is P × Q. Because a competitive firm is small compared to
the market, it takes the price as given. Thus, total revenue is proportional to the amount of
output sold—doubling output sold doubles total revenue.
Average revenue (AR) equals total revenue (TR) divided by the quantity of output (Q)
or AR = TR/Q. Because TR = P × Q, then AR = (P × Q) / Q = P. That is, for all firms,
average revenue equals the price of the good.
Marginal revenue (MR) equals the change in total revenue from the sale of an additional
unit of output or MR = ∆TR/∆Q. When Q rises by one unit, total revenue rises by P
dollars. Therefore, for competitive firms, marginal revenue equals the price of the good.
Profit Maximization and the Competitive Firm’s Supply Curve
Firms maximize profit by comparing marginal revenue and marginal cost. For the
competitive firm, marginal revenue is fixed at the price of the good and marginal cost is
increasing as output rises. There are three general rules for profit maximization:
■■ If marginal revenue exceeds marginal cost, the firm should increase output to increase
profit.
■■ If marginal cost exceeds marginal revenue, the firm should decrease output to increase
profit.
■■ At the profit-maximizing level of output, marginal revenue and marginal cost are
exactly equal.
Assume that we have a firm with typical cost curves. Graphically, marginal cost (MC)
is upward sloping, average total cost (ATC) is U-shaped, and MC crosses ATC at the
minimum of ATC. If we draw P = AR = MR on this graph, we can see that the firm will
choose to produce a quantity that will maximize profit based on the intersection of MR
and MC. That is, the firm will choose to produce the quantity where MR = MC. At any
quantity lower than the optimal quantity, MR > MC and profit is increased if output is
increased. At any quantity above the optimal quantity, MC > MR and profit is increased if
output is reduced.
If the price were to increase, the firm would respond by increasing production to the
point where the new higher P = AR = MR is equal to MC. That is, the firm moves up its
MC curve until MR = MC again. Therefore, because the firm’s marginal-cost curve determines
how much the firm is willing to supply at any price, it is the competitive firm’s supply curve.
A firm will temporarily shut down (produce nothing) if the revenue that it would get from
producing is less than the variable costs (VC) of production. Examples of temporary shutdowns
are farmers leaving land idle for a season and restaurants closing for lunch. For the
temporary shutdown decision, the firm ignores fixed costs because these are considered to
be sunk costs, or costs that are not recover­able because the firm must pay them whether
they produce output or not. Mathematically, the firm should temporarily shut down if
TR < VC. Divide by Q and get TR/Q < VC/Q, which is AR = MR = P < AVC. That is,
the firm should shut down if P < AVC. Therefore, the competitive firm’s short-run supply curve
is the portion of its marginal-cost curve that lies above the average-variable-cost curve.
In general, beyond the example of a competitive firm, all rational decision makers think
at the margin and ignore sunk costs when making economic decisions. Rational decision
makers undertake activities where the marginal benefit exceeds the marginal cost.
In the long run, a firm will exit the market (permanently cease operations) if the revenue it
would get from producing is less than its total costs. If the firm exits the industry, it avoids both
its fixed and variable costs, or total costs. Mathematically, the firm should exit if TR < TC.
Divide by Q and get TR/Q = TC/Q, which is AR = MR = P < ATC. That is, the firm
should exit if P < ATC. Therefore, the competitive firm’s long-run supply curve is the portion of
its marginal-cost curve that lies above the average-total-cost curve.
A competitive firm’s profit = TR − TC. Divide and multiply by Q and get profit =
(TR/Q − TC/Q) × Q or profit = (P − ATC) × Q. If price is above ATC, the firm is
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Chapter 14 Firms in Competitive Markets
profitable. If price is below ATC, the firm generates losses and would choose in the long
run to exit the market.
The Supply Curve in a Competitive Market
In the short run, the number of firms in the market is fixed because firms cannot quickly
enter or exit the market. Therefore, in the short run, the market supply curve is the
horizontal sum of the portion of the individual firm’s marginal-cost curves that lie above
their average-variable-cost curves. That is, the market supply curve is simply the sum of
the quantities supplied by each firm in the market at each price. Because the individual
marginal-cost curves are upward sloping, the short-run market supply curve is also upward
sloping.
In the long run, firms are able to enter and exit the market. Suppose all firms have
the same cost curves. If firms in the market are making profits, new firms will enter the
market, increasing the quantity supplied and causing the price to fall until economic
profits are zero. If firms in the market are making losses, some existing firms will exit the
market, decreasing the quantity supplied and causing the price to rise until economic
profits are zero. In the long run, firms that remain in the market must be making zero economic
profit. Because profit = (P − ATC) × Q, profit equals zero only when P = ATC. For the
competitive firm, P = MC and MC intersects ATC at the minimum of ATC. Thus, in the
long-run equilibrium of a competitive market with free entry and exit, firms must be operating at
their efficient scale. Also, because firms enter or exit the market if the price is above or below
minimum ATC, the price al­ways returns to the minimum of ATC for each firm but the
total quantity supplied in the market rises and falls with the number of firms. Thus, there
is only one price consistent with zero profits, and the long-run market supply curve must be
horizontal (perfectly elastic) at that price.
Competitive firms stay in business even though they are making zero economic profits
in the long run. Recall that economists define total costs to include all the opportunity
costs of the firm, so the zero-profit equilibrium is compensating the owners of the firm for
their time and their money invested.
In the short run, an increase in demand increases the price of a good and existing firms
make economic profits. In the long run, this attracts new firms to enter the market causing
a corresponding increase in the market supply. This increase in supply reduces the price
to its original level consistent with zero profits but the quantity sold in the market is now
higher. Thus, if at present firms are earn­ing high profits in a competitive industry, they can
expect new firms to enter the market and prices and profits to fall in the future.
Although the standard case is one where the long-run market supply curve is perfectly
elastic, the long-run market supply curve might be upward sloping for two reasons:
■■ If an input necessary for production is in limited supply, an expansion of firms in
that industry will raise the costs for all existing firms and increase the price as output
supplied increases.
■■ If firms have different costs (some are more efficient than others) in order to induce
new less ef­fi cient firms to enter the market, the price must increase to cover the less
efficient firm’s costs. In this case, only the marginal firm earns zero economic profits
while more efficient firms earn profits in the long run.
Regardless, because firms can enter and exit more easily in the long run than in the
short run, the long-run market supply curve is more elastic than the short-run market supply curve.
Conclusion: Behind the Supply Curve
The supply decision is based on marginal analysis. Profit-maximizing firms that supply
goods in competitive markets produce where marginal cost equals price equals minimum
average total cost.
Helpful Hints
1. We have determined that, in the short run, the firm will produce the quantity of
output where P = MC as long as the price equals or exceeds average variable cost.
An additional way to see the logic of this behavior is to recognize that because fixed
Chapter 14 Firms in Competitive Markets
costs must be paid regardless of the level of production, any time the firm can at least
cover its variable costs, any additional revenue beyond its variable costs can be applied
to its fixed costs. Therefore, in the short run, the firm loses less money than it would
if it shut down if the price exceeds its average variable costs. As a result, the short-run
supply curve for the firm is the portion of the marginal-cost curve that is above the
average-variable-cost curve.
2. Recall that rational decision makers think at the margin. The decision rule for
any action is that we should do things for which the marginal benefit exceeds the
marginal cost and continue to do that thing until the marginal benefit equals the
marginal cost. This decision rule translates directly to the firm’s production decision
in that the firm should continue to produce additional output until marginal revenue
(the marginal benefit to the firm) equals marginal cost.
3. In this chapter, we derived the equation for profit as profit = (P − ATC) × Q. It helps
to remember that, in words, this formula says that profit simply equals the average
profit per unit times the number of units sold. This holds true even in the case of
losses. If the price is less than average total cost, then we have the average loss per unit
times the number of units sold.
Self-Test
Multiple-Choice Questions
Table 14-1
Quantity
Total Revenue
0
$0
1
$7
2
$14
3
$21
4
$28
1. Refer to Table 14-1. The price and quantity relationship in the table is most likely
that faced by a firm in a
a. price discriminating monopoly market.
b. single price monopoly market.
c. oligopoly market.
d. monopolistically competitive market.
e. perfectly competitive market.
2. Which of the following is NOT a characteristic of a perfectly competitive market?
a. Firms are price takers.
b. Firms have difficulty entering the market.
c. There are many sellers in the market.
d. There are many buyers in the market.
e. Goods offered for sale are homogeneous.
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Chapter 14 Firms in Competitive Markets
Table 14-2
Quantity
Total Revenue
Total Cost
0
$0
$10
1
$9
$14
2
$18
$19
3
$27
$25
4
$36
$32
5
$45
$40
6
$54
$49
7
$63
$59
8
$72
$70
9
$81
$82
3. Refer to Table 14-2. At which quantity of output is marginal revenue equal to
marginal cost?
a. 2
b. 3
c. 6
d. 8
e. 9
4. Refer to Table 14-2. If the firm finds that its marginal cost is $11, it should
a. increase production to maximize profit.
b. increase the price of the product to maximize profit.
c. advertise to attract additional buyers to maximize profit.
d. reduce production to increase profit.
e. keep production at the current level.
Figure 14-1
Price
142
MC
11
10
9
8
7
6
5
4
3
2
1
ATC
AVC
P1
P2
P3
P4
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
5. Refer to Figure 14-1. If the market price is P3, in the short run, the perfectly
competitive firm will earn
a. positive economic profits.
b. negative economic profits but will try to remain open.
c. negative economic profits and will shut down.
d. zero economic profits.
e. break-even profits.
Chapter 14 Firms in Competitive Markets
6. Refer to Figure 14-1. Which of the four prices corresponds to a perfectly
competitive firm earning negative economic profits in the short run and shutting
down?
a. P1 only
b. P2 only
c. P3 only
d. P4 only
e. P3 and P4
Price
Figure 14-2
MC
ATC
P4
P2
AVC
P5
P3
P1
Q1 Q2
Q3 Q4
Quantity
7. Refer to Figure 14-2. When market price is P3, a profit-maximizing firm’s total
revenue
a. can be represented by the area P3 x Q3.
b. can be represented by the area P3 x Q2.
c. can be represented by the area (P3-P2) x Q3.
d. can be represented by the area (P3-P2) x Q2.
e. is zero.
8. Refer to Figure 14-2. When market price is P3, a profit-maximizing firm’s profit
a. can be represented by the area P3 x Q3.
b. can be represented by the area P3 x Q2.
c. can be represented by the area (P3-P2) x Q3.
d. can be represented by the area P3 x Q1.
e. is zero.
9. Refer to Figure 14-2. When market price is P3, a profit-maximizing firm’s total
costs
a. can be represented by the area P2 x Q2.
b. can be represented by the area P3 x Q2.
c. can be represented by the area (P3-P2) x Q3.
d. can be represented by the area P3 x Q3.
e. are zero.
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Chapter 14 Firms in Competitive Markets
10. A firm in a competitive market has the following cost structure.
Output
Total Cost
0
$5
1
$10
2
$12
3
$15
4
$24
5
$40
If the market price is $4, this firm will
a. produce two units in the short run and exit in the long run.
b. produce three units in the short run and exit in the long run.
c. produce four units in the short run and exit in the long run.
d. shut down in the short run and exit in the long run.
e. produce five units in the short run and the long run.
11. A firm in a competitive market has the following cost structure.
Output
Total Costs
0
$1
1
$6
2
$9
3
$10
4
$17
5
$26
What is the lowest price at which this firm might choose to operate?
a. $1
b. $2
c. $3
d. $4
e. $5
Chapter 14 Firms in Competitive Markets
(a)
(b)
Price
Price
Figure 14-3
MC
S0
ATC
P2
P2
P1
P1
P0
P0
B
A
C
D
D0
Q1 Q2
Quantity
S1
QA QB QC
QD
D1
Quantity
12. Refer to Figure 14-3. Assume that the market starts in equilibrium at point A in
panel (b). An increase in demand from D0 to D1 will result in
a. a new market equilibrium at point D.
b. an eventual increase in the number of firms in the market and a new long-run
equilibrium at point C.
c. rising prices and falling profits for existing firms in the market.
d. falling prices and falling profits for existing firms in the market.
e. a new long-run market equilibrium at point B.
Free Response Questions
1. Using correctly labeled side-by-side graphs for a market and a firm, graph a firm
earning short-run economic profits. Can this scenario be maintained in the long run?
Explain.
2. Using cost curve analysis, explain the derivation of a perfectly competitive firm’s
short-run supply curve.
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Chapter 14 Firms in Competitive Markets
Solutions
Multiple-Choice Questions
1. e TOP: Competitive markets
2. b TOP: Marginal revenue / Average revenue
3. c TOP: Profit maximization
4. d TOP: Profit maximization
5. b TOP: Supply curve
6. d TOP: Supply curve
7. b TOP: Total revenue
8. e TOP: Profit
9. b TOP: Total cost
10. b TOP: Losses
11. c TOP: Supply curve
12. b TOP: Long-run supply curve
Supply
Price
Free Response Questions
1. In a competitive market where firms are earning economic profits, new firms will have an incentive to enter the
market. This entry will expand the number of firms, increase the quantity of the good supplied, and drive down
prices and profits. Entry will cease once firms are producing the output level where price equals the minimum
of the average-total-cost curve, meaning that each firm earns zero economic profits in the long run.
Price
146
Supply
P0
Demand
Demand
Quantity
Quantity
Market
Individual Firm
TOP: Profit maximization
2. A perfectly competitive firm’s short-run supply curve is the rising portion of its marginal cost curve above the
variable cost curve. The supply curve for a perfectly competitive firm is represented by the various quantities
the firm would willingly put on the market at each possible alternative price. In the short run, a perfectly
competitive firm would operate and produce where MC=P, as long as that occurs above average variable cost.
If the price were below average variable cost, the firm would shut down in the short run.
TOP: Perfectly competitive firms