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Lecture 9 In this chapter, look for the answers to

these questions:
Firms in Competitive Markets
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 Characteristics of Perfect Competition

Three years after graduating, you run your own
business. 1. Many buyers and many sellers

You have to decide how much to produce, what 2. The goods offered for sale are largely the same.
price to charge, how many workers to hire, etc.
3. Firms can freely enter or exit the market.
What factors should affect these decisions?
Your costs (studied in preceding chapter) Because of 1 & 2, each buyer and seller is a
How much competition you face price taker takes the price as given.
We begin by studying the behavior of firms in
perfectly competitive markets.

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The Revenue of a Competitive Firm A C T I V E L E A R N I N G 1:

Exercise
Fill in the empty spaces of the table.
Total revenue (TR) TR = P x Q
Q P TR AR MR
TR
Average revenue (AR) AR = =P
Q 0 $10 n.a.
Marginal Revenue (MR): 1 $10 $10
TR
The change in TR from MR =
Q 2 $10
selling one more unit.
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: MR = P for a Competitive Firm

Answers
Fill in the empty spaces of the table. A competitive firm can keep increasing its output
TR TR without affecting the market price.
Q P TR = P x Q AR = MR =
Q Q So, each one-unit increase in Q causes revenue
0 $10 $0 n.a. to rise by P, i.e., MR = P.
$10
1 $10 $10 $10
Notice that $10
2 $10 $20 $10 MR = P is only true for
MR = P $10 firms in competitive markets.
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
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Profit Maximization Profit Maximization

What Q maximizes the firms profit? (continued from earlier exercise)

To find the answer, Q TR TC Profit MR MC

Profit =
At any Q with
Think at the margin. MR MC
MR > MC,
If increase Q by one unit, 0 $0 $5 $5
increasing Q $10 $4 $6
revenue rises by MR, raises profit. 1 10 9 1
cost rises by MC. 10 6 4
2 20 15 5
If MR > MC, then increase Q to raise profit. At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
If MR < MC, then reduce Q to raise profit. reducing Q 4 40 33 7
raises profit. 10 12 2
5 50 45 5

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MC and the Firms Supply Decision MC and the Firms Supply Decision
Rule: MR = MC at the profit-maximizing Q.
If price rises to P2,
At Qa, MC < MR. Costs then the profit- Costs
So, increase Q maximizing quantity
MC MC
to raise profit. rises to Q2.
P2 MR2
At Qb, MC > MR. The MC curve
So, reduce Q determines the
to raise profit. P1 MR firms Q at any price. P1 MR
At Q1, MC = MR. Hence,
the MC curve is the
Changing Q
Q firms supply curve. Q
would lower profit. Q2
Qa Q1 Qb Q1

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Shutdown vs. Exit A Firms Short-run Decision to Shut Down

Shutdown: If firm shuts down temporarily,
A short-run decision not to produce anything revenue falls by TR
because of market conditions. costs fall by VC
Exit: So, the firm should shut down if TR < VC.
A long-run decision to leave the market.
Divide both sides by Q: TR/Q < VC/Q
A firm that shuts down temporarily must still pay
its fixed costs. A firm that exits the market does So we can write the firms decision as:
not have to pay any costs at all, fixed or variable. Shut down if P < AVC

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A Competitive Firms SR Supply Curve The Irrelevance of Sunk Costs

Sunk cost: a cost that has already been
The firms SR committed and cannot be recovered
supply curve is Costs
the portion of MC Sunk costs should be irrelevant to decisions;
its MC curve you must pay them regardless of your choice.
If P > AVC, then
above AVC.
firm produces Q ATC FC is a sunk cost: The firm must pay its fixed
where P = MC. costs whether it produces or shuts down.
AVC
So, FC should not matter in the decision to shut
If P < AVC, then down.
firm shuts down
(produces Q = 0). Q

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A Firms Long-Run Decision to Exit A New Firms Decision to Enter Market

If firm exits the market, In the long run, a new firm will enter the market if
revenue falls by TR it is profitable to do so: if TR > TC.
costs fall by TC Divide both sides by Q to express the firms
So, the firm should exit if TR < TC. entry decision as:

Divide both sides by Q to rewrite the firms Enter if P > ATC

decision as:
Exit if P < ATC

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The Competitive Firms Supply Curve A C T I V E L E A R N I N G 2A:

Identifying a firms profit
A competitive firm
The firms Determine Costs, P
Costs
LR supply curve this firms
MC MC
is the portion of total profit.
its MC curve P = $10 MR
Identify the
above LRATC. LRATC ATC
area on the
graph that $6
represents
the firms
profit.
Q Q
50

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A C T I V E L E A R N I N G 2A: A C T I V E L E A R N I N G 2B:
Answers Identifying a firms loss
A competitive firm A competitive firm
Costs, P Determine Costs, P
this firms
profit per unit MC MC
total loss.
= P ATC
P = $10 MR
= $10 6 Identify the
profit ATC ATC
= $4 area on the
$6 graph that $5
represents
Total profit the firms P = $3 MR
= (P ATC) x Q loss.
= $4 x 50 Q Q
= $200 50 30

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A C T I V E L E A R N I N G 2B: A C T I V E L E A R N I N G 3:
Answers
A competitive firm As a recent graduate of this college, you have landed a job
in production management for Universal Clothes, Inc. You
Costs, P
are responsible for the entire company on weekends.
MC Your costs are shown below.
Total loss
Quantity Average Total Cost
= (ATC P) x Q
500 200
= $2 x 30 ATC 501 201
= $60 Your current level of production is 500 units. All 500 units
$5 have been ordered by your regular customers.
loss loss per unit = $2
P = $3 MR The phone rings. Its a new customer who wants to buy one
unit of your product. This means you would have to
increase production to 501 units. Your new customer offers
Q
30 you $450 to produce the extra unit.
a. Should you accept this offer?
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b. What is the net change in the firms profit? 25

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Market Supply: Assumptions The SR Market Supply Curve

1) All existing firms and potential entrants have As long as P AVC, each firm will produce its
identical costs. profit-maximizing quantity, where MR = MC.
2) Each firms costs do not change as other firms Recall from Chapter 4:
enter or exit the market. At each price, the market quantity supplied is the
3) The number of firms in the market is sum of quantity supplied by each firm.
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 Entry & Exit in the Long Run
Example: 1000 identical firms.
In the LR, the number of firms can change due
At each P, market Qs = 1000 x (one firms Qs) to entry & exit.
One firm Market If existing firms earn positive economic profit,
P P
MC S New firms enter.
P3
P3
SR market supply curve shifts right.
P2
AVC
P2 P falls, reducing firms profits.
P1 P1 Entry stops when firms economic profits have
been driven to zero.
Q Q
10 20 30 (firm) (market)
10,000 20,000 30,000
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Entry & Exit in the Long Run The Zero-Profit Condition

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.
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 Why Do Firms Stay in Business if Profit = 0?

In the long run, The LR market supply Recall, economic profit is revenue minus all
the typical firm curve is horizontal at costs including implicit costs, like the
earns zero profit. P = minimum ATC. opportunity cost of the owners time and money.

One firm Market In the zero-profit equilibrium, firms earn enough

P MC P revenue to cover these costs.
LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
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SR & LR Effects of an Increase in Demand Why the LR Supply Curve Might Slope Upward
A firm begins in but then an increase
long-run todriving
leadingeqm SR profits to zero
Over time, profits
in demandinduce entry,
raises P,
The LR market supply curve is horizontal if
and restoring long-run
profits for the firm. shifting S to theeqm.
right, reducing P 1) all firms have identical costs, and

P One firm P Market 2) costs do not change as other firms enter or

MC S1 exit the market.
S2
Profit ATC B
If either of these assumptions is not true,
P2 P2 then LR supply curve slopes upward.
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
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1) Firms Have Different Costs 2) Costs Rise as Firms Enter the Market
As P rises, firms with lower costs enter the market In some industries, the supply of a key input is
before those with higher costs. limited (e.g., theres a fixed amount of land
suitable for farming).
Further increases in P make it worthwhile
for higher-cost firms to enter the market, The entry of new firms increases demand for this
which increases market quantity supplied. input, causing its price to rise.
Hence, LR market supply curve slopes upward. This increases all firms costs.
At any P, Hence, an increase in P is required to increase
For the marginal firm, the market quantity supplied, so the supply curve
P = minimum ATC and profit = 0. is upward-sloping.
For lower-cost firms, profit > 0.
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CONCLUSION: The Efficiency of a

Competitive Market CHAPTER SUMMARY
Profit-maximization: MC = MR For a firm in a perfectly competitive market,
Perfect competition: P = MR price = marginal revenue = average revenue.

So, in the competitive eqm: 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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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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