Topic 8 :
Firms in Competitive Markets
In this chapter, look for the answers to
these questions:
What is a perfectly competitive market?
What is marginal revenue? How is it related to
total and average revenue?
How does a competitive firm determine the
quantity that maximizes profits?
When might a competitive firm shut down in the
short run? Exit the market in the long run?
What does the market supply curve look like in the
short run? In the long run?
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Characteristics of Perfect Competition
1. Many buyers and many sellers
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
Because of 1 & 2, each buyer and seller is a
price taker takes the price as given.
The Revenue of a Competitive Firm
Total revenue (TR)
TR = P x Q
Average revenue (AR)
TR
=P
AR =
Q
Marginal Revenue (MR):
The change in TR from
selling one more unit.
TR
MR =
Q
ACTIVE LEARNING
Exercise
1:
Fill in the empty spaces of the table.
TR
$10
n.a.
$10
$10
$10
$10
$10
AR
MR
$40
$10
5
$10
$50
4
MR = P for a Competitive Firm
A competitive firm can keep increasing its output
without affecting the market price.
So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
MR = P is only true for
firms in competitive markets.
Profit Maximization
What Q maximizes the firms profit?
To find the answer,
Think at the margin.
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
If MR > MC, then increase Q to raise profit.
If MR < MC, then reduce Q to raise profit.
Profit Maximization
(continued from earlier exercise)
At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.
TR
TC
$0
$5
$5
10
20
15
30
23
40
33
50
45
Profit MR MC
Profit =
MR MC
$10 $4
$6
10
10
10
10
10
12
5
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MC and the Firms Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
So, increase Q
to raise profit.
Costs
MC
At Qb, MC > MR.
So, reduce Q
to raise profit.
At Q1, MC = MR.
Changing Q
would lower profit.
MR
P1
Q a Q1 Q b
Q
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MC and the Firms Supply Decision
If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
The MC curve
determines the
firms Q at any price.
Costs
MC
P2
MR2
P1
MR
Hence,
the MC curve is the
firms supply curve.
Q1
Q2
Q
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Shutdown vs. Exit
Shutdown:
A short-run decision not to produce anything
because of market conditions.
Exit:
A long-run decision to leave the market.
A firm that shuts down temporarily must still pay
its fixed costs. A firm that exits the market does
not have to pay any costs at all, fixed or variable.
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A Firms Short-run Decision to Shut Down
If firm shuts down temporarily,
revenue falls by TR
costs fall by VC
So, the firm should shut down if TR < VC.
Divide both sides by Q: TR/Q < VC/Q
So we can write the firms decision as:
Shut down if P < AVC
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A Competitive Firms SR Supply Curve
The firms SR supply
curve is the portion of
its MC curve above
Costs
AVC.
If P > AVC, then
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).
MC
ATC
AVC
Q
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A Firms Long-Run Decision to Exit
If firm exits the market,
revenue falls by TR
costs fall by TC
So, the firm should exit if TR < TC.
Divide both sides by Q to rewrite the firms
decision as:
Exit if P < ATC
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A New Firms Decision to Enter Market
In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
Divide both sides by Q to express the firms
entry decision as:
Enter if P > ATC
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The Competitive Firms Supply Curve
The firms
LR supply curve
is the portion of
its MC curve
above LRATC.
Costs
MC
LRATC
Q
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2A:
Identifying a firms profit
ACTIVE LEARNING
A competitive firm
Determine
this firms
total profit.
Identify the
area on the
graph that
represents
the firms
profit.
Costs, P
MC
MR
ATC
P = $10
$6
50
16
2B:
Identifying a firms loss
ACTIVE LEARNING
A competitive firm
Determine
this firms
total loss.
Identify the
area on the
graph that
represents
the firms
loss.
Costs, P
MC
ATC
$5
MR
P = $3
30
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Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firms costs do not change as other firms
enter or exit the market.
3) The number of firms in the market is
fixed in the short run
(due to fixed costs)
variable in the long run
(due to free entry and exit)
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The SR Market Supply Curve
As long as P AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
Recall from Chapter 4:
At each price, the market quantity supplied is the
sum of quantity supplied by each firm.
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The SR Market Supply Curve
Example: 1000 identical firms.
At each P, market Qs = 1000 x (one firms Qs)
One firm
MC
P3
P3
P2
P2
AVC
P1
Market
S
P1
10 20 30
Q
(firm)
Q
(market)
10,000
20,000 30,000
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Entry & Exit in the Long Run
In the LR, the number of firms can change due
to entry & exit.
If existing firms earn positive economic profit,
New firms enter.
SR market supply curve shifts right.
P falls, reducing firms profits.
Entry stops when firms economic profits have
been driven to zero.
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Entry & Exit in the Long Run
In the LR, the number of firms can change due
to entry & exit.
If existing firms incur losses,
Some will exit the market.
SR market supply curve shifts left.
P rises, reducing remaining firms losses.
Exit stops when firms economic losses have
been driven to zero.
22
The Zero-Profit Condition
Long-run equilibrium:
The process of entry or exit is complete
remaining firms earn zero economic profit.
Zero economic profit occurs when P = ATC.
Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
Recall that MC intersects ATC at minimum ATC.
Hence, in the long run, P = minimum ATC.
23
The LR Market Supply Curve
The LR market supply
curve is horizontal at
P = minimum ATC.
In the long run,
the typical firm
earns zero profit.
One firm
MC
Market
LRATC
P=
min.
ATC
long-run
supply
Q
(firm)
Q
(market)
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Why Do Firms Stay in Business if Profit = 0?
Recall, economic profit is revenue minus all
costs including implicit costs, like the
opportunity cost of the owners time and money.
In the zero-profit equilibrium, firms earn enough
revenue to cover these costs.
25
SR & LR Effects of an Increase in Demand
A firm begins in but then an increase leading to SR
long-run eqm in demand raises P, profits for the firm.
Over time, profits induce entry,
driving profits to zero
shifting S to the right, reducing P and restoring long-run eqm.
Market
One firm
P
P
S1
MC
Profit
S2
ATC
P2
P2
P1
P1
Q
(firm)
B
A
long-run
supply
D1
Q1 Q2
Q3
D2
Q
(market)
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Why the LR Supply Curve Might Slope Upward
The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or
exit the market.
If either of these assumptions is not true,
then LR supply curve slopes upward.
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1) Firms Have Different Costs
As P rises, firms with lower costs enter the market
before those with higher costs.
Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
Hence, LR market supply curve slopes upward.
At any P,
For the marginal firm,
P = minimum ATC and profit = 0.
For lower-cost firms, profit > 0.
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2) Costs Rise as Firms Enter the Market
In some industries, the supply of a key input is
limited (e.g., theres a fixed amount of land
suitable for farming).
The entry of new firms increases demand for this
input, causing its price to rise.
This increases all firms costs.
Hence, an increase in P is required to increase
the market quantity supplied, so the supply curve
is upward-sloping.
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CONCLUSION: The Efficiency of a
Competitive Market
Profit-maximization:
Perfect competition:
So, in the competitive eqm:
MC = MR
P = MR
P = MC
Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
So, the competitive eqm is efficient, maximizes
total surplus.
In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.
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CHAPTER SUMMARY
For a firm in a perfectly competitive market,
price = marginal revenue = average revenue.
If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.
If P < ATC, a firm will exit in the long run.
In the short run, entry is not possible, and an
increase in demand increases firms profits.
With free entry and exit, profits = 0 in the long run,
and P = minimum ATC.
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