1. 12 Firms in Perfectly Competitive Markets Chapter Outline and
Learning Objectives
12.1
Perfectly Competitive Markets
12.2
How a Firm Maximizes Profit in a Perfectly Competitive Market
12.3
Illustrating Profit or Loss on the Cost Curve Graph
12.4
Deciding Whether to Produce or to Shut Down in the Short Run
12.5
The Entry and Exit of Firms in the Long Run
12.6
Perfect Competition and Efficiency

2. Monopolistic Competition
Pure Competition
Oligopoly
Monopoly

3. Market Structures Importance Importance Importance Importance
Pure Competition
Monopolistic Competition
Oligopoly
Monopoly
Number of Firms
Many small
Many small
A few large
one
Considers action or reaction of other firms
Importance
Diff or Homog
Product type
Homogeneous
Differentiated
one
Need to stress differences?
Importance
Barriers to Entry
none
none
large
large
Long run profits possible?
Importance
Price Taker/Maker
taker
taker/seeker
maker
maker
Importance
Ability to influence market price?
Non-price Competition no
yes
yes
yes
As important as price?
Importance

4. Entrepreneurs are continually introducing new products or new ways of selling products, which—when successful—enable them to earn economic profits in the short run.
But in the long run, competition among firms forces prices to the level where they just cover the costs of production.

5. Perfect Competition in Farmers’ Markets
Demand for organically grown food increased at a rate of 20 percent per year,
Prices rose
More farmers have begun participating in farmers’ markets.
Supply increased,
Prices dropped
Profits from farmers’ markets is no longer higher than what they earn selling to supermarkets.

6. Perfectly competitive market: 1. many buyers and sellers,
2. all firms selling identical products,
3. no barriers to new firms entering the market.
4. Price takers. Firms are unable to affect the market price.
A good crop from one wheat farmer, or if one wheat farmer stops growing wheat altogether, the market supply curve for wheat will not shift by enough to change the equilibrium price by even 1 cent.

7. Perfect Competition (many small firms)
Market supply & demand determine price.
The firm’s demand will be perfectly elastic.
Firms can sell as much as they want at P
Above P, they lose business
Below P they lose revenue.
Output
Price
Firm
Output
Price
Market
Market demand
Firms must take the market price
Market supply P P
Firm’s demand

8. Profit = Total revenue - total cost.
Average revenue (AR) - TR / Quantity sold = Price
Marginal revenue (MR) The change in total revenue from selling one more unit of a product, also = Price
AR = MR = Price = Demand

9. Farmer Parker’s Revenue from Wheat Farming Market Price (per bushel)
Number of Bushels
(Q)
Market Price (per bushel)
(P)
Total Revenue
(TR)
Average Revenue
(AR)
Marginal Revenue
(MR) 1 2 3 4 5 6 $4 $0 8 12 16 20 24 —
AR = MR = Price

10. Determining the Profit-Maximizing Level of Output
Quantity (bushels)
(Q)
Total Revenue
(TR)
Total Cost
(TC)
Profit
(TR−TC)
Marginal Revenue
(MR)
Marginal Cost
(MC) 1 2 3 4 5 6 7 8 9 10
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
$2.00
5.00
7.00
8.50
10.50
13.00
16.50
21.50
28.50
38.00
50.50
−$2.00
−1.00
1.00
3.50
5.50
7.50
6.50
−2.00
−10.50
— $4.00
— $3.00
2.00
1.50
2.50
9.50
12.50
Maximum Profit, or MR = MC

11. Maximum Profit
Profit is maximized where the vertical distance between total revenue and total cost is the largest.
This happens at an output of 6 bushels.

12. MR = MC MR = $4 per bushel. Profit is maximized by producing
up to the point where the marginal revenue of the last bushel produced is equal to its marginal cost, or MR = MC.
The closest Farmer Parker can come is to produce 6 bushels of wheat.
Once marginal cost is greater than marginal revenue profits begin to decline. .

13. Conclusions: The profit-maximizing level of output:
where TR – TC is the greatest.
where MR = MC.
2. In a perfectly competitive industry, P = MR.
So, we can restate the MR = MC condition as P = MC.

14. Showing a Profit on the Graph
A firm maximizes profit where MR = MC.
Price - average total cost = profit per unit of output.
Total profit is equal to P – ATC time quantity of output.
The green-shaded rectangle, which has a height equal to (P − ATC) and a width equal to Q.

15. Determining Profit-Maximizing Price and Quantity
a. Suppose the current equilibrium price in the basketball market is $12.50.
To maximize profit, how many basketballs will Andy produce?
What price will he charge?
And how much profit (or loss) will he make?
Draw a graph to illustrate your answer.
Label clearly Andy’s demand, ATC, AVC, MC, and MR curves;
the price he is charging;
the quantity he is producing;
and the area representing his profit (or loss).
Output per Day
Total Cost
$10.00 1
20.50 2
24.50 3
28.50 4
34.00 5
43.00 6
55.50 7
72.00 8
93.00 9
119.00

16. Determining Profit-Maximizing Price and Quantity
Step 1: Calculate Andy’s marginal cost, average total cost, and average variable cost.
Andy will produce the level of output where marginal revenue is equal to marginal cost.
We can calculate costs from the information given in the table to draw the required graph.
Average total cost (ATC) equals total cost (TC) divided by the level of output (Q).
Average variable cost (AVC) equals variable cost (VC) divided by output (Q).
To calculate variable cost, recall that total cost equals variable cost plus fixed cost.
When output equals zero, total cost equals fixed cost. In this case, fixed cost equals $10.00.
Output
per Day
(Q)
Total
Cost
(TC)
Fixed
(FC)
Variable
(VC)
Average
Total Cost
(ATC)
Cost (AVC)
Marginal
(MC)
$10.00
$0.00 — 1
20.50
10.00
10.50
$20.50
$10.50 2
24.50
14.50
12.25
7.25
4.00 3
28.00
18.00
9.33
6.00
3.50 4
34.00
24.00
8.50 5
43.00
33.00
8.60
6.60
9.00 6
55.50
45.50
9.25
7.58
12.50 7
72.00
62.00
10.29
8.86
16.50 8
93.00
83.00
11.63
10.38
21.00 9
119.00
109.00
13.22
12.11
26.00

17. or Andy will produce the level of output where MR = MC
Step 1: Calculate Andy’s marginal cost, and average total cost
Andy will produce the level of output where MR = MC
Average total cost (ATC) equals total cost (TC) divided by output (Q).
Output per Day (Q)
Total Cost
(TC)
Average Total
Cost (ATC)
Marginal
Cost (MC)
Marginal Revenue (MR)
$10.00 — 1
20.50
$20.50
$10.50
$12.50 2
24.50
12.25
4.00
12.50 3
28.00
9.33
3.50 4
34.00
8.50
6.00 5
43.00
8.60
9.00 6
55.50
9.25 7
72.00
10.29
16.50 8
93.00
11.63
21.00 9
119.00
13.22
26.00
Step 2: MR = MC when Andy produces 6 basketballs per day.
Profits per unit = MR – ATC at 6 units. (12.50 – 9.25 = 3.25). His total Profits equal per unit profits times output )3.25 x 6 = or TR – TC = 6 x – = $75.00 − $55.50 = $19.50.

18. Graphing Profits MR = MC when Andy produces 6 basketballs per day.
Andy’s profits are equal to his marginal revenue minus his average total costs times his output. ($12.50 – 9.25) x 6 = $19.50.

19. Suppose the equilibrium price of basketballs falls to $6.00.
Now how many basketballs will Andy produce?
What price will he charge?
And how much profit (or loss) will he make?
Draw a graph to illustrate this situation,
using the instructions in part (a).
Output per Day
Total Cost
$10.00 1
20.50 2
24.50 3
28.50 4
34.00 5
43.00 6
55.50 7
72.00 8
93.00 9
119.00

20. Andy will still produce the level of output where MR = MC, but MR = 6
Output per Day (Q)
Total Cost
(TC)
Average Total
Cost (ATC)
Marginal
Cost (MC)
Marginal Revenue (MR)
$10.00 — 1
20.50
$20.50
$10.50
$6.00 2
24.50
12.25
4.00
6.00 3
28.00
9.33
3.50 4
34.00
8.50 5
43.00
8.60
9.00 6
55.50
9.25
12.50 7
72.00
10.29
16.50 8
93.00
11.63
21.00 9
119.00
13.22
26.00
Now MR = MC when Andy produces 4 basketballs per day.
Profits per unit = MR – ATC at 4 units. (6 – 8.50 = -2.50). His total losses equal per unit losses times output ) x 4 = or TR – TC = 4 x 6.00 – = $24.00 − $34.00 = -$10.00.

21. Graphing Losses MR = MC when Andy produces 4 basketballs per day.
Andy’s losses are equal to his marginal revenue minus his average total costs times his output. ($6.00 – 8.50) x 4 = -$10.00.

22. Remember That Firms Maximize Their Total Profit, Not Their Profit per Unit
Only when the firm has expanded production to Q2 will it have produced every unit for which marginal revenue is greater than marginal cost.
At that point, it will have maximized profit.

23. Pure Competition Equilibrium Price Quantity Operating at Minimum ATC$6
ATC MC $5 $4 $3
Price = Demand = MR $2 $1 10 20 30 40 50 60
Quantity

24. Earn economic profit MR (P) > ATC MR Normal Profit MR (P) = ATC
Output
Price
Firm MC
ATC
AVC
Short Run Profits
Earn economic profit MR (P) > ATC MR P3
Normal Profit
MR (P) = ATC
Short Run Losses
Firm covers AVC, but not AFC:
MR (P) < ATC, but MR > AVC
Shut Down
Firm can’t cover AVC, minimize losses by shutting down
MR (P) < AVC

25. Case 1: Prices rise Supply Profits and Losses Entry and Exit Profits?
Entry or Exit?
Supply

26. An Increase in Market Demand
Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 …
market price increases to P2 …
shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits.
Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2.
Firm
Market
Price
Price S1 MC S2 D2
ATC P2 d2 P2 P1 d1 P1 D1
Output
Output q1 q2 Q1 Q2

27. The Adjustment S1 MC S2 ATC d2 d1 Slr d1 D1 D2
After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3).
As the market price returns to P1, the demand curve facing the firm returns to its original level.
In the long-run, economic profits are driven down to zero.
Firm
Market
Price
Price S1 MC S2
ATC P2 d2 P2 d1
Slr P1 d1 P1 D1 D2
Output
Output q1 q2 Q1 Q2 Q3

28. SR Profits 1. Price goes up 2. Firms enter, Supply increases$6
3. Price goes down
ATC MC $5 $4
SR Profits $3
Price = Demand = MR $2
4. No LR Profits $1 10 20 30 40 50 60
Quantity

29. Case 2: Prices fall Supply Profits and Losses Entry and Exit Profits?
Entry or Exit?
Supply

30. A Decrease in Demand S2 S1 MC ATC d1 d2 D2 D1
If, instead, something causes market demand for toothpicks to decrease from D1 to D2 …
the market price falls to P2
shifting the firm’s demand curve downward, leading to a reduction in output to q2. The firm is now making losses.
Short-run losses cause some competitors to exit the market, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2.
Firm S2
Market
Price
Price S1 MC
ATC D2 P1 d1 P1 d2 P2 P2 D1
Output
Output q2 q1 Q2 Q1

31. The Adjustment: S2 S1 MC ATC Slr d1 d1 d2 D2 D1
After the decrease in market supply, a new equilibrium is established at the original market price P1 and a smaller rate of output Q3.
As the market price returns to P1, the demand curve facing the firm returns to its original level.
In the long-run, economic profit returns to zero.
Note the long-run market supply curve is flat Slr.
Firm S2
Market
Price
Price S1 MC
ATC
Slr P1 d1 d1 P1 P2 d2 P2 D2 D1
Output
Output q2 q1 Q3 Q2 Q1

32. SR Losses 1. Price goes down 2. Firms leave, Supply decreases$6
3. Price goes up
ATC MC $5 $4
P = D = MR $3
SR Losses $2
4. No LR Losses $1 10 20 30 40 50 60
Quantity

33. The Supply Curve
The marginal cost curve (MC) is the firm’s supply curve.
Below MC = AVC, the firm will shut down Output = 0 below P1,,
At P2 MR = MC at q2.
At P3 MR = MC at q3.
Output
Price
Firm MC
ATC
AVC
MC is the firm’s Supply Curve P3 P2 P1 q1 q2 q3

34. Supply shifts out and price drops
Long Run Equilibrium
Short Run Profits
Cause firms to enter the market
Supply shifts out and price drops
Short Run Losses
Cause firms to leave the market
Supply shifts in and price rises

35. Long-run Equilibrium Ssr MC ATC d1 D
The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.
The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.
At the price established in the market, firms in the industry earn zero economic profit
Firm
Output
Price
Market P1 D
Ssr Q1
Price MC
ATC P1 d1
Output q1

36. Increasing-Cost Industries
An increase in Market Demand will lead to higher per-unit costs of production for all firms.
The long-run market supply curve in a
increasing-cost industry is upward-sloping.

37. Efficiency in Perfect Competition
1. Productive Efficiency
a. The situation in which a good or service is produced at the lowest possible cost.
b. The forces of competition will drive the market price to the minimum average cost of the typical firm.
Firm
Price MC
ATC P1 MR
c. Therefore, in the long run, only the consumer benefits from cost reductions.
Output q1

38. 2. Allocative Efficiency
a. Goods and services are produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.
Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last
unit.
MR = MC
Firm
Price MC
ATC P1 MR
Output q1

39. 12 Questions

40. In perfectly competitive markets, firms
a. can sell all of their output at the market price.
b. produce differentiated products.
c. can influence the market price by altering their output level.
d. are large relative to the total market.
When we say that a firm is a price taker, we are indicating that the
firm takes the price established in the market then tries to increase that price through advertising.
b. firm can change output levels without having any significant effect on price.
c. demand curve faced by the firm is perfectly inelastic.
d. firm will have to take a lower price if it wants to increase the number of units that it sells.
In perfectly competitive markets, individual firms have no control over price. Therefore, the firm’s marginal revenue curve is
a. a downward-sloping curve.
b. indeterminate.
c. constant at the market price of the product.
d. precisely the same as the firm’s total revenue curve.

41. If marginal revenue exceeds marginal cost, a perfectly competitive firm should
a. expand output b. reduce output.
c. lower its price d. do both a and c.
expand output
When firms in a perfectly competitive market are temporarily able to charge prices that exceed their production costs,
a. the firms will earn long-run economic profit.
b. additional firms will be attracted into the market until price falls to the level of per-unit production cost.
c. the firms will earn short-run economic profits that will be offset by long-run economic losses.
the existing firms must be colluding or rigging the market, otherwise, they would be unable to charge such high prices.

42. Suppose a restaurant that is highly profitable during the summer months is unable to cover its total cost during the winter months. If it wants to maximize profits, the restaurant should
a. shut down during the winter, even if it is able to cover its variable costs during that period.
b. continue operating during the winter months if it is able to cover its variable costs.
c. go a out of business immediately; losses should never be tolerated.
d. lower its prices during the summer months.

43. This graph illustrates a firm capable of earning economic profit.
that is only able to break even when it maximizes profit.
taking economic losses.
that should shut down immediately
This graph depicts the cost curves of a firm in a perfectly competitive industry. At what output would the firm’s per-unit cost be at a minimum?
a c. 150
b d. an output > 150
For the above graph, if the market price is $30, what is the firm’s profit-maximizing output and maximum profit.
a. output, 125; economic profit, zero
b. output, 125; economic profit, between $1,000 and $1,250
c. output, 150; economic profit, $1,500
d. output, 150; economic profit, between $1,250 and $1,500