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Survey of ECON
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Robert L. Sexton
Chapter 7
Firms in Competitive
Markets
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Chapter 7 Sections
– A Perfectly Competitive Market
– An Individual Price Taker’s
Demand Curve
– Profit Maximization
– Short-Run Profits and Losses
– Long-Run Equilibrium
– Long-Run Supply
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A Perfectly
Competitive Market
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Section 1
SECTION 1 QUESTIONS
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© MARIE-FRANCE BÉLANGER/ISTOCKPHOTO.COM
A Perfectly Competitive
Market
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Many Buyers and Sellers
• In a perfectly competitive market, there
are many buyers and sellers.
• Because each firm is so small in relation
to the industry, its production decisions
have no impact on the market.
• For this reason, perfectly competitive
firms are called price takers.
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Identical (Homogeneous)
Products
• Consumers believe that all firms in
perfectly competitive markets sell
identical or homogeneous products.
• For example, in the wheat market we
are assuming that it is not possible to
determine any significant and consistent
qualitative differences in the wheat
produced by different farmers.
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Easy Entry and Exit
• Product markets characterized by perfect
competition have no significant barriers
to entry or exit.
• This means that it is fairly easy for
entrepreneurs to become suppliers of the
product or, if they are already producers,
to stop supplying the product.
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Easy Entry and Exit
• Barriers to entry are modest, so large
numbers of firms can enter the business if
they so desire.
• Because of easy market entry and exit,
perfectly competitive markets generally
consist of a large number of small
suppliers.
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Perfectly Competitive
Markets: Examples
• Highly organized markets for securities
and agricultural commodities are the
best examples of perfectly competitive
markets.
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Easy Entry and Exit
• While the assumptions for perfect
competition may seem a bit unrealistic,
the model is useful.
• Many markets resemble perfect
competition: firms face very elastic
demand curves and relatively easy entry
and exit.
• It gives us a standard of comparison.
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Section 1
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An Individual Price Taker’s
Demand Curve
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Section 2
SECTION 2 QUESTIONS
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An Individual Price Taker’s
Demand Curve
• Perfectly competitive firms are price takers,
selling at the market-determined price.
• An individual seller cannot sell at any price
higher than the current market price because
buyers could purchase the same good from
someone else at the market price.
• A seller would not charge a lower price when
he could sell all he wants at the market price.
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An Individual Firm’s
Demand Curve
• In a perfectly competitive market, an
individual seller can change his output
and it will not alter the market price.
• Each producer provides such a small
fraction of the total supply that a
change in the amount he or she offers
does not have a noticeable effect on
market price.
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An Individual Firm’s
Demand Curve
• In a perfectly competitive market, then,
an individual firm can sell as much as it
wishes to place on the market at the
prevailing price.
• The demand, as seen by the seller, is
perfectly elastic at the market price.
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An Individual Firm’s
Demand Curve
• A perfectly competitive seller won't
charge more than the market price
because no one will buy at higher
prices, and will not charge less because
the seller can sell all she wants at the
market price.
• Thus, the demand curve is horizontal at
the market price over the entire range of
output that she could possibly produce.
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Exhibit 7.1: Market and Individual Firm Demand
Curves in a Perfectly Competitive Market
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A Change in Market Price and
the Firm’s Demand Curve
• The position or height of each firm’s
demand curve varies with every change
in the market price.
• Sellers are provided with current
information about market demand and
supply conditions as a result of price
changes.
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A Change in Market Price and
the Firm’s Demand Curve
• The perfectly competitive model does not
assume any knowledge on the part of
individual buyers and sellers about
market demand and supplythey only
have to know the price of the good they
sell.
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Exhibit 7.2: Market Prices and the Position
of a Firm’s Demand Curve
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Section 2
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Profit Maximization
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Section 3
SECTION 3 QUESTIONS
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Profit Maximization
• The firm’s objective is to maximize
profits.
• It wants to produce the amount that
maximizes the difference between its
total revenues and total costs.
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Total Revenue
TOTAL REVENUE (TR)
the product price times the
quantity sold
TR = P × q
• Total revenue for a perfectly competitive
firm equals the market price of the good
(P) times the quantity (q) of units sold.
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Average Revenue and
Marginal Revenue
AVERAGE REVENUE (AR)
the total revenue divided by the number of
units sold
AR = TR ÷ q
= (P × q) ÷ q
MARGINAL REVENUE (MR)
the increase in total revenue resulting from
a one-unit increase in sales
MR = ΔTR ÷ Δq
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Average Revenue and Marginal
Revenue
• In a perfectly competitive market,
additional units of output can be sold
without reducing the market price.
• Therefore, marginal revenue is constant
and equal to the market price, which is
also the average revenue.
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Average Revenue, Marginal
Revenue, and Price
• In perfect competition, marginal revenue,
average revenue, and price are all equal:
P = MR = AR
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Exhibit 7.3: Revenues for a Perfectly
Competitive Firm
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How Do Firms Maximize
Profits?
• In all types of market environments, the
firm will maximize its profits at the level of
output that maximizes the difference
between total revenue and total cost,
which is at the same output level at which
marginal revenue equals marginal cost.
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Equating Marginal Revenue
and Marginal Cost
• The importance of equating marginal
revenue and marginal costs for
maximizing profits is straightforward.
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Equating Marginal Revenue
and Marginal Cost
• As long as the marginal revenue derived
from expanded output exceeds the
marginal cost of that output, the
expansion of output creates additional
profits.
• However, expansion of output when the
marginal cost of production exceeds
marginal revenue will lead to losses on
the additional output, decreasing profits.
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The Profit-Maximizing Level
of Output
• The profit-maximizing output rule says a
firm should always produce where its
MR = MC.
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Exhibit 7.4: Finding the Profit-Maximizing
Level of Output
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The Profit-Maximizing Level
of Output
• As long as marginal revenue exceeds
marginal cost, producing and selling
those units add more to revenues than to
costs; in other words, they add to profits.
• However, once the production is
expanded beyond four units of output,
the costs are less than the marginal
revenues, and profits begin to fall.
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Exhibit 7.5: Cost and Revenue Calculations
for a Perfectly Competitive Firm
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Section 3
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Short-Run Profits and
Losses
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Section 4
SECTION 4 QUESTIONS
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Short-Run Profits and
Losses
• Producing at the profit-maximizing output
level does not mean that a firm is actually
generating profits.
• It merely means that a firm is maximizing
its profit opportunity at a given price level.
• A firm could be:
• Earning profits
• Generating losses
• Breaking even
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The Three-Step Method
• Three easy steps to determine economic
profits, economic losses, or zero economic
profits:
1. Where MR equals MC proceed down to
horizontal axis to find q*, the profit-maximizing
output level.
2. At q*, go straight up to demand curve, then to
price axis to find the market price, P*. Now you
can find TR at the profit-maximizing output level
because TR = P x q.
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The Three-Step Method
3. The last step is to find total costs. Go straight up
from q* to the short-run average total cost
(SRATC) curve; this will give you the average
cost per unit. If we multiply average total costs by
the output level, we can find the total costs TC =
ATC x q.
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The Three-Step Method
• If TR > TC at the profit-maximizing output
level, the firm is generating economic
profits.
• If TR < TC, the firm is generating
economic losses.
• If TR = TC, the firm is earning zero
economic profits,
– Covering both implicit and explicit costs,
economists sometimes call zero economic
profit a normal rate of return.
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Exhibit 7.6: Short-Run Profits, Losses, and
Zero Economic Profits
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The Three-Step Method
• Alternatively, to find total economic profits we
can take the product price at P* and subtract
the ATC at q*. This will give us per-unit profit. If
we multiply this by output, we will arrive at total
economic profit. Or (P* - ATC) × q* = total
economic profit.
• Economists sometimes call the zero economic
profit a normal rate of return.
• That is, the owners are doing as well as they
could elsewhere, in that they are getting the
normal rate of return on the resources they
invested in the firm.
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Evaluating Economic
Losses in the Short Run
• A firm generating an economic loss faces a
tough choice.
• Should it continue to produce or shut down
its operation?
• To make this decision, we need to consider
average variable costs.
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Evaluating Economic
Losses in the Short Run
• If a firm cannot generate enough revenues to
cover its variable costs, then it will have larger
losses if it operates than if it shuts down
(losses in that case = fixed costs).
• Thus, a firm will not produce at all unless the
price is greater than its average variable costs.
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Operating at a Loss
• At price levels greater than or equal to
average variable costs, a firm may
continue to operate in the short run even
if average total costs—variable and fixed
costs—are not completely covered.
• Because fixed costs continue whether
the firm produces or not, it is better to
earn enough to cover a portion of these
costs than to earn nothing at all.
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Operating at a Loss
• When price is less than average total
costs but more than average variable
costs, the firm produces in the short run,
but at a loss.
• To shut down would make this firm worse
off because it can cover at least some of
its fixed costs with the excess of revenue
over its variable costs.
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Exhibit 7.7: Short-Run Losses: Price above
AVC but below ATC
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• When the price a firm is able
to obtain for its product is
below its average variable
costs at all ranges of output,
it is unable to cover even its
variable costs in the short
run.
• Since it is losing even more
than the fixed costs it would
lose if it shut down, it is more
logical for the firm to cease
operations.
© BEAU LARK/PHOTOLIBRARY
The Decision to Shut Down
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Exhibit 7.8: Short-Run Losses: Price below AVC
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The Short-Run Supply Curve
• At all prices above minimum AVC, a firm
produces in the short run, even if ATC is
not completely covered.
• At all prices below the minimum AVC,
the firm shuts down.
• Therefore, the short-run supply curve
of an individual competitive seller is
identical to that portion of the MC curve
that lies above the minimum of the AVC
curve.
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The Short-Run Supply Curve
• As a cost relation, the MC curve above
minimum AVC shows the marginal cost
of producing any given output.
• As a supply curve, the MC curve above
minimum AVC shows the equilibrium
output that the firm will supply at various
prices in the short run.
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The Short-Run Supply Curve
• Beyond the point of lowest AVC, the MC
of successively larger outputs are
progressively greater, so the firm will
supply larger amounts only at higher
prices.
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Exhibit 7.9: The Firm’s Short-Run Supply Curve
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Deriving the Short-Run
Market Supply Curve
• The short-run market supply curve
is the summation of all the individual
firms’ supply curves (that is, the portion
of the firms’ MC above AVC) in the
market.
• Because the short run is too brief for new
firms to enter the market, the market
supply curve is the summation of existing
firms.
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Exhibit 7.10: Deriving the Short-Run Market
Supply Curve
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Section 4
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Long-Run Equilibrium
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Section 5
SECTION 5 QUESTIONS
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Long-Run Equilibrium
• If perfectly competitive producers make
economic profits:
– Resources devoted to that lucrative
business increase.
– More firms enter the industry and existing
firms expand, shifting the market supply
curve to the right over time.
– The impact of increasing supply, other things
equal, is to reduce the equilibrium price.
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Long-Run Equilibrium
• As entry into the profitable industry pushes
down the market price, producers will move
from making a profit (P > ATC) to zero
economic profits (P = ATC).
• In long-run equilibrium, perfectly competitive
firms make zero economic profits, earning a
normal return on the use of their capital.
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Long-Run Equilibrium
• Zero economic profits is an equilibrium or
stable situation because any positive
economic (above-normal) profits signal
resources into the industry, beating down
prices and thus revenues to the firm.
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Long-Run Equilibrium
• Economic losses signal resources to leave
the industry, causing supply reductions
that lead to increased prices and higher
firm revenues to the remaining firms.
• Only at zero economic profits is there no
tendency for firms to either enter or leave
the business.
67
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Exhibit 7.11: Profits Disappear with Entry
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Exhibit 7.12: Losses Disappear with Exit
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The Long-Run Equilibrium
for the Competitive Firm
• The long-run competitive equilibrium for a
perfectly competitive firm can be
graphically illustrated.
• Where MC = MR, short-run and long-run
average total costs are also equal.
– The ATC curves touch the MC and MR
(demand) curves at the equilibrium output
point.
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The Long-Run Equilibrium
for the Competitive Firm
• Because the MR curve is also the AR
curve, average revenues and average total
costs are equal at the equilibrium point.
71
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The Long-Run Equilibrium
for the Competitive Firm
• The long-run equilibrium output in perfect
competition occurs at the lowest point on
the ATC curve, so the equilibrium condition
in the long run in perfect competition is for
firms to produce at that output that
minimizes per-unit total costs.
72
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Exhibit 7.13: The Long-Run Competitive
Equilibrium
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Section 5
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Long-Run Supply
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Section 6
SECTION 6 QUESTIONS
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Long-Run Supply
• When the output of an entire industry changes,
the likelihood is greater that changes in costs will
occur.
• The three possible types of industries seen when
considering long-run supply are:
– Constant-costs
– Increasing-costs
– Decreasing-cost
• The shape of the long-run supply curve depends
on the extent to which input costs change when
there is entry or exit of firms in the industry.
77
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A Constant-Cost Industry
© WENDELL FRANKS/ISTOCKPHOTO.COM
• In a constant-cost industry, the prices of
inputs do not change as output is
expanded. The industry does not use
inputs in sufficient quantities to affect input
prices.
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A Constant-Cost Industry
• Because the industry is one of constant
costs, industry expansion does not alter
firms’ cost curves, and the industry
long-run supply curve is horizontal.
79
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A Constant-Cost Industry
• The short-run higher profits from an
increase in demand attracts entry until
long-run equilibrium is again reached.
• The long-run equilibrium price is at the
same level that prevailed before demand
increased.
• The only long-run effect of the increase in
demand is an increase in industry output.
80
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Exhibit 7.14: Demand Increase in a
Constant-Cost Industry
81
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Exhibit 7.14: Demand Increase in a
Constant-Cost Industry
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Exhibit 7.14: Demand Increase in a
Constant-Cost Industry
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An Increasing-Cost
Industry
• In an increasing-cost industry, the
cost curves of the individual firms rise as
the total output of the industry increases.
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An Increasing-Cost
Industry
• When an industry utilizes a large portion of
an input, input prices will rise when the
industry uses more of that input as it
expands output, which will shift firms’ cost
curves upward.
85
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An Increasing-Cost
Industry: Example
• For example, if a construction boom
occurs in a fully employed economy,
would it be more costly to obtain
additional resources such as workers
and raw materials?
• Yes, as an increasing-cost industry,
the industry can only produce more
output if it gets a higher price,
because the firm’s costs of
production rise as output expands.
86
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An Increasing-Cost
Industry
• As new firms enter and output expands, the
increase in demand for inputs causes the price of
inputs to rise—the cost curves of all construction
firms shift upward as the industry expands.
• The industry can produce more output, but only at
a higher price, enough to compensate the firm for
the higher input costs.
• In an increasing-cost industry, the long-run supply
curve is upward sloping.
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A Decreasing-Cost
Industry
• A firm experiences lower cost as an
industry expands. The new long-run
market equilibrium has more output at a
lower price—that is, the long-run supply
curve for a decreasing-cost industry
is downward sloping.
• This situation might occur in the
computer industry.
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A Decreasing-Cost
Industry
• The firms in the industry may be able to
acquire computer chips at a lower price
as the industry’s demand for computer
chips rises.
• The marginal and average costs of the
firm fall as input prices fall because of
expanded output in the industry.
• In this case, the LRS curve would be
negatively sloped.
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Perfect Competition and
Economic Efficiency
PRODUCTIVE EFFICIENCY
requires that firms produce goods and
services in the least costly way
• This is where P = minimum ATC.
• The output that results from equilibrium
conditions of market demand and
supply in perfectly competitive markets
is economically efficient.
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Perfect Competition and
Economic Efficiency
• Once the competitive equilibrium is
reached, the buyers’ marginal benefit
equals the sellers’ marginal cost.
• That is, in a competitive market, producers
efficiently use their scarce resources (labor,
machinery, and other inputs) to produce
what consumers want.
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Perfect Competition and
Economic Efficiency
• In this sense, perfect competition achieves
allocative efficiency.
• Allocative efficiency is where P = MC
and production will be allocated to reflect
consumer preferences.
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Exhibit 7.15: Allocative Efficiency and
Perfect Competition
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Section 6
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