PERFECT COMPETITION
This section analyzes the behavior of firms that
operate in competitive markets. We take up
the short-run first, and focus on two issues:
1) How firms choose their outputs.
2) How prices are determined.
Competitive firms in the short-run
slide 1
In the short-run firms have some fixed costs. In
addition, in the short-run firms cannot leave an
industry, and new firms cannot enter.
Competitive firms in the short-run
slide 2
STANDARD PROBLEM
Suppose a small accounting firm producing tax
return preparation services in East Lansing,
Michigan, has a short-run total cost curve like
the one in our example.
Suppose the firm is a perfect competitor and can
sell its services at a price of $44 per unit.
If the firm wants to maximize profits, how many
tax preparations should it produce in each time
period?
Competitive firms in the short-run
slide 3
The total cost
curve looks
like this.
Competitive firms in the short-run
Q
0
1
2
3
4
5
6
7
8
9
10
11
TC
50.0
63.0
71.0
76.0
82.4
97.0
130.0
174.0
233.0
314.0
460.0
656.0
slide 4
700
600
TC ($)
500
400
300
200
100
0
0
2
4
6
8
10
12
14
Q
Competitive firms in the short-run
slide 5
The firm’s total economic profit is total revenue
minus total cost.
Total revenue is price times quantity sold, where
price means the revenue per unit that the firm
takes in. Price is the fixed, known market
price of the firm’s output.
Competitive firms in the short-run
slide 6
Q
0
1
2
3
4
5
6
7
8
9
10
11
TR
0
44
88
132
176
Competitive firms in the short-run
TR is price times quantity.
Price here is $44/unit.
PQ = 3(44)
The total revenue curve shows total
receipts at each level of output.
The dependent variable is total revenue
and the independent variable is output.
slide 7
700
600
TR($)
500
400
Graph the
remaining points
on the Total
Revenue Curve.
300
200
100
0
0
2
4
6
8
10
12
14
Q
Competitive firms in the short-run
slide 9
($)
700
TC
600
500
TR
400
Here are the
total revenue
and cost
curves.
300
200
100
0
0
2
4
6
8
10
12
14
Q
Competitive firms in the short-run
slide 11
Q
0
1
2
3
4
5
6
7
8
9
10
11
TC
50.0
63.0
71.0
76.0
82.4
97.0
130.0
174.0
233.0
314.0
460.0
656.0
Competitive firms in the short-run
TR
0
44
88
132
176
220
264
308
352
396
440
484
PROFIT
-50.0
-19.0
17.0
56.0
93.6
Profit is total
revenue minus
total cost.
Profit = TR - TC
= 132-76
-20.0
-172.0
slide 12
($)
700
600
500
400
Plot the
missing points
of the total
profit curve.
300
200
100
0
-100 0
2
4
6
8
10
12
14
-200
-300
Q
Competitive firms in the short-run
slide 14
Where profit is maximized here is obvious from
looking at the previous figure.
The next thing to be shown is that the profit
maximizing output is the output at which
MARGINAL COST equals MARGINAL
REVENUE.
Competitive firms in the short-run
slide 16
The profit maximization problem is going to be
solved by looking at it from the point of view
of average and marginal quantities and curves,
instead of total quantities.
The reason for doing this is that some problems
are going to be much easier to solve if we look
at the firm’s choices in terms of marginal and
average revenue and cost.
Competitive firms in the short-run
slide 17
700
$
TC
600
500
400
300
200
100
0
0
120
2
4
6
8
$/Q
10
12
14
Q
MC
Recall what the marginal
and average cost curves
looked like in the case of
our example.
100
80
AC
60
40
20
Q
0
0
2
4
6
8
10
Competitive firms in the short-run
12
14
slide 18
Now for marginal revenue and average
revenue.
Average revenue: The firm’s total revenue divided by
output. Revenue per unit of output. The same thing
as PRICE.
The average revenue curve shows average revenue as a
function of output. The average revenue curve is the
demand curve for output as seen by the firm.
In the case of perfect competition, the average revenue
curve is horizontal at the going market price. The firm
is a price taker.
Competitive firms in the short-run
slide 19
THE AVERAGE REVENUE CURVE FOR
A COMPETITIVE FIRM IS A HORIZONTAL LINE
AT MARKET PRICE.
$/Q
120
100
80
60
P=AR
40
20
0
Q
0
2
Competitive firms in the short-run
4
6
8
10
12
14
slide 20
Marginal revenue: The change in total revenue
per unit change in output. The slope of the
total revenue curve. MR = TR / Q.
The marginal revenue curve shows marginal
revenue at each level of output. Output is the
independent variable, and MR is the dependent
variable.
For a competitive firm MR is constant.
Competitive firms in the short-run
slide 21
THE MARGINAL REVENUE CURVE FOR
A COMPETITIVE FIRM IS A HORIZONTAL LINE
AT MARKET PRICE.
$/Q
120
100
80
60
MR
40
20
0
Q
0
2
Competitive firms in the short-run
4
6
8
10
12
14
slide 22
Important point
In perfect competition, marginal revenue and
average revenue are always equal and constant
for a firm.
The sense of this is that a competitive firm can
always sell additional units of output at the
going market price.
Competitive firms in the short-run
slide 23
700
$
600
500
The total revenue and
the corresponding
marginal and average
revenue curves are a
“matched set.”
TR
400
300
200
100
0
0
120
2
4
6
8
10
12
14
Q
Notice that the rules
governing the
relationships between
total, average, and
marginal quantities hold
here.
$/Q
100
80
60
AR=MR
40
20
Q
0
0
2
4
6
8
Competitive firms in the short-run
10
12
14
slide 24
Here’s the cost and revenue curves together
on the same set of axes.
$/Q
MC
120
100
80
AC
60
MR
40
20
0
Q
0
2
Competitive firms in the short-run
4
6
8
10
12
14
slide 25
$/Q
MC
120
100
Without the data
markers the graphs
look like this.
80
AC
60
MR=P
40
The profit
maximizing output
here is 7 units.
20
0
Q
0
2
4
6
Competitive firms in the short-run
8
10
12
14
slide 26
WHY MUST 7 BE THE PROFIT MAXIMIZING OUTPUT?
$/Q
MC
120
100
80
AC
60
MR=P
40
20
0
Q
0
2
Competitive firms in the short-run
4
6
8
10
12
14
slide 27
REASONING: 1) Take any other output, say 4.
2) Now increase output by a small amount.
3) Profits increase, so they can’t be
maximized at an output of 4.
$/Q
MC
120
100
80
AC
60
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 28
Be sure you understand why profits increase when output is
increased from 4. The increase in output has two effects: it
increases revenue and it increases costs. At output = 4, the increase
in revenue exceeds the increase in costs, so profits grow.
$/Q
MC
120
100
80
AC
60
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 29
At an output of 9, profits can be increased by reducing output.
Why? At output of 9, MC > MR. Therefore, a reduction in output
reduces costs by more than it reduces revenues, so profits grow.
$/Q
MC
120
100
80
AC
60
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 30
At output of 7, MC = MR. That means that a small increase in output
adds exactly as much to revenues as it does to costs. But adding
the same amount to revenues as to costs leaves total profit unchanged.
$/Q
MC
120
100
80
AC
60
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 31
An important point: profits are not
maximized at the bottom of the AC
curve.
120
$/Q
MC
100
80
60
AC
40
MR=P
Average cost is
minimized here.
20
0
Q
0
2
Competitive firms in the short-run
4
6
8
10
12
14
slide 32
Measuring total profits in the average/marginal approach to
finding the profit maximizing output.
$/Q
MC
120
100
80
AC
First, find the area that
corresponds to TR.
60
(=PQ)
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 33
Measuring total profits in the average/marginal approach to
finding the profit maximizing output.
$/Q
MC
120
Then find the area that
corresponds to TC.
100
(= AC times Q)
80
AC
60
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 35
Measuring total profits in the average/marginal approach to
finding the profit maximizing output.
$/Q
MC
120
The difference between
the two is total profit.
Show it here.
100
80
AC
60
MR=P
40
20
0
Q
0
2
4
Competitive firms in the short-run
6
8
10
12
14
slide 37
Can you find total profit
at the output where
average cost is minimized?
Competitive firms in the short-run
slide 39
Rule to remember:
The output where profit is maximized is the
output where MC = MR.
(This rule works for all firms, not just firms in
perfect competition.)
Competitive firms in the short-run
slide 41
Review one more time!!!
$/Q
MC
120
100
The profit
maximizing output
here is 7 units.
80
AC
60
MR=P
40
20
0
Q
0
2
4
6
Competitive firms in the short-run
8
10
12
14
slide 42
Producer Surplus
The Producer Surplus for a firm is the difference
between the amount of revenue the firm
receives at a particular output level minus the
minimum amount it would accept to produce
that output.
The next (hidden) slide shows how to find
producer surplus for a competitive firm.
Competitive firms in the short-run
slide 43