1. Firms in Competitive Markets14
Firms in Competitive Markets

2. WHAT IS A COMPETITIVE MARKET?
In a perfectly competitive market
There are many buyers
There are many sellers
In the long run, firms can freely enter or exit the market
In the short run, the number of firms is assumed fixed (constant).
All sellers sell the same product.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

3. WHAT IS A COMPETITIVE MARKET?
As a result:
The actions of any single buyer or seller have a negligible impact on the market price.
That is, the market price is unaffected by the amount bought by a buyer or the amount sold by a seller
Therefore, every buyer and every seller takes the market price as given.
Everybody is a ‘price taker’
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

4. Total Revenue of a Competitive Firm
Total revenue for a firm is the selling price times the quantity sold.
TR = P  Q
We saw this in Chapters 5 and 13
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

5. Average Revenue of a Competitive Firm
Average revenue is the revenue per unit sold
P = AR.
This is simply because all units sold are sold at the same price.
If there is price discrimination, P is not necessarily equal to AR. In fact, if there is price discrimination there is no such thing as a market price. So, AR cannot be equal to the market price, because the latter does not exist.

6. Marginal Revenue of a Competitive Firm
Marginal Revenue is the increase (Δ) in total revenue when an additional unit is sold.
MR = TR / Q
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

7. The Revenue of a Competitive Firm
In perfect competition, marginal revenue equals price: P = MR.
We saw earlier that P = AR
Therefore, for all firms in perfect competition, P = AR = MR
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

8. Table 1 Total, Average, and Marginal Revenue for a Competitive Firm
Point out that price does not decrease even when output increases. Point out that P = AR = MR.
Note: (a) P = AR = MR (b) P does not fall as Q increases

9. Demand curves for the firm and the market (industry)
Jones and Peters, a firm
Market
Price
Price
Demand, P = AR = MR P
Demand, P = AR = MR
Quantity (firm)
Quantity (market)
The market price is P. No matter what amount Jones and Peters produces, the market price will not change. Therefore, J&P will be able to sell any feasible output if it charges the price P.
The market demand curve is negatively sloped, as usual. That is, the market price, which is the lowest prevailing price, is inversely related to the quantity demanded.

10. Supply
We have just seen the demand curves for a firm and for the entire industry
Next, we need to work out what the supply curves look like
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

11. Supply: short run and long run
The analysis of supply in perfect competition depends on whether it is the short run or the long run.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

12. Short run and long run: assumptions
All fixed costs are sunk costs in the short run, but not in the long run
Definition: Sunk costs are costs that are unavoidable even when production is zero
The number of firms in an industry is fixed in the short run, but not in the long run
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

13. The firm and the industry in the short run

14. Shut Down and Exit
Before a firm decides how much to produce, it must decide whether or not to stay in business
A shutdown refers to a short-run decision to stop production temporarily, perhaps because of poor market conditions.
An exit refers to a long-run decision to end production permanently.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

15. The Firm’s Short-Run Decision to Shut Down
A firm will shut down (temporarily) if its variable costs exceed its total revenue, no matter what quantity it produces
Its fixed costs do not matter!
This is because
Fixed costs are sunk costs in the short run
sunk costs are defined as costs that will have to be paid even if the firm shuts down.
Therefore, FC cannot affect a firm’s decision on whether to stay open or shut down
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16. Sunk Costs
Sunk costs will have to be paid even when a firm is in a temporary shutdown.
Examples:
If the firm signs a long-term contract with its landlord, the rent will have to be paid even when the firm is temporarily shut down.
Some maintenance costs will have to be incurred even when the firm is shut down.
The firm may be under contract to provide customer service to past customers even after it shuts down.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

17. The Firm’s Short-Run Decision to Shut Down
Total Revenue = $1000 per month
Variable Cost = $800 per month
Fixed Cost = $400 per month
Profit = –$200 per month (a loss)
Q: Would this firm stay in business or would it shut down for the time being?
A: It would stay in business
If it shuts down, the fixed cost (say, rent owed to the landlord) will still have to be paid—because it is sunk!—and the loss will then be even higher, $400 per month.
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18. The Firm’s Short-Run Decision to Shut Down
Total Revenue = $1000 per month
Variable Cost = $1200 per month
Fixed Cost = $400 per month
Profit = –$600 per month (a loss)
Q: Would this firm stay in business or would it shut down for the time being?
A: It would shut down.
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19. The Firm’s Short-Run Decision to Shut Down
A firm shuts down if total revenue is less than variable cost, no matter what quantity the firm produces. That is,
A firm shuts down if
TR < VC, no matter what Q is, or
TR/Q < VC/Q, no matter what Q is, or
P < AVC, no matter what Q is.
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20. A Firm’s Shut Down Decision$
If P = PH, the firm stays open because P > Minimum AVC
AVC PH
Minimum AVC PL
If P = PL, the firm shuts down because P < Minimum AVC
Quantity

21. Table 2 Profit Maximization: A Numerical Example
Is it possible to figure out the profit-maximizing output from just the MR and MC numbers?
Yes, it is where MR = MC.

22. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
When MR > MC increase Q
When MR < MC decrease Q
When MR = MC Profit is maximized; stick with this Q.
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23. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
Profit maximization occurs at the quantity where marginal revenue equals marginal cost.
This is a crucial principle in understanding the behavior of firms
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24. Figure 1 Profit Maximization for a Competitive Firm
We have seen before that, in perfect competition, P = AR = MR.
Costs
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
and
Revenue MC
We have also seen that, profit maximization requires MR = MC. MC 2 Q
ATC
P = MR
P the prevailing market price Q
MAX
AVC
Therefore, P = AR = MR = MC is the fingerprint of perfect competition. One can figure out the profit-maximizing quantity by looking for the quantity at which P = AR = MR = MC. MC 1 Q
Quantity
CHAPTER 14

25. Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve
Price MC P1
ATC P2
AVC P3 P4
Q4 = Q3 Q2 Q1
Quantity

26. Recall from Ch. 4: The Supply Curve
Price
Supply P 2 Q P 1 Q
Quantity

27. Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve
Price
This section of the
firm’s MC curve is
also the firm’s supply
curve. MC P 2 Q
ATC P 1 Q
AVC
Quantity

28. Figure 3 The Competitive Firm’s Short Run Supply Curve
Costs
Firm ’
s short-run
supply curve
If P > ATC, the firm will continue to produce at a profit. MC
ATC
If P > AVC, firm will continue to produce in the short run.
AVC
Firm
shuts
down if P
<
AVC
What can shift the supply curve to the right?
Quantity
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

29. The Short Run: Market Supply with a Fixed Number of Firms
The market supply curve is the horizontal sum of the individual firms’ short run supply curves.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

30. Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply
(b) Market Supply (# of firms fixed) It is the horizontal sum of the individual firms’ supply or MC curves
Price
Price MC
Supply
$2.00
200
$2.00
200,000
1.00
100
1.00
100,000
Quantity (firm)
Quantity (market)
Q: What is the number of firms?
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31. Short-Run Equilibrium!!
(a) Individual Firm Supply
(b) Market Supply (# of firms fixed)
Price
Price MC
Supply
$2.00
200
$2.00
200,000
1.00
100
1.00
100,000
DemandH
DemandL
Quantity (firm)
Quantity (market)
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32. Price = Minimum ATC; profit = zero; demand has no effect on price, and no effect on the quantity produced by a firm; demand does affect the quantity produced by the industry, and the number of firms in the industry
The long run

33. The Firm’s Long-Run Decision to Exit or Enter a Market
In the long run, the firm exits if it sees that its total revenue would be less than its total cost no matter what quantity (Q) it might produce
That is, a firm exits if
TR < TC, no matter what Q is.
TR/Q < TC/Q , no matter what Q is.
P < ATC , no matter what Q is.
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34. The Firm’s Long-Run Decision to Exit or Enter a Market
A new firm will enter the industry if it expects to be profitable.
That is, a new firm will enter if
TR > TC for some value of Q
TR/Q > TC/Q for some value of Q
P > ATC for some value of Q
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

35. Entry and Exit of Firms in the Long-Run
The number of firms will stabilize when P = Minimum ATC. This is the long run price! $
New firms will enter because P > Minimum ATC
ATC PH
Minimum ATC
This is the efficient scale output. This is each firm’s long-run equilibrium output! PL
Existing firms will exit because P < Minimum ATC
Quantity

36. Perfect Competition in the Long Run$
P = Minimum ATC is the long run price
ATC
Minimum ATC
The efficient scale output is each firm’s long-run equilibrium output
Quantity

37. Perfect Competition in the Long Run
To determine the number of firms in the industry and the total industry output, we need the market demand curve
Price
Price
ATC
Market Demand
$1.50
P = Minimum ATC =
$1.50
200 (efficient scale)
Quantity (firm)
6,000
Quantity (industry)
P = AR = MR = MC = ATC is the fingerprint of perfect competition in the long run.
This is it, as far as long-run equilibrium is concerned! How many firms are there in long-run equilibrium? What would happen if demand moves left (decreases)?
What could cause prices to increase?

38. Perfect Competition in the Long RunD3 D2 D1
Price
Price
ATC
Market Demand
$1.50
P = Minimum ATC =
$1.50
200 (efficient scale)
Quantity (firm)
6,000
Quantity (industry)
Industry’s long-run supply curve

39. A Firm’s Profit Profit equals total revenue minus total costs.
Profit = TR – TC
Profit/Q = TR/Q – TC/Q
Profit = (TR/Q – TC/Q)  Q
Profit = (P – ATC)  Q
We just saw that P = ATC in long-run equilibrium
Therefore, profit = 0 (zero!) in long-run equilibrium
Had profit been > 0, new firms would have entered and driven prices down

40. Figure 5 Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits
Price
ATC MC
Profit
ATC Q P P = AR MR
Quantity
(profit-maximizing quantity)

41. Figure 5 Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses
Price MC
ATC
ATC Q
Loss P = AR MR
Quantity
(loss-minimizing quantity)

42. The Long Run: Market Supply with Entry and Exit
Firms will enter or exit the market until profit is driven to zero.
Price equals the minimum of average total cost.
The long-run market supply curve is a horizontal line at this price.
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43. Figure 7 Market Supply with Entry and Exit
(a) Firm ’
s Zero-Profit Condition
(b) Market Supply (# of firms variable)
Price
Price MC
ATC
P = minimum ATC
Supply
Quantity (firm)
Quantity (market)
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44. Why Do Competitive Firms Stay in Business If They Make Zero Profit?
Profit = TR – TC
Total cost = explicit cost + implicit cost.
Profit = 0 implies TR = explicit cost + implicit cost
In the zero-profit equilibrium, the firm earns enough revenue to compensate the owners for the time and money they spend to keep the business going.
So, don’t feel sorry for the owners!

45. Recap: Economic and Accounting Profits (Chapter 13)
How an Economist
How an Accountant
Views a Firm
Views a Firm
Revenue
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Total
opportunity
costs
Explicit
costs
Explicit
costs

46. Application
We will now work through what happens when the demand for a product increases.
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47. Short Run and Long Run Effects of a Shift in Demand: an application
An increase in demand raises price and quantity (for each firm and the industry) in the short run.
Firms earn positive profits
because price now exceeds average total cost.
New firms enter
Market supply increases (shifts right)
Price decreases; gradually returns to minimum ATC
Profits decrease; gradually return to zero
So, the long-run effect of an increase in demand is as follows: the price is unchanged, each firm’s output is unchanged, the number of firms increases, industry output increases.

48. Figure 8 An Increase in Demand in the Short Run and Long Run
(a) Initial zero-profit long-run equilibrium
Firm
Market
Price
Price
ATC MC S
Short-run supply, 1 D
Demand, 1 1 Q A P 1
Long-run
supply P 1 q1
Quantity (firm)
Quantity (market)
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49. Figure 8 An Increase in Demand in the Short Run and Long Run
(b) Short-Run Response to an increase in demand
Firm
Market
Price
Price D 2
ATC MC
Profit S 1 Q 2 P B P 2 D 1 q2 Q 1 A P 1 P
Long-run q1 1
supply
Quantity (firm)
Quantity (market)
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50. Figure 8 An Increase in Demand in the Short Run and Long Run
(c) Long-Run Response to positive short-run profits: new firms enter,
pushing the short-run market supply to the right.
Firm
Market
Price
Price D 2 S MC
ATC 1 S 2 B P 2 A Q 3 C P P
Long-run 1 q1 1
supply D 1
Quantity (firm) Q Q
Quantity (market) 1 2
An increase in demand leads to an increase in price in the short run. But this price increase will not last. New firms will enter and push the price back to P1, the minimum ATC. Each firm’s output will return to q1. The only long-run effect of demand will be to increase the number of firms.

51. Any Questions?
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

52. Summary
Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces.
The price of the good equals both the firm’s average revenue and its marginal revenue.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

53. Summary
To maximize profit, a firm chooses the quantity of output such that marginal revenue equals marginal cost.
This is also the quantity at which price equals marginal cost.
Therefore, the firm’s marginal cost curve is its supply curve.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

54. Summary
In the short run, when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost.
In the long run, when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost.
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55. Summary
In a market with free entry and exit, profits are driven to zero in the long run and all firms produce at the efficient scale.
Changes in demand have different effects over different time horizons.
In the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium.
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS