FIRMS IN COMPETITIVE
MARKETS
What Is A Competitive Market?
A perfectly competitive market has
the following characteristics:
There are many buyers and sellers in
the market.
2) The goods offered by the various
sellers are the same (identical).
3) Firms can freely enter or exit the
market.
4) Information is perfect. Buyers and
sellers know all prices offered,...
1)
What Is A Competitive Market?
As a result of these characteristics,
the perfectly competitive market has
the following outcomes:
The actions of any single buyer or seller
in the market have no impact on the
market price.
Each buyer and seller takes the market
price as given.
Ex: Gasoline, fish, eggs, pencils, tomatoes,
etc.
What Is A Competitive Market?
Buyers and sellers must accept the
price determined by the market. No
single seller has market power (the
power to influence the market
price).
“Demand Faced By A Competitive
Firm” versus “Market Demand”
Price
Price
Pm
QTY
(millions)
QTY
(ones)
Demand faced by
one competitive firm
Market Demand
The Revenue of a Competitive
Firm
Total revenue for a firm is the market
price times the quantity sold.
TR = P  Q
Table 1 Total, Average, and Marginal Revenue for a
Competitive Firm
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The Revenue of a Competitive Firm
Marginal revenue is the change in
total revenue when an additional unit
is sold.
MR =TR / Q
The Revenue of a Competitive Firm
1. Only in a competitive market, marginal
revenue equals the price of the good. This
is because a firm in a competitive market
can sell as much as it wants at the
constant market price.
2. If a monopolist or oligopolist sells more,
this causes the price of the good to fall.
Ex1: Think of crude oil price and OPEC.
Ex2: Consider a downward sloping
demand curve.
Profit Maximization and The
Competitive Firm’s Supply Curve
The goal of a competitive firm is to
maximize profit.
This means that the firm wants to
produce the quantity that maximizes
the difference between total revenue
and total cost.
Table 2 Profit Maximization: A Numerical Example
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Profit Maximization and The
Competitive Firm’s Supply Curve
Profit maximization occurs at the
quantity where marginal revenue
equals marginal cost.
Profit Maximization And The
Competitive Firm’s Supply Curve
When MR > MC, profit is
increasing, so must produce more.
When MR < MC, profit is
decreasing, so must produce less.
When MR = MC, profit is constant,
so this is the point where profit is
maximized.
Figure 1 Profit Maximization for a Competitive Firm
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
MC
MC2
P = MR1 = MR2
P = AR = MR
MC1
0
Q1
QMAX
Q2
Quantity
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Figure 2 Marginal Cost as the Competitive Firm’s
Supply Curve
Price
P2
This section of the
firm’s MC curve is
also the firm’s supply
curve.
MC
ATC
P1
AVC
0
Q1
Q2
Quantity
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The Firm’s Short-Run Decision to
Shut Down
A shutdown refers to a short-run
decision to stop production
temporarily because the firm’s
revenue cannot even cover variable
costs.
Exit refers to a long-run permanent
decision to leave the market. A firm
exits the market if it makes negative
economic profit in the long-term.
The Firm’s Short-term Decision to
Shut Down
The firm ignores its fixed costs (=
sunk costs) when deciding to shut
down or not in the short-term, but
considers them when deciding
whether to exit or not in the long-term.
Fixed costs are costs that have already
been committed and cannot be
recovered in the short-term. example:
rent and lease contracts.
The Firm’s Short-Run Decision to
Shut Down
The firm shuts down if its revenue is
less than its variable costs:
Shut down if
TR < VC
–
Shut down if TR / Q < VC / Q
– Shut down if
P < AVC
Figure 3 The Competitive Firm’s Short Run
Supply Curve
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
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The Firm’s Long-Run Decision to
Exit or Enter a Market
In the long run, a firm exits the market
if the profit is negative .
Exit if TR < TC
if TR/Q < TC/Q
if P < ATC
A new firm Enters the market if profit
is positive, or if: P > ATC
Figure 4 The Competitive Firm’s Long-Run
Supply Curve
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
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THE SUPPLY CURVE IN A
COMPETITIVE MARKET
The competitive firm’s long-run supply
curve is the part of its marginal-cost
curve that lies above average total
cost.
Figure 5 Profit as the Area between Price
and Average Total Cost
(a) A Firm with Profits
Price
MC
ATC
Profit
P
ATC
P = AR = MR
0
Quantity
Q
(profit-maximizing quantity)
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Figure 5 Profit as the Area between Price and
Average Total Cost
(b) A Firm with Losses
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Q
(loss-minimizing quantity)
Quantity
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FIRM VERSUS MARKET SUPPLY
Market supply equals the sum of the
quantities supplied by all firms in the
market.
The Short Run: Market Supply with
a Fixed Number of Firms
For any given price, each firm
supplies a quantity of output so that
its marginal cost equals price.
The market supply curve adds up the
individual firms’ marginal cost curves.
Figure 6: SR Market Supply with a Fixed
Number of Firms
(a) Individual Firm Supply
(b) Short Run Market Supply
Price
Price
SR
MC
Supply
$2.00
$2.00
1.00
1.00
0
100
200
Quantity (firm)
0
100,000
200,000 Quantity (market)
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The Long Run: Market Supply with
Entry and Exit
Long run equilibrium is reached when
there are no more entries or exits in
the market.
Firms will enter or exit the market until
profit approaches to zero. Then longrun equilibrium happens when profit
equals zero.Then at the long run
equilibrium, price must be equal to the
minimum of average total cost.
The Long Run: Market Supply with
Entry and Exit
Then long-run market supply curve is
horizontal at price = min(ATC).
At the long-run equilibrium, firms
operate at their efficient scale (scale
that minimizes ATC).
Figure 7 Market Supply with Entry and Exit
(a) Firm’s Zero-Profit Condition
(b) Long Run Market Supply
Price
Price
SR
MC
Supply
ATC
LR
P = minimum
ATC
Supply
Demand, D1
0
Quantity (firm)
0
Quantity (market)
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Why Do Competitive Firms Stay in
Business If They Make Zero Profit?
Remember that accounting (nominal)
profit is positive even if economic
profit is zero.
The firm making zero economic profit
means the firm is doing the best it can
and there is no other alternative that
will give better profit. If there was,
current economic profit would be
negative. See example in notes.
Exercise: A Shift in Demand and
Short Run and Long Run
Consequences
An increase in demand raises price
and quantity in the short run.
Firms earn profits because price now
exceeds average total cost.
Figure 8 An Increase in Demand in the Short Run
and Long Run
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
Short-run supply, S1
A
P1
Long-run
supply
P1
Demand, D1
0
Quantity (firm)
0
Q1
Quantity (market)
Figure 8 An Increase in Demand in the Short
Run and Long Run
(b) Short-Run Response
Market
Firm
Price
Price
Profit
MC
ATC
P2
B
P2
S1
A
P1
P1
D2
Long-run
supply
D1
0
Quantity (firm)
0
Q1
Q2
Quantity (market)
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Figure 8 An Increase in Demand in the Short
Run and Long Run
(c) Long-Run Response
Market
Firm
Price
Price
MC
ATC
B
P2
S1
S2
C
A
P1
Long-run
supply
P1
D2
D1
0
Quantity (firm)
0
Q1
Q2
Q3 Quantity (market)
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