Chapter 14
Firms in Competitive Markets
What is a Competitive Market?
• Characteristics:
– Many buyers & sellers
– Goods offered are largely the same
– Firms can freely enter &/or exit the market
– Buyers & sellers are price takers
Revenue of a Competitive Firm
• Total Revenue = Price x Quantity
(remember these types of firms can’t change
price, so they have to change Q)
• Average Revenue = TR/Quantity
• Marginal Revenue = Change in TR/Change in Q
• For perfectly competitive firms, AR & MR are
equal to the price
Profit Maximization
• If MR > MC, increasing output raises profit
• If MR < MC, decreasing output raises profit
• Therefore, profit maximization is where
MR = MC
Profit Maximization
• Since MR = Market Price for perfectly
competitive firms, it looks like…
Profit Maximization
• Since MC determines Q, it becomes the
competitive firm’s supply curve
Short-Run Decision to Shut Down
• Shutdown vs. Exit
- If you temporarily shut down, you still pay
fixed costs
• You shut down if TR < VC or similarly, P < AVC
• Competitive Firm’s short-run supply curve is
portion of MC curve above AVC
Short-Run Decision to Shut Down
Sunk Costs
• Cost has already been committed and cannot
be recovered – ignore them in decisionmaking
• Cases: Near Empty Restaurants & Off-Season
Miniature Golf
Firm’s Long-Run Decision
to Exit or Enter a Market
• Firm will exit market if revenue it would get
from producing is less than its total costs
(exit if P < ATC)
• Firm will enter market if P > ATC
• Firm’s long-run supply curve is the portion of
its MC curve that lies above ATC
Measuring Profit
• Profit = (P – ATC) x Q
Short Run: Fixed # of Firms
• As long as P > AVC, each firm’s MC curve is its
supply curve
• Market is just a sum of the Q for each indiv.
firm
Long Run: Entry & Exit
• Firms will enter or exit based on incentives
(are existing firms profitable?)
• At the end of the process, firms that remain in
the market must be making zero economic
profit
• This happens when P = ATC or TR = TC
SO…
Long-Run Equilibrium
• If firms maximize profit at P = MC and P = ATC
to make economic profits equal zero then…
The level of production
will be at the efficient
scale where MC = ATC
Why stay in business with Zero Profit?
• Zero profit includes opportunity costs, so to
stay in business, firm’s revenues must be
compensating owner for opp. costs
Shift in Demand in Short & Long Run
• Side by Side Analysis
• If market is in long-run equilibrium, firms earn
zero profit and P = min. of ATC
• If demand increases, price increases and firms
will produce more in short run… so, P is now
greater than ATC and firms are earning profit
• Profit attracts new firms and supply curve
shifts to right, lowering price and returning us
to zero economic profit
Side by Side Analysis
Why Long-Run Supply Curve Might
Slope Upward
• Normally, we assume all entrants to market
face same costs and ATC was unaffected by
entry of others, so long-run Supply curve of
industry is horizontal line at minimum of ATC
Why Long-Run Supply Curve Might
Slope Upward
• 2 possible reasons why this might not be the
case:
1. If a resource is limited in quantity, entry will
increase price of resource and raise ATC
2. If firms have different costs, it’s likely those
with lowest costs enter industry first. If
demand then increases, firms that would
enter will likely have higher costs