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Competitive firms
and markets
2
Introduction

Profit maximization

Behavior of a firm in a competitive
market:
 In
the short run (SR)
 In
the long run (LR)
3
Profit maximization
π(q) = R(q) – C(q)
2 steps:
 What
is the output level, q*, which
maximizes profits (minimises losses) ?
 Is
the firm better off producing q* or
shutting down?
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Output decision
What do you think is the
typical shape of a profit
curve?
π
At q*, what is the slope
of this curve?
Conclusions?
q*
q
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The single MOST important thing
A firm maximizes profits when:
MC = MR

If MC < MR, how can the firm increase
its profits?

What if MC > MR?
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Perfect competition

A competitive firm is said to be a « price
taker »
Explain.

A competitive firm faces a demand curve
which is perfectly elastic.
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Conditions for perfect competition
Five conditions:

Large number of firms and consumers

Identical product sold across firms

Free entry and exit in the market

Perfect information

No transaction costs
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Competition in the short run
MC = MR
firm’s internal
structure
market structure
Yet, R = p x q
and « price taker »
 MR = ____
Hence, profit is max if:
MC = _____
Profit maximization (graph.)
$
C
R
π
q
q*
$/q
MC
P=8
AC
MR=P
6.5
6
 Shade the area
corresponding to the
firm’s maximum profit.
Compute the value of
this maximum profit?
0
q*=280
q
Firm behavior in a
competitive market
1. Short-run behavior
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Shutdown decision
Should a firm shut down if π(q*) < 0 ?
Ex1: At q*, R = $2,000, VC = $1,000 and F = $3,000
Ex2: At q*, R = $500, VC = $1,000 and F = $3,000
Conclusion ?
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Output decision (cont.)
A firm should continue to operate in the
short run if its revenue covers its variable
cost.
Shutdown if:
R < VC
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Shutdown decision
Shutdown if R < VC  P x q < VC
 P < VC / q
Therefore:
Shutdown if P < AVC
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Shutdown decision (graph.)
MC
$/q
AC
If the firm produces
q* units, what will be
its profit (or its loss)?

If the firm shuts
down, what will it
lose?
AVC
A
P
B
0

q*
q
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Three regions
operate
p
MC
AC
π>0
break-even point
AVC
shutdown
π<0
shutdown point
π<0
0
q
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Firm’s supply curve
$/q
MC
AC
AVC
Draw the firm’s
supply curve.
Explain
q
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Market supply curve
Horizontal sum of individual firms’ supply
curves (like D)
Ex: 2 firms, Q = q1 + q2.
p
100
s1
400
p
q1 100 300
p
s2
q2
S = s1 + s2
200
700
Q
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Price-elasticity of supply
Similar to the price elasticity of demand:
Esp
% change in Qs
∆Qs/Qs
= --------------------------- = ---------------% change in P
∆P/P
Interpretation: The price elasticity of supply
represents the percentage change in Qs when P
changes by 1%.
Firm behavior in a
competitive market
2. Long-run behavior
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Competition in the long run
Recall: all costs are variable

Profit maximization: MC = MR  MC = P

Shutdown decision: R < C,
(selling below cost is not sustainable in the long-run).
Hence, shutdown if R < C  π < 0.
In the LR, a firm only produces if it does not incur
any losses
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LR firm supply curve
$/q
MCLR
ACLR
Draw.
AVCLR
q
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LR market supply curve
As before: horizontal sum of individual curves…
BUT… how many firms are there?
If the market is profitable (π > 0  p > AC), what
will happen?

Else, if π < 0 (LR loss), describe the sequence of
events.

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Graphically
$/q
MCLR
p
ACLR
SLR
p = min ACLR
q
Q
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Zero profits in the long run ???
Recall: We’re talking about economic profit
(π = πaccounting – Copportunity)
π < 0  I could earn more money elsewhere
Hence, when π = 0, the firm « makes money »
(πaccounting > 0), but no more than it would if it utilized
its resources differently: it is making normal profits.
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Conclusion

Behavior of a competitive firm

MC = MR : Reconciling the internal
structure of the firm with current market
conditions

Next: Supply and demand, a cooperative
process
Example (1)
A pizza shop in a perfectly competitive environment with the
following total costs produces six pizzas.
Quantity
0
1
2
3
4
5
6
7
Total Costs ($)
10
15
25
40
60
85
115
150
What is the price of a a pizza in this industry?
Example (1)
Perfect competition Firm is a price taker so it sets q
such that MC=P
Quantity Total Costs ($) MC
0
10
--1
15
5
2
25
10
3
40
15
4
60
20
5
85
25
6
115
30
7
150
35
At q=6, MC=30, the price is 30$
Example (2)
You operate Econsultants. One of your clients, Handspring, has
recently decided to start a cell phone division in addition to
producing handheld personal organizers. Unfortunately, this
division of the company is not doing as well as they had hoped
and has asked you to assess whether or not they should
continue to operate in the short run. The current market
price for a cell phone is $100/phone and at this price,
Handspring would like to supply 100 phones. However, at a
quantity of 100 phones, Handspring has an ATC of $110/phone
and an AVC of $75/phone. Starting a cell phone division
involved many one-time costs (i.e. the building of factories). In
the short run, would you suggest that Handspring continue to
operate this division of the company? Explain your answer.
Example (2)
Operate in SR or not? Represent graphically.
P=100$
q=100
ATC=110$
AVC=75$
The question assumes that q is such that
P=MC, the firm is optimizeing.
SR decision  is P > than AVC?
Yes  Operate in the short run to eat some of
the fixed costs.
Example (3)
The owner of a firm wants to know if it should
change the level of output and/or if it should
stay in the business in the short and long run.
You are given the following information.
Rev=3,000$
AVC is @ min
FC=500$
TC=3125$
P=40$
Example (3)
1. Is P=MC?
MC=AVC because it is @ min. We need AVC.
VC=TC-FC  3125$-500$=2625$.
AVC=VC/Q, We need Q.
Rev=P*Q  3,000$=Q*40$
 Q=3,000$/40$=75
AVC=2625$/75$=35$
 P (40$) > AVC (35$)!!!!! This means that the level
of output is not chosen optimally. Output needs to be
raised before decisions about SR and LR are to be
taken.