Chapter 14

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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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 Introduction: A Scenario
 Three years after graduating, you run your own
business.
 You have to decide how much to produce, what price to
charge, how many workers to hire, etc.
 What factors should affect these decisions?
• Your costs (studied in preceding chapter)
• How much competition you face
 We begin by studying the behavior of firms in perfectly
competitive markets.

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Characteristics of Perfect Competition

1.
1. Many
Many buyers
buyers and
and many
many sellers
sellers
2.
2. The
The goods
goods offered
offered for
for sale
sale are
are largely
largely the
the same.
same.

3.
3. Firms
Firms can
can freely
freely enter
enter or
or exit
exit the
the market.
market.

 Because of 1 & 2, each buyer and seller is a “price

taker” – takes the price as given.

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 The Revenue of a Competitive Firm

 Total revenue (TR) TR = P x Q

 Average revenue (AR) TR

AR = =P
Q
 Marginal Revenue (MR):
The change in TR from ∆TR
MR =
selling one more unit. ∆Q

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A C T I V E L E A R N I N G 1:
Exercise
Fill in the empty spaces of the table.

Q P TR AR MR

0 $10 n.a.

1 $10 $10

2 $10

3 $10

4 $10 $40
$10
5 $10 $50
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A C T I V E L E A R N I N G 1:
Answers
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n.a.
$10
1 $10 $10 $10
Notice that $10
2 $10
Notice
$20
that$10
MR
MR == PP $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
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 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
MR == PP is
is only
only true
true for
for
firms
firms in
in competitive
competitive markets.
markets.

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 Profit Maximization
 What Q maximizes the firm’s 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.

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 Profit Maximization
(continued from earlier exercise)

Q TR TC Profit MR MC
Profit =
At any Q with
MR – MC
MR > MC,
increasing Q 0 $0 $5 –$5
$10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

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 MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.

At Qa, MC < MR. Costs

So, increase Q MC
to raise profit.

At Qb, MC > MR.

So, reduce Q
to raise profit. P1 MR

At Q1, MC = MR.
Changing Q
Q
would lower profit. Qa Q1 Qb

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 MC and the Firm’s Supply Decision

If price rises to P2,

then the profit- Costs
maximizing quantity
MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2

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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 Firm’s 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 firm’s decision as:

Shut down if P < AVC

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A Competitive Firm’s SR Supply Curve
The firm’s SR supply
curve is the portion
of
its MC curve above Costs
AVC.
MC
If P > AVC, then
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

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 The Irrelevance of Sunk Costs
 Sunk cost: a cost that has already been committed and
cannot be recovered
 Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
 FC is a sunk cost: The firm must pay its fixed costs
whether it produces or shuts down.
 So, FC should not matter in the decision to shut down.

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 A Firm’s 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 firm’s decision as:

Exit if P < ATC

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 A New Firm’s Decision to Enter the
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 firm’s entry
decision as:

Enter if P > ATC

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The Competitive Firm’s LR Supply Curve

The firm’s
LR supply curve Costs
is the portion of MC
its MC curve
above LRATC.
LRATC

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A C T I V E L E A R N I N G 2 A:
Identifying a firm’s profit
A competitive firm
Determine Costs, P
this firm’s
MC
total profit.
P = $10 MR
Identify the
ATC
area on the
graph that $6
represents
the firm’s
profit.
Q
50

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A C T I V E L E A R N I N G 2 A:
Answers
A competitive firm
Costs, P
profit per unit MC

P = $10 MR
= P – ATC ATC
= $10 – 6 profit
= $4 $6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
50
= $200

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A C T I V E L E A R N I N G 2 B:
Identifying a firm’s loss
A competitive firm
Determine Costs, P
this firm’s
MC
total loss.
Identify the
ATC
area on the
graph that
$5
represents
the firm’s P = $3 MR
loss.
Q
30

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A C T I V E L E A R N I N G 2 B:
Answers
A competitive firm
Costs, P
MC
Total loss
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30

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 Market Supply: Assumptions
1) All existing firms and potential entrants have identical
costs.
2) Each firm’s 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 firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (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.

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 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.

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 The LR Market Supply Curve

In the long run, The LR market supply

the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (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
owner’s time and money.
 In the zero-profit equilibrium, firms earn enough revenue
to cover these costs.

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SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits induce
in demand entry,
raises P,…
and
profits for the restoring
firm. long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (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., there’s 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: MC = MR
 Perfect competition: P = MR
 So, in the competitive eq’m: P = MC
 Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
 So, the competitive eq’m 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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End: Chapter 14

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