Chapter 14

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?
 Introduction: A Scenario
• Three years after graduating, you run your own
business.
• You must 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.
 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

TR
• Average revenue (AR) AR =
Q
=P

• Marginal revenue (MR): ∆TR

The change in TR from MR =
∆Q
selling one more unit.
 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 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.
 Profit Maximization
(continued from earlier exercise)

Q TR TC Profit MR MC
Profit =
At any Q with MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $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
 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
would lower profit. Q
Qa Q1 Qb
 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
 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 key difference:
– If shut down in SR, must still pay FC.
– If exit in LR, zero costs.
 A Firm’s Short-run Decision to Shut Down

• Cost of shutting down: revenue loss = TR

• Benefit of shutting down: cost savings = VC
(firm must still pay FC)
• So, shut down if TR < VC
• Divide both sides by Q: TR/Q < VC/Q
• So, firm’s decision ruleifis:P < AVC
Shut down
 A Competitive Firm’s SR Supply Curve

The firm’s SR
supply curve is Costs
the portion of MC
its MC curve
aboveIf AVC.
P > AVC, then
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q
 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.
 A Firm’s Long-Run Decision to Exit

• Cost of exiting the market: revenue loss = TR

• Benefit of exiting the market: cost savings =
TC
(zero FC in the long run)
• So, firm exits if TR < TC
• Divide both sides
Exitby
if PQ< to
ATCwrite the firm’s
decision rule as:
 A New Firm’s 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 firm’s
entry decision Enter
as: if P > ATC
 The Competitive Firm’s Supply Curve

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

Q
 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)
 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 quantities supplied by all firms.
 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

 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 shifts right.
– P falls, reducing profits and slowing entry.
• If existing firms incur losses,
– some firms exit, SR market supply shifts left.
– P rises, reducing remaining firms’ losses.
 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.
 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
– accounting profit is positive
 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)
 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase in
long-run to …driving
…leadingeq’m… SR profits to zero
Over time, profits
demand induce
raisesentry,
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)
 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.
 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.
 2) Costs Rise as Firms Enter the Market

• In some industries, the supply of a key input is

limited (e.g., amount of land suitable for farming is
fixed).
• 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.
 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 and production
decisions, deadweight loss, regulation.