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Chapter 14
Firms in
Competitive Markets
Ratna K. Shrestha
Entry in Personal Computers
•
When IBM introduced its first PC in 1981, there
was little competition; the price was $7,000, and
IBM earned a large economic profit on the new
machine.
•
But new firms such as Compaq, NEC, Dell, and a
host of others entered the market with machines
that were technologically identical to IBM’s.
Exit in Farm Machines
•
•
•
On the other hand in the
case of market for farm
machines, International
Harvester, a manufacturer
of farm equipment, left the
market.
The market became
intensely competitive, and
the firm began to incur an
economic loss.
Why new firms enter some
market while old firms exit
from some other markets?
Overview



What is a Competitive Market?
Profit Maximization and the Competitive Firm
The Supply Curve in a Competitive Market
A Perfectly Competitive Market




A Market in which:
-There are a large number of buyers and sellers such
that no one controls the price.
-The goods offered are functionally identical products.
-There is freedom of market entry & exit.
Examples: markets for oil, agricultural products, lumber,
steel, etc.
These products are more or less identical irrespective of
the producers.
Compare with Water, telephone, and natural gas
markets in which a single producer controls the market.
Perfect Competition-Price Takers

The individual firm produces a small portion of the
total market output such that it cannot influence the
price it charges for the product it sells.

The firm is a Price Taker in the sense that it takes the
market-determined price as the price it will receive for
its output. An individual firm sells all of its products at
that market-determined price.
Revenue of a Competitive Firm



Total Revenue (TR) for a firm is the market selling price
times the quantity sold.
TR = (P x Q)
Total revenue increases at a constant rate, as each unit
sold sells for a constant price, P.
Average Revenue (AR):
– Tells us how much revenue a firm receives for the
typical unit sold.
AR = TR/Q
– Average Revenue equals the Price of the good, in
Perfect Competition.
AR = PQ/Q = P
Revenue of a Competitive Firm

Marginal Revenue:
– Tells us how much revenue a firm receives for
one additional unit of output.
MR = TR/ Q
Marginal Revenue = Price of the good, in Perfect
Competition.
Each unit sold will add the same amount (equal to
the price) to total revenue.
–

Profit Maximization

The goal of a competitive firm (or
any other firm for that matter) is to
maximize profit.
Profit = TR –TC

Maximum profits occur at a
quantity that maximizes the
difference between revenue and
costs.
Profit Maximization
$
$25
Total
Cost
Total Revenue
$20
$15
$ Maximum
Profit
at Q = 3 units!
}
$10
$5
Quantity
1
2
3
4
5
Competitive Firm’s Cost Curves




If there is diminishing marginal productivity (the
productivity of each extra input is smaller and smaller)
then the marginal-cost curve (MC) increases with
output.
The average-total-cost curve (ATC) is U-shaped.
Marginal Cost crosses the ATC curve at the minimum
ATC.
Graphically. . .
Shape of Typical Cost Curves
MC
ATC
Cost ($’s)
AVC
Quantity
Profit- Maximizing Output
In a competitive market P = AR = MR.
 For a given Price, producers maximizes profits when
P = MC.
 Economic rationale: if P > MC (of the last unit
produced), then the firm can add to its profits by
producing more. On the other hand if P < MC (of the
last unit produced), then the firm can increase its
profits by producing less.
 producers produce at the level where P = MC.

Profit- Maximizing Output
Price
MC
ATC
P=MR=AR
P
AVC
Quantity
QMax
Profit- Maximizing Output
MC
Price
ATC
P
ATC
P=MR=AR
AVC
Profits = (P – ATC)Qmax
QMax
Quantity
Profit-Maximizing Output


Profit is maximized when MR = MC.
Economic Rationale:
If MR > MC, then by selling one more good the firm can
make more revenue than the cost it incurs to produce
that good. This means that the firm should produce more
to increase profits.
On the other hand if MR < MC, the firm should decrease
production to increase profits.


A competitive firm will adjust its level of production until
profit is maximized.
In a competitive market, P = MR, so for profit
maximization, P = MR = MC.
A Numerical Example
Price
(P)
$6.00
$6.00
$6.00
$6.00
$6.00
$6.00
$6.00
$6.00
Quantity Total Revenue
(Q)
(TR=PxQ)
0
$0.00
1
$6.00
2
$12.00
3
$18.00
4
$24.00
5
$30.00
6
$36.00
7
$42.00
8
$48.00
Total Cost
(TC)
$3.00
$5.00
$8.00
$12.00
$17.00
$23.00
$30.00
$38.00
$47.00
Profit
(TR-TC)
-$3.00
$1.00
$4.00
$6.00
$7.00
$7.00
$6.00
$4.00
$1.00
Marginal Revenue Marginal Cost
(MR=TR / Q ) MC=  TC /  Q
$6.00
$6.00
$6.00
$6.00
$6.00
$6.00
$6.00
$6.00
$2.00
$3.00
$4.00
$5.00
$6.00
$7.00
$8.00
$9.00
Competitive Firm’s Shut-Down Decision





Shut down: short-run decision not to produce.
Exit: long-run decision to leave the market
permanently.
If P < minimum AVC, the firm should shut-down!
because in this case, the firm is not covering even the
variable costs of production.
In this case if the firm shuts down (variable cost would
be zero), it still has to incur the fixed costs and as a
result, its minimum loss would equal to the firm’s Total
Fixed Cost.
If it produces in such a case, the loss would be equal to
FC plus the VC not covered by the revenue.
Shut-Down! when P < AVC
MC
Price
ATC
AVC
P=MR=AR
Quantity
Q Don’t Produce!
Shut-Down! Condition
MC
Price
ATC
AVC
Q Don’t Produce!
P=MR=AR
Loss in Excess of
Fixed Costs If Produced
Quantity
Competitive Firm’s Shut-Down
Decision




If P > minimum AVC but < ATC, the firm should
produce in the short-run a quantity that corresponds
with P = MR = MC.
Incurs economic losses, but loss is minimized.
The firm will cover VC and also a portion of FC.
Why should firm produce even at loss?
Economic Rationale: If it shuts down, loss = FC.
But it it produces, loss = FC – (R – VC) < FC as R
covers more than VC.
Short-Run Production
Minimize Losses when MR = MC
MC
Price
ATC
AVC
ATC
P
P=MR=AR
Losses are less
than fixed costs
 Produce
Q short-run
Quantity
Competitive Firm’s Output Decision


If P > minimum ATC, then the firm should produce a
quantity that corresponds with P = MR = MC.
In this case, the firm makes economic profits
because in this case P > ATC.
Short-Run Production
Maximize Profits when MR = MC
Price
MC
ATC
P=MR=AR
P
ATC
AVC
Maximum
Economic
Profit
QMax
Quantity
Near-Empty Restaurants and Off-Season
Miniature Golf
Why do restaurants stay close for late lunch hours?
 Few customers could not possibly cover the variable
cost (VC) of running the restaurants.
 In making this decision only the price and VC (such as
the cost of food and additional staff) are relevant. If the
restaurant decide to provide the service, then its loss will
be higher than the loss that would incur by shutting down.

Similarly, golf course should be open for business only
during those times of year when R > VC.

Competitive Firm’s Supply Curve

Short-Run Supply curve:
– Is the portion of its MC curve that lies above AVC.
– Because firm shuts down if
P < AVC
Competitive Firm’s Supply Curve
MC
Price
ATC
P3
AVC
P2
P1
Firms ShortRun Supply
Curve
Q1
Q2
Q3
Quantity
Long-Run Production


-
-
In the long-run, P = MR = MC = minimum ATC
 Economic Profits = 0. Note that when P = ATC,
economic profits = 0 (as in this case R = C)
Why Economic Profits = 0 in the long run?
Due to Intense Competition
As long as Profits > 0, new firms enter the market.
Once Profits are zero, there is neither entry nor exit.
The market is in long-run equilibrium.
Long-Run Production
Normal Profits when P = MR = MC
Price
MC
ATC
P=MR=AR
QLR
Quantity
Competitive Firm’s Decision To
Produce, Shut-Down or Exit


In the short-run, a firm will choose to shut-down
temporarily if
P < AVC.
In the long-run, when the firm can recover both fixed
and variable costs, the firm will choose to exit
(permanently) if P < ATC.
Firm’s Short/Long-Run Decision
to Shut Down
Fixed costs are sunk costs in the short run and so
cannot be recovered. So firms ignores them in deciding
to whether to shut down temporarily.
 In the long run, however, fixed costs may be
recoverable.
Why Air Canada continued flying despite loss while
Canada 3000 and more recently Jets Go and Zoom
Airlines shut down permanently (exit) for good?

The competitive firm’s long-run supply curve is the
portion of its MC curve that lies above ATC. If P < ATC,
the firm exits.

Competitive Firm’s Long-Run
Supply Curve...
Costs
MC = Long-run S
Firm enters
if P > ATC
ATC
AVC
Firm exits
if P < ATC
0
Quantity
In the News: Russia is Not Poland
and that’s too bad



In 1990s many countries tried to make transition to
Free Market Economies.
However, not all succeeded. For example, Poland
succeeded but not Russia, Why?..
One reason is Russia did not encourage free entry and
exit. .
Market Supply
Market supply equals the sum of the quantities supplied
by the individual firms in the market.

For any given price, each firm supplies a quantity of
output so that its MC = P.
 The market supply curve reflects the individual firms’
MC curves.
 Thus market supply curve is the horizontal summation
of all individual supply curves.

Short Run: Market Supply with a Fixed
Number of Firms...
If there are 1000 identical firms then at say P =$2, total
supply = 200X1000 = 200,000.
Price
(a) Individual Firm Supply
Price
Supply
MC
$2.00
$2.00
1.00
1.00
0
100
200
(b) Market Supply
Quantity
(firm)
0
100,000 200,000Quantity
(market)
Long Run: Market Supply with
Entry and Exit






Firms will enter or exit the market until economic profit
= 0.
In the long run,
P = minimum of ATC.
The long-run market supply curve is horizontal at this
price.
At the end of the process of entry and exit, firms that
remain must be making zero economic profit.
The process of entry & exit ends only when P = ATC
(with zero economic profits).
Long-run equilibrium must have firms operating at their
efficient scale (where P = ATC).
Long Run: Market Supply with
Entry and Exit...
(a) Firm’s Zero-Profit Condition
Price
(b) Market Supply
Price
MC
ATC
P=
minimum
Supply
ATC
0
Quantity
(firm)
0
Quantity
(market)
Why Firms Stay in Business even
with Zero Profit?





Profit = TR – TC = (P - ATC)Q.
TC includes all the opportunity costs of the firm.
In the zero-economic-profit equilibrium, the firm is
earning normal profits, the returns you could have
earned from the best alternative investment elsewhere.
Suppose you invest $1 million to open a farm, which
otherwise could have been invested in a bank and earn
$50,000 in interest.
In the zero-economic-profit equilibrium, you are still
earning the sum equal to this interest income.
Although economic profit = 0 in this case, Accounting
Profits = $50, 000.
Increase in Demand in the Short Run
 An increase in demand raises price and quantity in the
short run.
 As a result, firms earn profits (in the short run) because
P > ATC.
Increase in Demand in the Short Run...
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
P1
S1
P1
A
D1
0
Quantity
(firm)
0
Q1
Quantity
(market)
Increase in Demand in the Short Run...
(b) Short-Run Response
Market
Firm
Price
Price
Profit
MC ATC
P2
P2
P1
P1
B
S1
A
D1
0
Quantity
(firm)
0
Q1 Q2
D2
Quantity
(market)
Increase in Demand in the Short Run...
(c) Long-Run Response
Market
Firm
Price
Price
MC ATC
P1
P2
P1
B
A
S1
C
D1
0
Quantity
(firm)
0
Q1 Q2 Q3
S2
Long-run
supply
D2
Quantity
(market)
Why Long-Run Supply Curve
Might Slope Upward?


Long Run Supply curve is horizontal at the price level.
But it might slope upward when:
 Some resources used in production may be
available only in limited quantities.
 Firms may have different costs (new firms have
higher ATC).
Summary/Conclusion

If business firms are competitive and profit-maximizing,
P = MC.

If firms can freely enter and exit the market, then
P = minimum ATC of production
 Zero Economic Profits