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Chapter 9:
Competitive Markets
Copyright © 2014 Pearson Canada Inc.
Chapter Outline/Learning Objectives
Section
Learning Objectives
After studying this chapter, you will be able to
9.1 Market Structure
and Firm Behaviour
1.
state the difference between competitive behaviour and
a competitive market.
9.2 The Theory of
Perfect Competition
2.
list the four key assumptions of the theory of perfect
competition.
9.3 Short-Run Decisions
3.
derive a competitive firm's supply curve.
4.
determine whether competitive firms are making profits
or losses in the short run.
5.
explain the role played by profits, entry, and exit in
determining a competitive industry's long-run
equilibrium.
9.4 Long-Run Decisions
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 2
LO1
Industry
• a group of producers
Market
• the interaction of both producers and consumers
Perfect Competition
• a market in which all buyers and sellers are price
takers
© 2012 McGraw-Hill Ryerson Limited
8-3
LO1
© 2012 McGraw-Hill Ryerson Limited
8-4
9.1
Market Structure and Firm Behaviour
Competitive Market Structure
The competitiveness of the market—the influence that individual
firms have on market prices.
The less power an individual firm has to influence the market price,
the more competitive is that market's structure.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 5
Competitive Behaviour
The term competitive behaviour refers to the degree to which
individual firms actively vie with one another for business.
Examples:
1. MasterCard and Visa engage in competitive behaviour but their
market is not competitive.
2. Two wheat farmers do not engage in competitive behaviour
but they both exist in a very competitive market.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 6
The Significance of Market Structure
The demand curve faced by an individual firm may be different from
the demand curve for the industry as a whole.
Market structure plays a central role in determining the efficiency
of the market.
In this chapter we focus on competitive market structures.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 7
9.2
The Theory of Perfect Competition
The Assumptions of Perfect Competition
1. All firms sell a homogeneous product.
2. Customers know the product and each firm's price.
3. Each firm reaches its minimum LRAC at a level of output
that is small relative to the industry's total output
4. Firms are free to exit and enter the industry.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 8
The Demand Curve for a Perfectly Competitive Firm
Fig. 9-1
The Demand Curve for a Competitive Industry and
for One Firm in the Industry
Each firm in a perfectly competitive market faces a horizontal demand
curve—even though the industry demand curve is downward sloping.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 9
This does not mean the firm could actually sell an infinite amount
at the market price.
 "Normal" variations in the firm's level of output have a negligible
effect on total industry output.
APPLYING ECONOMIC CONCEPTS 9-1
Why Small Firms Are Price Takers
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide10
Total, Average, and Marginal Revenue
Total revenue (TR):
TR = p x q
Average revenue (AR):
AR = (p x q)/q = p
Marginal revenue (MR):
MR =  TR/ q = p
Note: For a perfectly competitive firm, AR = MR = p
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide11
LO3
Total Revenue
• total quantity sold (Q) times price (P)
Average Revenue
• the amount of revenue received per unit sold
Total Revenue (TR) Q  P
Average Revenue (AR) 
or
P
Output (Q)
Q
Marginal Revenue
• the extra revenue derived from one more unit
Marginal Revenue 
© 2012 McGraw-Hill Ryerson Limited
Total Revenue (TR) Q  P
or
P
Output (Q)
Q
8-12
Fig. 9-2
Revenues for a Price-Taking Firm
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 13
9.3
Short-Run Decisions
The firm's objective is to maximize profits:
Profits = TR – TC
As the firm changes its level of output:
• Firm's costs vary
• Firm's total, average, and marginal revenue vary
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 14
Should the Firm Produce at All?
If the firm produces nothing
 must pay its fixed costs (TFC)
If the firm decides to produce
must also pay the variable cost of production (TVC)
receives revenue from sales (TR)
A firm should produce only if at some level of output, TR exceeds TVC.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 15
Should the Firm Produce at All?
A firm should produce only if at some level of output, price exceeds
AVC.
At the shut-down price the firm can just cover its average variable
cost, and so is indifferent between producing and not producing.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 16
Fig. 9-3
Shut-Down Price for a Competitive Firm
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Chapter 9, Slide 17
How Much Should the Firm Produce?
Suppose p > AVC  firm does not shut down.
To maximize profits, the firm chooses the output where MR = MC.
But for a competitive firm, MR = p:
 The rule: choose output where p = MC.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 18
Fig. 9-4(i) Profit Maximization for a Competitive Firm
The market determines
the equilibrium price.
The firm then picks the
quantity of the output that
maximizes its own profits.
When the firm has
reached q*, it has no
incentive to change its
output.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 19
Fig. 9-4(ii) Profit Maximization for a Competitive Firm
The profit maximizing
level of output is the
point at which price
(marginal revenue)
equals marginal cost.
When the firm has
reached q*, it has no
incentive to change its
output.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 20
Self-Test
LO3
Given the data for Marshall’s Meat Ltd., calculate total profits at
each output. What are break-even and profit-maximizing
outputs?
Q
0
1
2
3
4
5
6
7
8
© 2012 McGraw-Hill Ryerson Limited
P
50
50
50
50
50
50
50
50
50
TR
TC
40
135
180
220
230
250
280
350
450
Tп
8-21
Self-Test
LO4
The accompanying graph shows the costs for a perfectly competitive firm.
a) What is the break-even price?
b) What is the shutdown price?
© 2012 McGraw-Hill Ryerson Limited
8-22
Short-Run Supply Curves
Fig. 9-5 The Derivation of the Supply Curve for a Competitive Firm
A competitive firm's supply curve is given by its marginal cost curve
(at prices above AVC).
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 23
Fig. 9-6
The Derivation of a Competitive Industry's Supply Curve
A competitive industry's supply curve is the horizontal summation of
the individual MC curves (above minimum of AVC curves).
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 24
Self-Test
LO5
Given the data for a competitive firm, what quantities will the
firm produce at prices of $25, $35, $45, $55, $65, and $75?
Output
0
1
2
3
4
5
6
7
8
© 2012 McGraw-Hill Ryerson Limited
MC
—
$40
20
30
40
50
60
70
80
AVC
—
$40
30
30
32.5
36
40
44.3
48
8-25
Short-Run Equilibrium in a Competitive Market
When an industry is in short-run equilibrium, two things are true:
• market price is such that the market clears
• each firm is maximizing its profits at this price
But how large are each firm's profits in this SR equilibrium?
There are three possibilities:
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 26
Case 1: Zero Economic Profits
Fig. 9-8(ii) Alternative Short-Run Profits of a Competitive Firm
The typical firm is just
covering its costs, p = ATC.
There is zero economic profit.
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Chapter 9, Slide 27
Case 2: Positive Economic Profits
Fig. 9-8(iii) Alternative Short-Run Profits of a Competitive Firm
Typical firm maximizes profit at
q*.
Since p > ATC, the firm makes
positive economic profits
equal to the blue area.
Positive profits means that
this firm is earning more
than it could in its next
best alternative venture.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 28
Case 3: Negative Economic Profits (Losses)
Fig. 9-8(i) Alternative Short-Run Profits of a Competitive Firm
The typical firm maximizes its
profits by producing at q*.
But if p < ATC, the firm suffers
losses equal to the red shaded
area.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 29
MyEconLab
www.myeconlab.com
A firm that is maximizing its profit but still making losses is actually
minimizing its losses. To see a detailed numerical example of a firm
in such a situation, look for An Example of Loss Minimization as
Profit Maximization in the Additional Topics section of this book's
MyEconLab.
APPLYING ECONOMIC CONCEPTS 9-2
The Parable of the Seaside Inn
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 30
9.4
Long-Run Decisions
Entry and Exit
If existing firms have positive economic profits, new firms have an
incentive to enter the industry.
If existing firms have zero profits, there are no incentives for new firms
to enter, and no incentives for existing firms to exit.
If existing firms have economic losses, there is an incentive for existing
firms to exit the industry.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 31
Fig. 9-9(i) The Effect of New Entrants Attracted by Positive Profits
Example: suppose there
are positive profits at initial
SR equilibrium:
1. Positive profits attract
new firms.
2. Entry leads to an
increase in supply and a
decline in price.
3. Positive profits are
eroded.
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Chapter 9, Slide 32
How about negative profits, and exit?
Fig. 9-10
The Effect of Exit Caused by Losses
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Chapter 9, Slide 33
Long-Run Equilibrium
The LR industry equilibrium occurs when there is no longer any
incentive for entry or exit (or expansion).
In long-run equilibrium, all existing firms
• must be maximizing their profits.
• are earning zero economic profits.
• are not able to increase their profits by changing
the size of their production facilities.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 34
Fig. 9-11
Short-Run Versus Long-Run Profit Maximization
for a Competitive Firm
In LR equilibrium, competitive
firms produce at the minimum
point on their LRAC curves.
At q0, the firm is maximizing
short-run profits but not its
long-run profits.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 35
Fig. 9-12
A Typical Competitive Firm When the Industry
is in Long-Run Equilibrium
Minimum Efficient Scale (MES)
In LR competitive equilibrium,
each firm's average cost of
production is the lowest
attainable, given the limits
of known technology and
factor prices.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 36
Consider a competitive industry that is in long-run equilibrium.
Now suppose that the market demand for the industry's product
increases.
The price will rise, and profits will rise. Entry will then occur, and
price will eventually fall.
But what will the new long-run equilibrium look like?
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 37
MyEconLab
www.myeconlab.com
Copyright © 2014 Pearson Canada Inc.
Demand shocks in competitive industries naturally lead to price
changes. As prices change, firms' profits rise or fall, and these
adjustments cause entry to or exit from the industry. After a new
long-run equilibrium is reached, will the market price be at its initial
level? The answer depends on the nature of costs within the
industry. For more details, look for The Long-Run Industry Supply
Curve in the Additional Topics section of this book's MyEconLab.
38
Changes in Technology
Suppose technological development reduces the costs for
newly built plants.
New plants will earn economic profits, expand industry output
and drive down price.
The price will fall until it is equal to the SRATC of the new plants.
Old plants may continue, but will earn losses. They will eventually
exit.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 39
Fig. 9-13
Plants of Different Vintages in an Industry
with Competitive Technological Progress
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Chapter 9, Slide 40
Declining Industries
What happens when a competitive industry in LR equilibrium
experiences a continual decrease in demand?
The efficient response is to continue operating with existing
equipment as long as variable costs of production can be covered.
As demand shrinks, so will capacity.
Antiquated equipment in a declining industry is often the effect
rather than the cause of the industry's decline.
Copyright © 2014 Pearson Canada Inc.
Chapter 9, Slide 41