1

Basic Economics Chapter 14

Competitive markets

(1) Market with many buyers and sellers (e.g., ________)

(2) Trading identical products (e.g., ________)

(3) Each buyer and seller is a price taker (no price

influence)

(4) Firms can freely enter or exit the market (e.g.,

________)

The revenue of a competitive firm

- Maximize profit (= total revenue total cost)

Total revenue = price times quantity = P × Q

- Proportional to the amount of output

Average revenue (AR) = total revenue (TR) divided by the

quantity/units sold (Q)

Marginal revenue (MR) = change in total revenue (TR)

from an additional unit sold (Q)

For competitive firms, average revenue (AR) = P

marginal revenue (MR) = P

The Firm’s Goal of Profit Maximization: Maximize profit: produce quantity (Q) where profit (total

revenue total cost) is greatest

- Compare marginal revenue (MR) with marginal cost

(MC): i.e.,

Firms in Competitive Markets

What is a Competitive Market

In perfectly competitive industries, price is a given for the typical firm (company)

because the firm has no influence on the price (it’s a price taker).

2

if MR > MC, then increase production (Q);

if MR < MC, then decrease production (Q); maximize

profit where MR = MC

Table 1 Total, Average, and Marginal Revenue for a Competitive Firm

Table 2 Profit Maximization: A Numerical Example

3

The marginal-cost curve and the firm’s supply decision: MC

curve is upward sloping

- ATC curve is U-shaped; MC curve crosses the ATC

curve at the minimum of ATC curve

P = AR = MR

Rules for profit maximization:

- If MR > MC, then firm should increase output

- If MR < MC, then firm should decrease output

- If MR = MC, then this is the profit-maximizing level of

output

Marginal-cost curve

- Determines the quantity of the good the firm is willing to

supply at any price; it is also the firm’s supply curve

Profit Maximization

This figure shows the marginal-cost curve (MC), the average-total-cost curve

(ATC), and the average-variable-cost curve (AVC). It also shows the market

price (P), which equals marginal revenue (MR) and average revenue (AR). At

the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising

production increases profit. At the quantity Q2, marginal cost MC2 is above

marginal revenue MR2, so reducing production increases profit. The profit-

maximizing quantity QMAX is found where the horizontal price line intersects

the marginal-cost curve.

Fig. 1 Profit Maximization for a Competitive Firm

4

Shutdown

- Short-run decision not to produce anything is made for a

specified period of time (say, for a month only) due to

current market conditions (say, the firm wants to ride out a

weak market).

- Even if it shuts down, the firm still has to pay fixed costs

Exit: the long-run decision to leave the market (e.g._____)

- Firm doesn’t have to pay any costs

The firm’s short-run decision to shut down depends on TR

(total revenue) and VC (variable costs) or, on P and AVC.

Firm’s decision: shut down if TR<VC (or, P < AVC)

The competitive firm’s short-run supply curve: it is the

portion of its MC curve that lies above AVC

Fig. 2 Marginal Cost as the Competitive Firm’s Supply Curve

An increase in the price

from P1 to P2 leads to an

increase in the firm’s

profit-maximizing

quantity from Q1 to Q2.

Because the marginal-cost

curve shows the quantity

supplied by the firm at

any given price, it is the

firm’s supply curve.

5

Sunk cost

- Cost that has already been committed (e.g., ________)

- It cannot be recovered

- Ignore them when making decisions

Example: Near-empty restaurants

The near-empty restaurant: Should it stay open for lunch?

- Fixed costs

Not relevant in decision to shut down

Fixed costs are sunk costs in short run

- Variable costs (VC) are relevant

- Shut down if revenue from lunch < variable costs

- Stay open if revenue from lunch > variable costs

Firm’s long-run decision

- Exit the market if TR < TC (or if P < ATC)

- Enter the market if TR > TC (or if P > ATC)

The competitive firm’s long-run supply curve

- The portion of its marginal-cost curve that lies above

ATC

Fig. 3 The Competitive Firm’s Short-Run Supply Curve

In the short run, the

competitive firm’s

supply curve is its

marginal-cost curve

(MC) above average

variable cost (AVC).

If the price falls below

average variable cost,

the firm is better off

shutting down.

6

Measuring profit:

- If P > ATC (we have positive profit)

Profit, = TR – TC = (P – ATC) × Q

- If P < ATC (we have a loss or negative profit)

Loss = TR – TC = (P – ATC) × Q (i.e., minus)

The area of the shaded box between price and average total

cost represents the typical firm’s profit. The height of this

box is price minus average total cost (P – ATC), and the

Fig. 4 The Competitive Firm’s Long-Run Supply Curve

In the long run, the

competitive firm’s supply

curve is its marginal-cost

curve (MC) above average

total cost (ATC). If the

price falls below average

total cost, the firm is better

off exiting the market.

Fig. 5 Profit as the Area between Price and Average Total Cost

1

2

(a) A firm with profits

7

width of the box is the quantity of output (Q). In panel (a),

price is above average total cost, so the firm has positive

profit. In panel (b), price is less than average total cost, so

the firm suffers a loss.

Short run: market supply with a fixed number of firms

- In the short run, the number of firms is fixed

- Each firm supplies quantity where P = MC

- For P > AVC: supply curve is the MC curve

- To get the market supply curve, add up quantity

supplied by each firm

Long run: Firms can enter and exit the market

- If P > ATC, firms make positive profit so then

new firms enter the market because they are attracted.

- If P < ATC, firms make negative profit so then

existing firms exit the market because they’re suffering

losses.

In the short run, the number of firms in the market is fixed.

As a result, the market supply curve, shown in panel (b),

reflects the individual firms’ marginal-cost curves, shown in

Supply Curve

Fig. 6 Short Run Market Supply

8

panel (a). Here, in a market of 1,000 firms, the quantity of

output supplied to the market is 1,000 times the quantity

supplied by each firm.

Long run - Process of entry and exit ends when:

(i) Firms still in market (existing firms) make zero

economic profit (P = ATC):

remember: = (P – ATC) × Q so that if P = ATC, then

= (0) × Q

= 0

(ii) Because MC = ATC, then firms are producing at an

efficient scale (min. pt. of the ATC curve)

Long run supply curve for the industry is perfectly

elastic, i.e., it is horizontal at the minimum pt. of the ATC

curve

Why do competitive firms stay in business even if they

make zero profit?

- Remember? It is also the case that profit, = TR – TC

- Remember? Total cost includes all opportunity costs

Thus, zero-profit equilibrium means:

- Economic profit is zero

- Accounting profit is positive

9

In the long run, firms will enter or exit the market until profit

is driven to zero. As a result, price equals the minimum of

average total cost, as shown in panel (a). The number of

firms adjusts to ensure that all demand is satisfied at this

price. The long-run market supply curve is horizontal at

this price, as shown in panel (b).

The market in long run equilibrium:

(1) P = minimum ATC

(2) Zero economic profit

Increase in demand: the demand curve shifts right

Short run results in:

- Higher equilibrium quantity (Q), and

- Higher price: P > ATC , i.e., positive economic profit

Positive economic profit in the short run

Long run (over time), firms enter the market, and so, the

short run supply curve shifts right, and so price decreases

back to minimum ATC.

But equilibrium quantity increases because there are more

firms in the market. Efficient scale is achieved.

Fig. 7 Long Run Market Supply

10

The market starts in a long-run equilibrium, shown as point

A in panel (a). In this equilibrium, each firm makes zero

profit, and the price equals the minimum average total cost

(ATC).

Panel (b) shows what happens in the short run when demand

rises from D1 to D2. The equilibrium goes from point A to

point B, price rises from P1 to P2, and the quantity sold in

Fig. 7 An Increase in Demand in the Short and Long Run (a)

11

the market rises from Q1 to Q2. Because price now exceeds

average total cost, firms make profits, which over time

encourage new firms to enter the market.

This entry shifts the short-run supply curve to the right from

S1 to S2, as shown in panel (c). In the new long-run

equilibrium, point C, price has returned to P1 but the

quantity sold has increased to Q3. Profits are again zero,

price is back to the minimum of average total cost, but the

market has more firms to satisfy the greater demand.

Fig. 7 An Increase in Demand in the Short and Long Run (a)