Firms in Competitive
Markets
14
WHAT IS A COMPETITIVE MARKET?
• In a perfectly competitive market
• There are many buyers
• There are many sellers
• Firms can freely enter or exit the market, in the long run.
• In the short run, the number of firms is assumed fixed
(constant).
• All sellers sell the same product.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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WHAT IS A COMPETITIVE MARKET?
• As a result:
• The actions of any single buyer or seller have a
negligible impact on the market price.
• That is, the market price is unaffected by the amount
bought by a buyer or the amount sold by a seller
• Therefore, every buyer and every seller takes the
market price as given.
• Everybody is a ‘price taker’
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Price takers
• A firm in a perfectly competitive market cannot stay in
business if its price is higher than what the other firms are
charging
• No firm would be able to raise the market price by reducing
production and attempting to create a shortage.
• Conversely, there is no danger that a firm would drive the
market price down by producing too much.
• Therefore, no firm would want to charge a price lower than
what the others are charging.
• In short, each firm takes the prevailing market price as a
given—like the weather—and charges that price.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Total Revenue of a Competitive Firm
• Total revenue for a firm is the selling price
times the quantity sold.
TR = P  Q
• We saw this in Chapters 5 and 13
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Average Revenue of a Competitive Firm
Total revenue
Average Revenue =
Quantity
Price  Quantity

Quantity
 Price
• Average revenue is the revenue per unit sold
• P = AR.
• This is simply because all units sold are sold at the
same price.
6
Marginal Revenue of a Competitive Firm
• Marginal Revenue is the increase (Δ) in total
revenue when an additional unit is sold.
MR = TR / Q
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The Revenue of a Competitive Firm
• In perfect competition, marginal revenue
equals price: P = MR.
• We saw earlier that P = AR
• Therefore, for all firms in perfect competition,
P = AR = MR
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Table 1 Total, Average, and Marginal Revenue for
a Competitive Firm
Note:
(a) P = AR = MR
9
(b) P does not fall as Q increases
Demand curves for the firm and the market (industry)
Jones and Peters, a firm
Price
Price
P
Market
Demand, P = AR = MR
Demand, P = AR
0
Quantity (firm)
The market price is P. No matter
what amount Jones and Peters
produces, the market price will not
change. Therefore, J&P will be
able to sell any feasible output if it
charges the price P.
0
Quantity (market)
The market demand curve is
negatively sloped, as usual. That
is, the market price, which is the
lowest prevailing price, is
inversely related to the quantity
10
demanded.
Supply
• We have just seen
the demand curves
for a firm and for the
entire industry
• Next, we need to
work out what the
supply curves look
like
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Supply: short run and long run
• The analysis of supply in perfect competition
depends on whether it is the short run or the
long run.
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Short run and long run: assumptions
• The quantity of a resource used by a firm may
be fixed in the short run but not in the long
run.
• Example: If a firm currently has three custom-made
machines and if it takes six months to get new machines,
then the firm is stuck with its three machines for the next
six months.
• All fixed costs are sunk costs in the short run
but not in the long run
• The number of firms in an industry is fixed in
the short run but not in the long run
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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THE FIRM AND THE INDUSTRY IN
THE SHORT RUN
14
Shut Down and Exit
• Before a firm decides how much to supply, it
must decide whether or not to stay in business
• A shutdown refers to a short-run decision to
stop production temporarily, perhaps because
of poor market conditions.
• Exit refers to a long-run decision to end
production permanently.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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The Firm’s Short-Run Decision to Shut Down
• A firm will shut down (temporarily) if its
variable costs exceed its total revenue, no
matter what quantity it produces
• Its fixed costs do not matter!
• This is because
• Fixed costs are sunk costs in the short run
• sunk costs are defined as costs that will have to be paid
even if the firm shuts down.
• Therefore, FC cannot affect a firm’s decision on
whether to stay open or shut down
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Sunk Costs
• Sunk costs will have to be paid even when a
firm is in a temporary shutdown.
• Examples:
• If the firm signs a long-term contract with its landlord,
the rent will have to be paid even when the firm is
temporarily shut down.
• Some maintenance costs will have to be incurred even
when the firm is shut down.
• The firm may be under contract to provide customer
service to past customers even after it shuts down.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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The Firm’s Short-Run Decision to Shut Down
•
•
•
•
Total Revenue = $1000 per month
Variable Cost = $800 per month
Fixed Cost = $400 per month
Profit = –$200 per month (a loss)
• Q: Should this firm stay in business or should it shut down
for the time being?
• A: It should stay in business
• If it shuts down, the fixed cost (say, rent owed to the landlord) will
still have to be paid—because it is sunk!—and the loss will then be
even higher, $400 per month.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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The Firm’s Short-Run Decision to Shut Down
•
•
•
•
Total Revenue = $1000 per month
Variable Cost = $1200 per month
Fixed Cost = $400 per month
Profit = –$600 per month (a loss)
• Q: Should this firm stay in business or should it
shut down for the time being?
• A: It should shut down.
• The lesson from this and the previous slide is
that …
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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The Firm’s Short-Run Decision to Shut Down
• A firm shuts down if total revenue is less than
variable cost, no matter what quantity the
firm produces. That is,
• A firm shuts down if
• TR < VC, no matter what Q is, or
• TR/Q < VC/Q, no matter what Q is, or
• P < AVC, no matter what Q is.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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A Firm’s Shut Down Decision
$
The firm stays open
because P > Minimum AVC
AVC
PH
Minimum AVC
Minimum AVC
PL
Quantity
0
The firm shuts down
because P < Minimum AVC
21
Table 2 Profit Maximization: A Numerical Example
Is it possible
to figure out
the profitmaximizing
output from
just the MR
and MC
numbers?
Yes, it is where
MR = MC.
22
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
We have seen before
that, as firms are price
takers in perfect
competition, P = AR =
MR.
We have also seen
that, profit
maximization implies
MR = MC.
ATC
P = MR1 = MR2
P = AR = MR
AVC
Therefore, P = AR =
MR = MC is the
fingerprint of perfect
competition
MC1
CHAPTER 14
0
Q1
QMAX
Q2
Quantity
23
PROFIT MAXIMIZATION AND THE COMPETITIVE
FIRM’S SUPPLY CURVE
• Profit maximization occurs at the quantity
where marginal revenue equals marginal cost.
• This is a crucial principle in understanding the
behavior of firms
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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PROFIT MAXIMIZATION AND THE COMPETITIVE
FIRM’S SUPPLY CURVE
• When MR > MC
increase Q
• When MR < MC
decrease Q
• When MR = MC
Profit is maximized;
stick with this Q.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Recall: The Supply Curve
Price
Supply
P2
P1
0
Q1
Q2
Quantity
26
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
27
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.
Firm
shuts
down if
P < AVC
AVC
What can shift the supply
curve to the right?
0
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Quantity
28
The Short Run: Market Supply with a Fixed
Number of Firms
• The market supply curve is the horizontal sum
of the individual firms’ short run supply curves.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
29
Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply
(b) Market Supply (# of firms fixed)
Price
Price
MC
Supply
$2.00
$2.00
1.00
1.00
0
100
200
Quantity (firm)
0
100,000
200,000 Quantity (market)
Q: What is the number of firms?
30
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Short-Run Equilibrium: back where we began!
(a) Individual Firm Supply
(b) Market Supply (# of firms fixed)
Price
Price
MC
Supply
$2.00
$2.00
1.00
1.00
DemandL
0
100
200
Quantity (firm)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
0
100,000
DemandH
200,000 Quantity (market)
31
Price = Minimum ATC; profit = zero; demand has no effect on price, and
no effect on the quantity produced by a firm; demand does affect the
quantity produced by the industry, and the number of firms in the
industry
THE LONG RUN
32
The Firm’s Long-Run Decision to Exit or Enter a
Market
• In the long run, the firm exits if it sees that its
total revenue would be less than its total cost
no matter what quantity (Q) it might produce
• That is, a firm exits if
• TR < TC, no matter what Q is.
• TR/Q < TC/Q , no matter what Q is.
• P < ATC , no matter what Q is.
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The Firm’s Long-Run Decision to Exit or Enter a
Market
• A new firm will enter the industry if it can
expect to be profitable.
• That is, a new firm will enter if
• TR > TC for some value of Q
• TR/Q > TC/Q for some value of Q
• P > ATC for some value of Q
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Entry and Exit of Firms in the Long-Run
$
The number of firms will
stabilize when P = Minimum
ATC. This is the long run price!
New firms will enter
because P > Minimum ATC
ATC
PH
Minimum ATC
PL
0
Minimum ATC
This is the efficient scale output.
This is each firm’s long-run
equilibrium output!
Existing firms will exit
because P < Minimum ATC
Quantity
35
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
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Quantity
36
THE SUPPLY CURVE IN A COMPETITIVE
MARKET
• A Firm’s Short-Run Supply
Curve
• The portion of its (short run)
marginal cost curve that lies
above the (short run) average
variable cost curve.
MC
ATC
AVC
• A Firm’s Long-Run Supply
Curve
• The portion of its (long run)
marginal cost curve that lies
above the (long run) average
total cost curve.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
ATC
37
Long-Run Equilibrium
Price
Price
Market
Demand
ATC
$1.50
P = Minimum ATC = $1.50
200
(efficient
scale)
Quantity
(firm)
This is it, as far as long-run equilibrium is concerned!
How many firms are there in long-run equilibrium?
What would happen if demand moves left (decreases)?
What could cause prices to increase?
6,000 Quantity
(industry)
P = AR = MR = MC = ATC is the
fingerprint of perfect competition in
the long run.
38
A Firm’s Profit
• Profit equals total revenue minus total costs.
•
•
•
•
Profit = TR – TC
Profit/Q = TR/Q – TC/Q
Profit = (TR/Q – TC/Q)  Q
Profit = (P – ATC)  Q
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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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)
40
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
CHAPTER 14 FIRMS IN COMPETITIVE
MARKETS
(loss-minimizing
quantity)
Quantity
41
The Long Run: Market Supply with Entry and Exit
• Firms will enter or exit the market until profit is
driven to zero.
• Price equals the minimum of average total
cost.
• The long-run market supply curve is a
horizontal line at this price.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
42
Figure 7 Market Supply with Entry and Exit
(a) Firm’s Zero-Profit Condition
(b) Market Supply (# of firms variable)
Price
Price
MC
ATC
P = minimum
ATC
0
Supply
Quantity (firm)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
0
Quantity (market)
43
Why Do Competitive Firms Stay in Business If
They Make Zero Profit?
• Profit = TR – TC
• Total cost = explicit cost + implicit cost.
• Profit = 0 implies TR = explicit cost + implicit
cost
• In the zero-profit equilibrium, the firm earns
enough revenue to compensate the owners for
the time and money they spend to keep the
business going.
• So, don’t feel sorry for the owners!
44
Recap: Economic and Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
45
Application
• We will now work through what happens when
the demand for a product increases.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
46
Short Run and Long Run Effects of a Shift in
Demand: an application
• An increase in demand raises price and quantity (for
each firm and the industry) in the short run.
• Firms earn positive profits
• because price now exceeds average total cost.
•
•
•
•
•
New firms enter
Market supply increases (shifts right)
Price decreases; gradually returns to minimum ATC
Profits decrease; gradually return to zero
So, the long-run effect of an increase in demand is as
follows: the price is unchanged, each firm’s output is
unchanged, the number of firms increases, industry
output increases.
47
Figure 8 An Increase in Demand in the Short Run and
Long Run
(a) Initial zero-profit long-run equilibrium
Market
Firm
Price
Price
MC
ATC
Short-run supply, S1
A
P1
Long-run
supply
P1
Demand, D1
0
q1
Quantity (firm)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
0
Q1
Quantity (market)
48
Figure 8 An Increase in Demand in the Short Run and
Long Run
(b) Short-Run Response to an increase in demand
Market
Firm
Price
Price
Profit
MC
ATC
P2
B
P2
S1
A
P1
P1
D2
Long-run
supply
D1
0
q1
q2
Quantity (firm)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
0
Q1
Q2
Quantity (market)
49
Figure 8 An Increase in Demand in the Short Run and
Long Run
(c) Long-Run Response to positive short-run profits: new firms enter,
pushing the short-run market supply to the right.
Market
Firm
Price
Price
MC
ATC
B
P2
S1
S2
C
A
P1
Long-run
supply
P1
D2
D1
0
q1
Quantity (firm)
0
Q1
Q2
Q3 Quantity (market)
An increase in demand leads to an increase in price in the short run. But this
price increase will not last. New firms will enter and push the price back to P1,
the minimum ATC. Each firm’s output will return to q1. The only long-run effect 50
of
demand will be to increase the number of firms.
Any Questions?
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
51
Summary
• Because a competitive firm is a price taker, its
revenue is proportional to the amount of
output it produces.
• The price of the good equals both the firm’s
average revenue and its marginal revenue.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
52
Summary
• To maximize profit, a firm chooses the quantity
of output such that marginal revenue equals
marginal cost.
• This is also the quantity at which price equals
marginal cost.
• Therefore, the firm’s marginal cost curve is its
supply curve.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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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
both fixed and variable costs, it will choose to
exit if the price is less than average total cost.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
54
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 time horizons.
• In the long run, the number of firms adjusts to
drive the market back to the zero-profit
equilibrium.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
55