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Chapter Eight
Competitive
Firms and
Markets
Application
• Cheap handheld video cameras have
revolutionized the hard-core pornography market.
Previously, making movies required expensive
equipment and some technical expertise. Now
anyone with a couple of thousand dollars and a
moderately steady hand can buy and use a video
camera to make a movie. Consequently, many
new firms have entered the market, and the
supply curve of porn movies has slithered
substantially to the right. Whereas only 1,000 to
2,000 video porn titles were released annually in
the United States from 1986 to 1991, the number
grew to nearly 10,000 by 1999 (“Branded Flesh,”
Economist, August 14, 1999: 56).
© 2007 Pearson Addison-Wesley. All rights reserved.
8–2
Competitive Firms and Markets
• In this chapter, we examine five main
topics
– Competition
– Profit maximization
– Competition in the short run
– Competition in the long run
– Zero profit for competitive firms in the long
run
© 2007 Pearson Addison-Wesley. All rights reserved.
8–3
Competition
• Competition is a common market
structure that has very desirable
properties, so it is useful to compare
other market structures to competition.
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8–4
Price Taking
• Economists say that a market is
competitive if each firm in the market is
a price taker: a firm that cannot
significantly affect the market price for
its output or the prices at which it buys
its inputs.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–5
Why the Firm’s Demand Curve is
Horizontal
• Consumers believe that all firms in the market
sell identical products.
• Firms freely enter and exit the market.
• Buyers and sellers know the prices charged
by firms.
• Transaction costs—the expenses of finding a
trading partner and making a trade for a good
or service other than the price paid for that
good or service—are low.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–6
Why the Firm’s Demand Curve is
Horizontal
• We call a market in which all these
conditions hold a perfectly competitive
market. In such a market, if a firm raised
its price above the market price, the firm
would be unable to make any sales.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–7
Why We Study Perfect Competition
• Perfectly competitive markets are
important for two reasons. First, many
markets can be reasonably described
as competitive. Many agricultural and
other commodity markets, stock
exchanges, retail and wholesale
markets, building construction markets,
and others have many or all of the
properties of a perfectly competitive
market.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–8
Why We Study Perfect Competition
• Second, a perfectly competitive market
has many desirable properties.
Economists use this model as the ideal
against which real-world markets are
compared.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–9
Profit Maximization
• Profit

– A firm’s profit, , is the difference between
a firm’s revenues, R, and its cost, C:
  R  C.
If profit is negative,   0 , the firm makes
a loss.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–10
Application (Page 223) Breaking
Even on Christmas Trees
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8–11
Two Steps to Maximizing Profit
• A firm’s profit varies with its output level. The
firm’s profit function is
 (q)  R(q)  C (q).
To maximize its profit, any firm (not just
competitive, price-taking firms) must answer
two questions:
– Output decision: If the firm produces, what
output level, q*, maximizes its profit or
minimizes its loss?
– Shutdown decision: Is it more profitable to
produce q* or to shut down and produce no
output?
© 2007 Pearson Addison-Wesley. All rights reserved.
8–12
π, Profit
Figure 8.1 Maximizing Profit
π*
Profit
Dπ < 0
Dπ> 0
1
0
© 2007 Pearson Addison-Wesley. All rights reserved.
1
q*
Quantity, q, Units
per day
8–13
Output Rules
• marginal profit
– the change in profit a firm gets from
selling one more unit of output
• marginal revenue (MR)
– the change in revenue a firm gets
from selling one more unit of output
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8–14
Output Rules
• Output Rule 1: The firm sets its output at
when its profit is maximized.
• Output Rule 2: A firm sets its output where
its marginal profit is zero.
Marginal profit(q)  MR(q)  MC (q).
Because profit is  (q)  R(q)  C (q) , marginal
profit is the difference between marginal
revenue and marginal cost:
d (q) dR(q) dC (q)


 MR  MC.
dq
dq
dq
© 2007 Pearson Addison-Wesley. All rights reserved.
8–15
Output Rules
• Output Rule 3: A firm sets its output
where its marginal revenue equals its
marginal cost
MR(q)  MC (q).
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8–16
Shutdown Rules
• Shutdown Rule 1: The firm shuts down only if
it can reduce its loss by doing so.
The firm compares its revenue to its variable
cost only when deciding whether to stop
operating. Because the fixed cost is sunk—
the expense cannot be avoided by stopping
operations (Chapter 7) —the firm pays this
cost whether it shuts down or not. The sunk
fixed cost is irrelevant to the shutdown
decision.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–17
Shutdown Rules
• Shutdown Rule 2: The firm shuts down
only if its revenues is less than its
avoidable cost.
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8–18
Competition in the Short Run
• Short-Run Output Decision
– Because a competitive firm’s marginal
revenue equals the market price, a
profit-maximizing competitive firm
produces the amount of output at which
its marginal cost equals the market price:
MC (q )  p.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–19
Figure 8.2
How a
Competitive
Firm
Maximizes
Profit
(a)
Cost, C
4,800
1
2,272
MR =
8
π*
1,846
426
100
0
– 100
Revenue
π(q )
π* = $426,000
140
284
q, Thousand metric tons of lime per year
(b)
MC
10
AC
e
8
p = MR
π* = $426,000
6.50
6
0
© 2007 Pearson Addison-Wesley. All rights reserved.
140
284
q, Thousand metric tons of lime per year
8–20
Solved Problem 8.1

• If a specific tax of
is collected from
only one competitive firm, how should
that firm change its output level to
maximize its profit, and how does its
maximum profit change?
1. How the tax shifts the marginal cost and average
cost curves?
2. Determine the before-tax and after-tax equilibria
and the amount by which the firm adjusts its
output.
3. How the profit changes after the tax?
© 2007 Pearson Addison-Wesley. All rights reserved.
8–21
Page 229 Solved Problem 8.1
MC 2 = MC1 + 
MC1
AC2 = AC1 + 
AC1
e2
p
e1
p = MR
A

AC2 (q 2)
B
AC1(q 1)

q2
© 2007 Pearson Addison-Wesley. All rights reserved.
q1
q, Units per year
8–22
Short-Run Shutdown Decision
• The firm can gain by shutting down only if its
revenue is less than its short-run variable
cost:
pq  VC.
(8.3)
By dividing both sides of Equation 8.3 by
output, we can write this condition as
p  AVC (q ).
A competitive firm shuts down if the market
price is less than the minimum of its short-run
average variable cost curve.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–23
Short-Run Shutdown Decision
• In summary, a competitive firm uses a twostep decision-making process to maximize its
profit.
• First, the competitive firm determines the
output that maximizes its profit or minimizes its
loss when its marginal cost equals the market
price (which is its marginal revenue): MC  p.
• Second, the firm chooses to produce that
quantity unless it would lose more by
operating than by shutting down. The firm
shuts down only if the market price is less than
the minimum of its average variable
cost, p  AVC.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–24
Figure 8.3 The Short-Run Shutdown
Decision
MC
AC
b
6.12
6.00
AVC
A = $62,000
5.50
B = $36,000
5.14
5.00
a
0
50
p
e
100
© 2007 Pearson Addison-Wesley. All rights reserved.
140
q, Thousand metric tons of lime per year
8–25
Short-Run Firm Supply Curve
• Tracing Out the Short-Run Supply
Curve
– The competitive firm’s short-run
supply curve is its marginal cost curve
above its minimum average variable
cost.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–26
Figure 8.4 How the Profit-Maximizing
Quantity Varies with Price
S
e
4
p4
8
e
3
AC
7
p
AVC
e2
6
e
1
p
p
5
3
2
1
MC
0
q 1 = 50
q 2 = 140
© 2007 Pearson Addison-Wesley. All rights reserved.
q 3 = 215
q4 = 285
q, Thousand metric tons of lime per year
8–27
Figure 8.5 Effect of an Increase in the Cost of
Materials on the Vegetable Oil Supply Curve
S2
S1
AVC 2
AVC 1
e
12
2
e
1
p
8.66
7
MC 2
MC 1
0
100
© 2007 Pearson Addison-Wesley. All rights reserved.
145
178
q, Hundred metric tons of oil per year
8–28
Short-Run Market Supply Curve
• Short-Run Market Supply with Identical
Firms.
– The market supply curve flattens as the
number of firms in the market increases
because the market supply curve is the
horizontal sum of more and more upwardsloping firm supply curves.
– The more identical firms producing at a
given price, the flatter (more elastic) the
short-run market supply curve at that price.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–29
Figure 8.6 Short-Run Market Supply
with Five Identical Lime Firms
(a) Firm
(b) Market
S1
7
7
S1
S2
S3
S4
6.47
AVC
6.47
S5
6
6
5
5
MC
0
50
140 175
q, Thousand metric tons
of lime per year
© 2007 Pearson Addison-Wesley. All rights reserved.
0
50 150 250
100 200
700
Q, Thousand metric tons
of lime per year
8–30
Short-Run Market Supply Curve
• Short-Run Market Supply with Firms
That Differ.
– Where firms differ, only the low-cost firm
supplies goods at relatively low prices. As
the price rises, the other, higher-cost firm
starts supplying, creating a stairlike market
supply curve. The more suppliers there are
with differing costs, the more steps there
are in the market supply curve.
– Differences in costs are one explanation for
why some market supply curves are
upward sloping.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–31
Figure 8.7 Short-Run Market Supply
with Two Different Lime Firms
S2
8
S1
S
7
6
5
0
25 50
100 140 165
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215
315
450
q, Q, Thousand metric tons of lime per year
8–32
Short-Run Competitive Equilibrium
• By combining the short-run market
supply curve and the market demand
curve, we can determine the short-run
competitive equilibrium.
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8–33
Figure 8.8 Short-Run Competitive
Equilibrium in the Lime Market
(a) Firm
(b) Market
8
e
7
6.97
A
S
8
S1
1
D1
7
E
AC
B
1
D2
6.20
6
AVC
6
C
5
5
e
2
0
q = 50
2
q = 215
1
q, Thousand metric tons
of lime per year
© 2007 Pearson Addison-Wesley. All rights reserved.
0
E
2
Q = 250
2
Q = 1,075
1
Q, Thousand metric tons
of lime per year
8–34
Solved Problem 8.3
• What is the effect on the short-run
equilibrium of a specific tax of
per unit
that is collected from all n firms in s market?
What is the incidence of the tax?

1. How the tax shifts a typical firm’s marginal cost
and average cost curves and hence its supply
curve?
2. How the market supply curve shifts?.
3. Determine how the short-run market equilibrium
changes.
4. The incidence of the tax: The equilibrium price
increase, but by less than the full amount of the
tax: p  p   .
2
1
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8–35
Page 238 Solved Problem 8.3
(a) Firm
(b) Market
S1 +  S1
S+
AVC + 
AVC

e2
p
2
p

E2
p +
1

E1
e1
1
S

D
MC + 
MC
q q
2 1
© 2007 Pearson Addison-Wesley. All rights reserved.
q, Units per year
Q = nq Q = nq
2
2 1
1
q, Units per year
8–36
Competition in the Long Run
• Long-run competitive profit
maximization
– In the long run, typically all costs are
variable, so the firm does not have to
consider whether fixed costs are sunk or
avoidable.
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8–37
Long-Run Output Decision
• The firm picks the quantity that
maximizes long-run profit, the difference
between revenue and long-run cost.
• Equivalently, it operates where long-run
marginal profit is zero and where
marginal revenue equals long-run
marginal cost.
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8–38
Long-Run Shutdown Decision
• After determining the output level, q*,
that maximizes its profit or minimizes its
loss, the firm decides whether to
produce or shut down
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8–39
Long-Run Firm Supply Curve
• A firm’s long-run supply curve is its
long-run marginal cost curve above the
minimum of its long-run average cost
curve (because all costs are variable in
the long run).
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8–40
Figure 8.9 The Short-Run and
Long-Run Supply Curves
S SR
S LR
LRAC
SRAC
SRAVC
p
35
B
A
28
25
24
20
LRMC
SRMC
0
50
© 2007 Pearson Addison-Wesley. All rights reserved.
110
q, Units per year
8–41
Long-Run Market Supply Curve
• The competitive market supply curve is the
horizontal sum of the supply curves of the
individual firms in both the short run and long
run.
• In the long run, firms can enter or leave the
market. Thus before we can add all the
relevant firm supply curves to obtain the longrun market supply curve, we need to
determine how many firms are in the market
at each possible market price.
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8–42
Role of Entry and Exit
• The number of firms in a market in the
long run is determined by the entry and
exit of forms.
– A firm enters the market if it can make a
long-run profit,   0 .
– A firm exits the market to avoid a long-run
loss,   0.
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8–43
Table 8.1 Average Annual Entry and Exit Rates
in Selected U.S. Industries, 1989–1996
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8–44
Long-Run Market Supply with Identical
Firms and Free Entry
• The long-run market supply curve is flat
at the minimum long-run average cost if
firms can freely enter and exit the
market, an unlimited number of firms
have identical costs, and input prices
are constant.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–45
Figure 8.10 Long-Run Firm and Market
Supply with Identical Vegetable Oil Firms
(a) Firm
(b) Market
S1
LRAC
10
Long-run market supply
10
LRMC
0
150
q, Hundred metric tons of oil per year
© 2007 Pearson Addison-Wesley. All rights reserved.
0
Q, Hundred metric tons of oil per year
8–46
Long-Run Market Supply When Entry
is Limited
• If the number of firms in a market is
limited in the long run, the market
supply curve slopes upward.
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8–47
Long-Run Market Supply When Firms
Differ
• A second reason why some long-run
market supply curves slope upward is
that firms differ.
• Firms with relatively low minimum longrun average costs are willing to enter
the market at lower prices than others,
resulting in an upward-sloping long-run
market supply curve.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–48
Application (Page 246) Upward-Sloping
Long-Run Supply Curve for Cotton
Iran S
1.71
United States
1.56
Nicaragua, Turkey
1.43
Brazil
1.27
1.15
1.08
0.71
0
Australia
Argentina
Pakistan
1
2
© 2007 Pearson Addison-Wesley. All rights reserved.
3
4
5
6
6.8
Cotton, billion kg per year
8–49
Long-Run Market Supply When Input
Prices Vary with Output
• A third reason why market supply
curves may slope is nonconstant input
prices.
• In conclusion, the long-run supply curve
is upward sloping in an increasing-cost
market and flat in a constant-cost
market.
© 2007 Pearson Addison-Wesley. All rights reserved.
8–50
Figure 8.11 Long-Run Market
Supply in an Increasing-Cost Market
(a) Firm
(b) Market
MC 2
MC 1
AC 2
S
AC 1
e
E
2
p
2
2
e
p
E
1
1
1
q q
1 2
q, Units per year
© 2007 Pearson Addison-Wesley. All rights reserved.
Q =n q Q =n q
1
1 1
2
2 2
Q, Units per year
8–51
Figure 8.12 Long-Run Market
Supply in a Decreasing-Cost Market
(a) Firm
(b) Market
MC 1
MC 2
AC1
AC 2
e
p
1
p
E
1
e
1
E
2
2
2
S
q1 q2
q, Units per year
© 2007 Pearson Addison-Wesley. All rights reserved.
Q1 = n1q1 Q2 = n2q 2
Q, Units per year
8–52
Long-Run Competition Equilibrium
• The intersection of the long-run market
supply and demand curves determines
the long-run competitive equilibrium.
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8–53
Figure 8.14 The Short-Run and
Long-Run Equilibria for Vegetable Oil
(a) Firm
(b) Market
D1
MC
D2
AC
S SR
f2
11
10
7
0
AVC
e
f1
100 150165
q, Hundred metric tons
of oil per year
© 2007 Pearson Addison-Wesley. All rights reserved.
F2
11
10
7
0
E1
E 2 S LR
F1
1,500 2,000
3,300 3,600
Q, Hundred metric tons
of oil per year
8–54
Zero Profit for Competitive Firms in the
Long Run
• Competitive firms earn zero profit in the
long run whether or not entry is
completely free.
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8–55
Zero Long-Run Profit with Free Entry
• The long-run supply curve is horizontal
if firms are free to enter the market,
firms have identical cost, and input
prices are constant.
• All firms in the market are operating at
minimum long-run average cost.
• The are indifferent between shutting
down or not because they are earning
zero profit.
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8–56
Zero Long-Run Profit When Entry is
Limited
• In some markets, firms cannot enter in
response to long-run profit opportunities.
• One reason for the limited number of
firms is that the supply of an input is
limited.
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8–57
Zero Long-Run Profit When Entry is
Limited
• One might think that firms could make
positive long-run economic profits in
such markets; however, that’s not true.
• The reason why firms earn zero
economic profits is that firms bidding for
the scarce input drive its price up until
the firms’ profits are zero.
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8–58
Figure 8.15 Rent
MC
AC (including rent)
AC (excluding rent)
p*
π* = Rent
q*
© 2007 Pearson Addison-Wesley. All rights reserved.
q, Bushels of tomatoes per year
8–59