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FIRMS IN COMPETITIVE
MARKETS
Characteristics of Perfect Competition
1.
2.
3.
4.
5.
6.
7.
There are many buyers and sellers in the market.
The goods offered by the various sellers are largely
the same.
Firms can freely enter or exit the market.
The individual firm produces a small portion of total
market output.
The firm cannot have any influence over the price it
charges.
The individual firm in a perfectly competitive market
is a price taker.
It takes the price determined by the market as the
price that it will receive for its output.
Revenue of a Competitive Firm
• Total revenue for a firm is the selling price
times the quantity sold.
TR = (P X Q)
Revenue of a Competitive Firm
• Total revenue is proportional to the
amount of output.
Revenue of a Competitive Firm
• Average revenue tells us how much
revenue a firm receives for the typical
unit sold.
Revenue of a Competitive Firm
• In perfect competition, average revenue
equals the price of the good.
Revenue of a Competitive Firm
• In perfect competition, average revenue
equals the price of the good.
Total revenue
Average revenue =
Quantity
(Price  Quantity)
=
Quantity
= Price
Revenue of a Competitive Firm
• Marginal revenue is the change in total
revenue from an additional unit sold.
MR =DTR/DQ
Revenue of a Competitive Firm
• For competitive firms, marginal revenue
equals the price of the good.
Profit Maximization for the
Competitive Firm
• The goal of a competitive firm is to
maximize profit.
This means that the firm will want to
produce the quantity that maximizes the
difference between total revenue and
total cost.
Profit Maximization for the
Competitive Firm
• Profit maximization occurs at the
quantity where marginal revenue
equals marginal cost.
If MR > MC, increase Q to increase profit.
If MR < MC, decrease Q to increase profit.
If MR = MC, profit is maximized.
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
0
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
ATC
AVC
0
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
ATC
AVC
0
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
ATC
P
0
P = AR = MR
AVC
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
MC
ATC
P
0
P = AR = MR
AVC
QMAX
Quantity
Profit Maximization for the
Competitive Firm
• A competitive firm will adjust its
production level until quantity reaches
QMAX where profit is maximized.
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
ATC
P
0
P = AR = MR
AVC
QMAX
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
ATC
P = MR1
P = AR = MR
AVC
MC1
0
Q1
QMAX
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
ATC
P = MR1
P = AR = MR
AVC
MC1
MR > MC,
increase Q
0
Q1
QMAX
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
MC2
ATC
P = MR2
0
P = AR = MR
AVC
QMAX
Q2
Quantity
Profit Maximization for the
Competitive Firm
Costs
and
Revenue
MC
MC2
ATC
P = MR2
P = AR = MR
AVC
MR < MC,
decrease Q
0
QMAX
Q2
Quantity
The Firm’s Decision to Shut
Down
• A shutdown refers to a short-run decision
not to produce anything during a specific
period of time.
• Exit refers to a long-run decision to leave
the market.
The Firm’s Decision to Shut
Down
• The firm considers its sunk costs when
deciding to exit, but ignores them when
deciding whether to shut down.
Sunk costs are costs that have already
been committed and cannot be
recovered.
The Firm’s Decision to Shut
Down
• The firm shuts down if the revenue it gets
from producing is less than the variable
cost of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC
The Firm’s Decision to Shut
Down
Costs
0
Quantity
The Firm’s Decision to Shut
Down
Costs
MC
ATC
AVC
0
Quantity
The Firm’s Decision to Shut
Down
Costs
If P > ATC,
keep producing
at a profit.
MC
ATC
AVC
0
Quantity
The Firm’s Decision to Shut
Down
Costs
If P > ATC,
keep producing
at a profit.
MC
ATC
If P > AVC,
keep producing
in the short run.
0
AVC
Quantity
The Firm’s Decision to Shut
Down
Costs
If P > ATC,
keep producing
at a profit.
MC
ATC
If P > AVC,
keep producing
in the short run.
AVC
If P < AVC,
shut down.
0
Quantity
The Firm’s Decision to Shut
Down
• The portion of the marginal-cost curve
that lies above average variable cost is
the competitive firm’s short-run supply
curve.
The Firm’s Decision to Shut
Down
Costs
If P > ATC,
keep producing
at a profit.
MC
ATC
If P > AVC,
keep producing
in the short run.
AVC
If P < AVC,
shut down.
0
Quantity
The Firm’s Decision to Shut
Down
Costs
Firm’s short-run
supply curve
MC
ATC
AVC
0
Quantity
The Long-Run Decision to Exit
an Industry
• In the long-run, the firm exits if the
revenue it would get from producing is
less than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
The Long-Run Decision to
Enter an Industry
• A firm will enter the industry if such an
action would be profitable.
Enter if TR > TC
Enter if TR/Q > TC/Q
Enter if P > ATC
The Competitive Firm’s LongRun Supply Curve
The Competitive Firm’s LongRun Supply Curve
Costs
0
Quantity
The Competitive Firm’s LongRun Supply Curve
Costs
MC
ATC
AVC
0
Quantity
The Competitive Firm’s LongRun Supply Curve
Costs
Firm enters
if P > ATC
MC
ATC
AVC
0
Quantity
The Competitive Firm’s LongRun Supply Curve
Costs
MC
Firm enters
if P > ATC
ATC
AVC
Firm exits
if P < ATC
0
Quantity
The Competitive Firm’s LongRun Supply Curve
• The competitive firm’s long-run supply
curve is the portion of its marginal-cost
curve that lies above average total cost.
The Competitive Firm’s LongRun Supply Curve
Costs
MC
Firm enters
if P > ATC
ATC
AVC
Firm exits
if P < ATC
0
Quantity
The Competitive Firm’s LongRun Supply Curve
Costs
Firm’s long-run
supply curve
MC
ATC
AVC
0
Quantity
The Firm’s Short-Run and
Long-Run Supply Curves
• Short-Run Supply Curve
The portion of its marginal cost curve that
lies above average variable cost.
• Long-Run Supply Curve
The marginal cost curve above the
minimum point of its average total cost
curve.
Profit as the Area Between Price
and Average Total Cost
Profit as the Area Between Price
and Average Total Cost
Price
0
Quantity
Profit as the Area Between Price
and Average Total Cost
Price
MC
0
ATC
Quantity
Profit as the Area Between Price
and Average Total Cost
Price
MC
ATC
P
P = AR = MR
0
Quantity
Profit as the Area Between Price
and Average Total Cost
Price
MC
P
ATC
P = AR = MR
ATC
Profit-maximizing
quantity
0
Q
Quantity
Profit as the Area Between Price
and Average Total Cost
Price
MC
ATC
Profit
P
P = AR = MR
ATC
Profit-maximizing
quantity
0
Q
Quantity
Loss as the Area Between Price
and Average Total Cost
Loss as the Area Between Price
and Average Total Cost
Price
MC
0
ATC
Quantity
Loss as the Area Between Price
and Average Total Cost
Price
MC
ATC
P
P = AR = MR
0
Quantity
Loss as the Area Between Price
and Average Total Cost
Price
MC
ATC
ATC
P
P = AR = MR
Loss-minimizing quantity
0
Q
Quantity
Loss as the Area Between Price
and Average Total Cost
Price
MC
ATC
ATC
P
P = AR = MR
Loss
Loss-minimizing quantity
0
Q
Quantity
Quick Quiz!
• How does the price faced by a profitmaximizing competitive firm compare to
its marginal cost?
Quick Quiz!
• When will a profit-maximizing firm
decide to shut down?
Supply in a Competitive
Market
• Market supply equals the sum of the
quantities supplied by the individual
firms in the market.
Supply in a Competitive
Market
• Market Supply with a Fixed Number of
Firms
For any given price, each firm supplies a
quantity of output so that price equals its
marginal cost.
The market supply curve reflects the
individual firms’ marginal cost curves.
Supply in a Competitive
Market
• Market Supply with Entry and Exit
Firms will enter or exit the market until
profit is driven to zero.
In the long-run, price equals the
minimum of average total cost.
The long-run market supply curve is
horizontal at this price.
The Supply Curve in a
Competitive Market
(a) Firm’s Zero-Profit Condition
Price
(b) Market Supply
Price
MC
P=
minimum
ATC
0
ATC
Supply
Quantity
(firm)
0
Quantity
(market)
Increase in Demand in the
Short Run
• An increase in demand raises price and
quantity in the short run.
• Firms earn profits because price now
exceeds average total cost.
Initial Condition
Market
Firm
Price
0
Price
Quantity
(firm)
0
Quantity
(market)
Initial Condition
Market
Firm
Price
Price
MC ATC
S1
A
P1
Long-run
supply
P1
D1
0
Quantity
(firm)
0
Q1
Quantity
(market)
Short-Run Response
Market
Firm
Price
Price
MC ATC
B S1
A
P1
P1
D1
0
Quantity
(firm)
0
Q1
Long-run
supply
D2
Quantity
(market)
Short-Run Response
Market
Firm
Price
Price
MC ATC
B
P2
P2
P1
P1
S1
A
D1
0
Quantity
(firm)
0
Q1 Q2
Long-run
supply
D2
Quantity
(market)
Short-Run Response
Market
Firm
Price
Price
Profit
MC ATC
B
P2
P2
P1
P1
S1
A
D1
0
Quantity
(firm)
0
Q1 Q2
Long-run
supply
D2
Quantity
(market)
Increase in Demand in the
Long Run
• Over time, the short-run supply curve
shifts as profits encourage new firms to
enter the market.
Increase in Demand in the
Long Run
• Price falls as new firms enter the market.
Increase in Demand in the
Long Run
• In the new long-run equilibrium profits
return to zero and price returns to
minimum average total cost.
Increase in Demand in the
Long Run
• The market has more firms to satisfy the
greater demand.
Long-Run Response
Market
Firm
Price
Price
Profit
MC ATC
B
P2
P2
P1
P1
S1
A
D1
0
Quantity
(firm)
0
Q1 Q2
Long-run
supply
D2
Quantity
(market)
Long-Run Response
Market
Firm
Price
Price
Profit
MC ATC
B
P2
P2
P1
P1
S1
S2
A
Long-run
supply
D2
D1
0
Quantity
(firm)
0
Q1 Q2
Quantity
(market)
Long-Run Response
Market
Firm
Price
Price
MC ATC
B
P2
P1
S1
S2
A
Long-run
supply
P1
D2
D1
0
Quantity
(firm)
0
Q1 Q2
Quantity
(market)
Increase in Demand in the
Short and Long Run
Market
Firm
Price
Price
MC ATC
B
A
P1
S1
C
P1
S2
Long-run
supply
D2
D1
0
Quantity
(firm)
0
Q1 Q2 Q3 Quantity
(market)
Why the Long-Run Supply
Curve Might Slope Upward
• Some resources used in production may
be available only in limited quantities.
• Firms may have different costs.
Conclusion
• 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
Conclusion
• To maximize profit a firm chooses the
quantity of output where marginal
revenue equals marginal cost.
• This is also the quantity at which price
equals marginal cost.
Conclusion
• In the short run, the firm will choose to
shut down temporarily if the price of the
good is less than average variable cost.
• In the long run, it will choose to exit if the
price is less than average total cost.
Conclusion
• If firms can freely enter and exit the
market, the price also equals the lowest
possible average total cost of production
in the long run.
• The number of firms adjusts to drive the
market back to the zero-profit
equilibrium.
Conclusion
• Because firms can enter and exit more
easily in the long run than the short run,
the long-run supply curve is typically
more elastic than the short-run supply
curve.
FIRMS IN COMPETITIVE
MARKETS
End of Chapter 14
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
MC
MC2
ATC
P = MR1 = MR2
P = AR = MR
AVC
MC1
0
Figure 14-1
Q1
QMAX
Q2
Quantity
Price
MC
P2
ATC
P1
AVC
0
Figure 14-2
Q1
Q2
Quantity
Costs
Firm’s short-run
supply curve
MC
ATC
AVC
Firm
shuts
down if
P < AVC
0
Figure 14-3
Quantity
Costs
Firm’s long-run
supply curve
MC
ATC
AVC
Firm exits
if P < ATC
0
Figure 14-4
Quantity
(a) A Firm with Profits
Price
MC
ATC
Profit
P
Figure 14-5a
ATC
P = AR = MR
0
Q
Quantity
(profit-maximizing quantity)
(b) A Firm with Losses
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Figure 14-5b
Q
(loss-minimizing quantity)
Quantity
(a) Individual Firm Supply
Price
(b) Market Supply
Price
MC
Supply
$2.00
$2.00
1.00
1.00
0
Figure 14-6
100
200
Quantity (firm)
0
100,000
200,000
Quantity (market)
(a) Firm s Zero-Profit Condition
Price
(b) Market Supply
Price
MC
ATC
P = minimum
ATC
0
Figure 14-7
Supply
Quantity (firm)
0
Quantity (market)
(a) Initial Condition
Market
Firm
Price
Price
MC
P1
ATC
Short-run supply
P
P1
A
Long-run
supply
Demand
0
Quantity (firm)
0
Q1
Quantity (market)
(b) Short-Run Response
Market
Firm
Price
Price
Profit
B
MC ATC
P2
P2
P
1
P1
S1
A
D1
0
Quantity (firm)
0
Q1 Q2
Long-run
supply
D2
Quantity (market)
(c) Long-Run Response
Firm
Market
Price
Price
MC
ATC
P1
P2
P1
B
A
S1
C
S2
Long-run
supply
D2
D1
0
Figure 14-8
Quantity (firm)
0
Q 1 Q 2 Q 3 Quantity (market)
(a) Initial Condition
Market
Firm
Price
Price
MC ATC
P1
0
Figure 14-8a
P
Quantity
(firm)
P1
0
A
Q1
Short-run supply, S1
Long-run
supply
Demand, D1
Quantity
(market)
(b) Short-Run Response
Market
Firm
Price
Price
Profit
MC ATC
B
P2
P2
P1
P1
S1
A
D1
0
Figure 14-8b
Quantity
(firm)
0
Q1 Q2
Long-run
supply
D2
Quantity
(market)
(c) Long-Run Response
Firm
Market
Price
Price
MC
ATC
P1
P2
P1
B
A
S1
C
S2
Long-run
supply
D2
D1
0
Figure 14-8c
Quantity
(firm)
0
Q1 Q2 Q3 Quantity
(market)