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Perfectly Competitive
Theory of The Firm
Learning Objectives
 Describe using examples, the assumed characteristics of
the perfectly competitive market.
 Explain, using a diagram the shape of the PC’s AR, MR,
MC.
 Explain, using a diagram, that it is possible for PC markets
to make economic, normal and negative profit in the shortrun based on MC and MR rule.
 Distinguish between SR shut-down P and break-even P
 Explain, using a diagram, how a PC will move from SR
equilibrium to LR equilibrium, Allocative and productive
efficiency
Types of Markets (degrees of
competition)
One firm
2-12 firms
many firms
many, many firms
Monopoly
Oligopoly
Monopolistic
Perfect
Competition
Competition
3
Assumptions of the Perfectly Competitive
Market
• large number of firms
• Selling homogeneous (identical) products
• no barriers to entry or exit
• no control over the market price (Price-taker)
• Makes only normal profit in the long run (break-even)
Example:
 There are hundreds of coffee shops in the city of
Toronto
 They all pay the same wages
 They all sell identical products (coffee, muffins and etc.)
 It is cheap and easy to open a coffee shop
Price Takers
 This means that PC firms have no control over the
price as it’s determined by the market
 This is also true in the case of AR and MR as P is
constant
 Demand for the output is perfectly elastic
Profit Maximization
 This has already been discussed in in the previous
section
 Profit is maximized when MR=MC
SHORT-RUN
PRODUCTION
COST CURVES:
• Marginal Cost, which slopes upwards
because of diminishing marginal
returns
• Average variable cost, which is the
per unit labor costs of production
• Average total cost, which is the
average variable costs plus the
average fixed costs (the per-unit
costs of fixed capital resources)
• Recall also that MC must intersect
the average cost curves at their
lowest points.
 REMEMBER
Profit Max.- Profit Earning
Firm:
 when producing at its MC=MR point
 When P>ATC, then the firm is making ECONOMIC
PROFIT
 This means the firm has covered all explicit and implicit
cost and earning revenue beyond its cost
Graph
 The firm’s economic profits is the blue area (P-ATC)xQ
 The firm is maximizing its profits by producing where
MR=MC.
Keep In Mind
 Due to the absence of entry barriers, these profits will
not be sustained in the long-run, as new firms will enter
the market.
Discuss
 Discuss with your partner the profit earning firm
Loss-minimization Firm
 when producing at its MC=MR point
 And P<ATC , then the firm will be minimizing its losses
 Earning no economic profit at all
 loss minimizing firm will either exit the industry in the
long-run
 Or hope other firms exit until the supply decreases,
 This will cause the price to rise once again
Graph
 Since the market demand is low, the firm selling price is below ATC
 The firm’s economic losses are the colored area (ATC-P)xQ.
 The firm is minimizing its losses by producing where MR=MC.
 Due to the absence of entry barriers, these losses will be eliminated in the
long-run as firms exit the industry to avoid further losses.
Discuss
 Discuss with your partner the econ loss earning firm
The Breaking-even Firm
 This is when a firm is producing at P=ATC
 Breaking even means a firm is covering all of its explicit
and implicit costs, but earning no additional profit
 Normal Profit
Graph
 The market’s price is set to be = to the ATC
 The firm covering all its costs but no profit
 There is no incentive for the firm to enter or exit
Test Your knowledge
 With your partner, answer the following question in your
note book
 Explain, using a diagram, that it is possible for PC
markets to make economic, normal and negative profit
in the short-run based on MC and MR rule.
Long-Run
Profit Maximization in the Long-run
 The period of time over which firms can adjust all its
variable factors
 Entry and exit in the long-run:
 If econ profits are being earned, firms may want to enter
the market
 If econ losses are being earned, firms may want to
minimize losses by exiting the market
 Due to entry and exit in PC, there are no Econ profits in
the LONG-RUN
 Therefore, all firms BREAK EVEN in the long-run
Entry Eliminates Profit
 When individual firms are earning economic profits in a
PC market, new firms will be attracted to the market
 leading to an increase in market supply and a fall in the
price
 Therefore Profit shall decrease
Example
 In the current market for pizza, Pe is $20 and ATC is
$16, $4 a pizza and total of $800 profit
 Since profits are to be made, more firms want to enter
the market. This will increase the supply and therefore
reduces the price to a breakeven point
Example
 The price of pizza falls from $20 to $15
 MR falls to maintain profit max.,MR=MC
 Profits are eliminated as price falls to firm’s min. ATC
Exit Eliminates Losses
 When individual firms are earning losses in a perfectly
competitive market,
 certain firms will choose to leave the market to avoid
losses and to seek profits elsewhere
Example
 $20 a pizza at $16 ATC, $4 a pizza in losses
 The shop shuts down
 This will cause the S to decrease and therefore price
will rise again
Example
 The price of pizza rises from $12 to $15
 MR rises, causing the firm to increase its output to
maintain its MR=MC level
 Losses are eliminated, as the price rises to the firm’s
minimum ATC
Discussion
 Why in a PC market, firms always break-even in the
long-run?
Pop Quiz
 How will the existence of economic profits in a purely
competitive market affect the total supply in that
market? 2 marks
 How will the existence of economic losses among the
firms in a purely competitive market affect the total
supply in the market? 2 marks
Answers
 Because there are NO BARRIERS TO ENTRY, new
firms will enter a market where profits are being
earned. As new firms enter, market supply will shift out,
lowering the market price faced by firms, eliminating
economic profits.
 Because firms are loss averse, and there are NO
BARRIERS TO EXIT, some firms will leave the
industry, reducing market supply, increasing the price,
eliminating losses for the remaining firms!
Shut-down Rule
 Which firms leave the market and which firms stay?
 The cost of production varies from firm to firm
 This depends on the IMPLICT cost of the owner
 Some owners value their skills and time higher than
others
 Therefore this demines the period they are willing to
stay in the market
 A firm facing econ losses have 2 choices:
 Continue to operate with hope of P=ATC, breakeven
 Shut-down and give up fixed costs (explicit cost = Fc and VC)
 When to shutdown?
 P>AVC or firms total losses continuing to operate >TFC
 If this is not the case, the firm should stay in the market
• Total losses if it continues to operate = (AR-ATC)xQ
• Total losses if it shuts down= (ATC-AVC)xQ
Example
• The demand for pizzas is so low that the price ($10) is lower than the
firm’s AVC ($11). The firm cannot even afford to pay its workers.
• The firm’s total losses (17-10)x160, are greater than its total fixed costs
(17-11)x160. The firm would minimize its losses by shutting down
• This firm should exit the market
Test Your Knowledge
 Explain the shut-down rule.
 Post your answers on edmodo
MC and “Supply” Curve
 As we know, if the price of a good ever falls below a
firm’s AVC, the firm will no longer produce the good.
Reasoning
• As price rises above AVC, the
firm will increases its quantity
in direct relationship with the
price
P
PC Firm
P4
MC
MR4
• As price decreases, but
remains above AVC, the firm
will reduce its output.
Firm's Supply curve
P3
MR3
AVC
• In this regard, the firm’s MC
above its AVC is similar to a
firm’s supply curve. The
quantity supplied by the firm
reflects a direct relationship
with the price of the good
P2
MR2
P1
MR1
Q1
Q2 Q3 Q4
Q
• The MC increases as output increases because of
diminishing marginal returns
• Since the MC increases at higher level of output, firms
require a higher prices in order for them to increase
output, so they can maintain the MR=MC level and
maximize profits.
• In other words, the MC curve represents the
relationship between price and quantity supplied. This is
a direct relationship (demonstrating the law of supply!)
Graph
P
PC Firm
MC
Firm's Supply curve
AVC
Q
Test Your Knowledge
 How does MC curve is similar to the SUPPLY curve?
Explain using laws of supply.
Efficiency in PC
 In long-run equilibrium, purely competitive firms will
produce the efficient level of output and price
 Firms can be productively efficient and an industry can
be allocatively efficient.
Productive efficiency
 Is achieved when firms produce at min ATC
 This means that firms are producing output at lowest cost
possible.
• If price is high enough that firms are earning profits, then the
signal from buyers to sellers is WE WANT MORE
• If price is low enough that firms are earning losses, then the
signal from buyers to sellers is WE WANT LESS
Graph
• Price is higher than the firm’s ATC.
• The firm’s are earning economic profits
• The signal from buyers is “we want more”, so more firms will enter
the market to satisfy demand.
• As new firms enter, price will fall to minimum ATC, and firms will be
more productively efficient!
Allocative Efficiency
 is achieved if a market produces at the quantity where
marginal benefit equals marginal cost (where Price =
Marginal Cost)
• It means: The right amount of output is being
produced. There is neither under nor over-allocation of
resources towards a good in a purely competitive
industry.
 If the price were higher than the MC, this is a signal
that MB(demand) exceeds MC(supply) and more
output is desired
 If price were lower than MC, the signal from buyers to
sellers is that MC exceeds MB and less output is
desired.
 Only when P = MC is the right amount of output being
produced.
Explain the Following Graph in relation to allocative efficiency
Practice Questions
 With your partner, answer the following questions:
 Describe the situation in the market below and firm below:
1. Show the firm's: i) MR, ii) Output, iii) Economic profit or loss
2. Assuming this is a PC market, describe and illustrate the long
run adjustments that will restore this market to Equilibrium.
Show on the graphs, for both the industry and the firm, the
price and output after long-run adjustments
P
Industry
Sindustry
Firm
P
MC
Pe
P
ATC
AVC
MR=D=AR=P1
Industry
Dindustry
Q
Sindustry
Q
P
Firm
MC
ATC
AVC
Pe
MR=D=AR=P1
Dindustry
Q
P
Industry
Sindustry
Q
P
Firm
MC
ATC
AVC
Pe
MR=D=AR=P1
Dindustry
Q
Q