1

Firms in Competitive Markets

Chapter 14
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What we learn in this chapter?

• In Ch.13 we looked into the details of the cost
structure of the firms
• The next four chapters study how profit maximising
firms decide on the quantity of output to produce and
the price at which to sell that output
• This decision is based
– On the cost structure of the firms
– On the kind and level of competition in the market
• Ch.14 deals with the equilibrium of the firm in
perfectly competitive markets
• We will distinguish between the equilibrium of the
short run and that of the long run
• To gain valuable insights about the market system
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The meaning of competition

• A perfectly competitive market has the following
characteristics
– There are many buyers and sellers in the market
– The goods and services offered by various sellers
are largely the same
– Firms can freely enter or exit the market
• And the following outcomes:
– The individual firm produces a small portion of
total market output
– The firm cannot have any influence over the price
it charges
• Only a small number of markets are perfectly
competitive in real life
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The firm as a price taker

• What distinguishes perfectly competitive markets
from other competitive markets is the fact that the
firm is a price taker
• What do we mean by “price taker”?
• The firm takes the price determined by the market as
the price that it will receive for it output
• In other words the decision of the individual firm
about its level output has no impact on price
• This is a very important characteristic of perfect
competition that we should always remember
• It means that the price elasticity of the demand curve
for the individual firm is infinite
• The demand curve of the firm is horizontal
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Revenue of a competitive firm

• A horizontal demand curve for the individual firm
has very important consequences for our analysis
• A price-taker competitive firm does not need to
lower its price to sell a larger amount because it can
sell all its product at this price
• Also, the firm can’t increase its price by reducing its
output
• This makes total revenue of the firm proportional to
the amount of output sold on the market
• Average revenue tells us how much revenue a firm
receives for the typical unit sold
• In perfect competition average revenue equals the
price of the good or service
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Total and average revenue

• Total revenue for a firm is the selling price
multiplied by the quantity sold
TR = ( P x Q )
• Average revenue tells us how much revenue a firm
receives for the typical unit sold
• In perfect competition average revenue equals the
price of the good or service
Total revenue
Averagerevenue=
Q uantity
(Price Quantity)
=
Quantity
=Price
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Marginal revenue
• When we analysed costs we distinguished between
average cost and marginal cost
• We must do the same distinction for the revenue
side
• Marginal revenue is the change in total revenue due
to an additional unit sold
MR =  TR /  Q
• For competitive firms marginal revenue equals the
price of the good or service
Marginal Revenue = Price x one
MR = Price
• Therefore for the competitive firm
Price = Average Revenue = Marginal Revenue
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Profit maximisation
• The main objective of every firm is to maximise the
profits it earns for its owners
• Profit maximising firm is a key assumption of
economic theory
• Profit maximisation means that the firm will want to
produce the quantity of output where the difference
between total revenue and total cost is
– the biggest if it is positive, corresponding to
maximum profit
– the smallest if it is negative, corresponding to
minimum loss
• This assumption is valid irrespective of competition
and other market conditions
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Marginal revenue = Marginal cost

• Remember Principle 3 from Ch.1: Rational People
Think at the Margin
• We now prove this principle while establishing the
output level at which the competitive firm
maximises its profits
• Profit maximisation occurs at the quantity where
marginal revenue is equal to marginal cost
• If MR  MC, the firm can increase its profits by
increasing Q
• If MR  MC, the firm can increase its profits by
reducing Q
• If MR = MC, profit is maximised because any
change in Q will imply lower profits
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Profit Maximization for the

Competitive Firm
The firm maximizes
Costs profit by producing
and the quantity at which
Revenue marginal cost equals
marginal revenue. MC

ATC
P P = AR = MR
AVC

0 QMAX Quantity
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Equilibrium of the firm:

too little production
Costs
and
Revenue
MC

ATC
P = MR1 P = AR = MR
AVC

MC1

MR > MC,
increase Q

0 Q1 QMAX Quantity
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Equilibrium of the firm:

too much production
Costs
and
Revenue
MC

MC2
ATC
P = MR2 P = AR = MR
AVC

MR < MC,
decrease Q

0 QMAX Q2 Quantity
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Other decisions by the firm

• Compairing the price with various measures of cost
such as the average total-cost and the average
variable cost highlights other decisions of the firm
• Two decisions are very important: when to shut
down the firm and when to exit from the market
• A shutdown refers to a short-run decision not to
produce anything during a specific period of time
• Exit refers to a long run decision to leave the market
• The firm considers its sunk costs when deciding to
exit, but ignores them when deciding to shut down
• Sunk costs are those costs that have already been
committed and cannot be recovered by the firm by
continuing to operate in the market
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The firm’s decision to shut down

• A firm may temporarily halt production even though
it remains in the market
• In other words, it plans to restart operations when
market conditions are suitable in the future
• The firm shuts down if the revenue it gets from
producing is less than the variable cost of production
Shut down if TR < VC
Shut down if TR / Q < VC / Q
Shut down if P < AVC
• All the formula mean the same thing: not much point
in continuing with production if the market price is
below even the average variable cost (every unit
produced and sold increases total loss)
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The Firm’s decision to shut down

Costs
If P > ATC, MC
keep producing
at a profit.

ATC
If P > AVC, AVC
keep producing
in the short run.

If P < AVC,
shut down.

0 Quantity
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Marginal cost and supply curve

• We saw that the marginal cost curve is of vital
importance to the firm for its output decisions
• The marginal cost curve of the firm has one other
important characteristic
• The portion of the marginal cost curve that lies
above the average variable cost curve is the
competitive firm’s short run supply curve
• Below the point where MC curve crosses the AVC
curve the firm will shut down
• Above that point the firm has an incentive to
produce in the short run even if it makes a loss for
those prices below the ATC curve
• Therefore marginal cost curve is the supply curve
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Shut down and short run supply

Costs

Firm’s short-run MC
supply curve

ATC

AVC

0 Quantity
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The long-run decision to exit

• In the long run, under certain circumstances the firm
may decide that there is not much point in staying in
a specific market or industry
• Therefore exits from that market or industry
• In the long run, the firm exists from a market or an
industry if the revenue it receives from producing is
less than its total costs
Exit if TR < TC
Exit if TR / Q < TC / Q
Exit if P < ATC
• There is no point in staying in a market or industry if
the firm is consistently making losses by staying in
that market or industry
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The long-run decision to enter

• In the long run while some firms may exit some
markets or industris other firms will decide to enter
some markets or industries
• In the long run, a firm enters a market or an industry
if the revenue it receives from its production is
higher than its total costs
Enter if TR > TC
Enter if TR / Q > TC / Q
Enter if P > ATC
• Entry decision is symetrical to exit decision
• If an industry is consistently making profits, other
enterpreneurs will enter that industry by settign up
new firms
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Exit and entry in the long run

Costs

MC
Firm enters
if P > ATC

ATC

AVC

Firm exits
if P < ATC

0 Quantity
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The firm’s short run and long run

supply curve
• The time period we adopt for the analysis has an
impact on the supply curve of the firm
• We have already defined the short-run and the long-
run depending on whether the capital stock is fixed
or it becomes variable
• Short run supply curve (shut-down decision)
– The portion of the marginal cost curve that lies
above average variable cost curve
• Long run supply curve (exit and entry decisions)
– The portion of the marginal cost curve that lies
above average total cost curve
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Profit and loss of competitive firm

• We know that the firm maximises profits through the
equality of marginal cost and marginal revenue
• We can now calculate the profits of the firm
• Profits of the competitive firm is the area between
price and the average total cost if price is higher than
average total cost
• Remember: this is economic profit and will be lower
than accounting profit
• Losses of the competitive firm is the area between
the price and the average total cost if price is below
average total cost
• Remember: a firm may have economic loss despite
accounting profits
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Profit as the area between price and

average total cost
Price

MC ATC
Profit

P P = AR = MR

ATC

Profit-maximizing
quantity

0 Q Quantity
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Loss as the area between price and

average total cost
Price

MC ATC

ATC

P P = AR = MR

Loss

Loss-minimizing quantity

0 Q Quantity
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Supply in a competitive market

• It is easy to move from the supply of the individual
firm to the market supply in a competitive market
• Market supply equals the sum of the quantities
supplied by individual firms in the market
• Market supply in the short run
– For any given price, each firm supplies a quantity
of output so that P=MR=MC
• Market supply in the long run
– Firms will enter or exit the market until profit is
driven to zero
– In the long run price equals the minimum of ATC
– The long run market supply curve is horizontal at
that price
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Supply curve in a competitive

market
(a) Firm’s Zero-Profit Condition (b) Market Supply

Price Price

MC
ATC
P=
minimum Supply
ATC

0 Quantity 0 Quantity
(firm) (market)
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Change in demand in the short run

• An intellectual experiment will help us understand
better the equilibrium in the competitive market
• Assume that the demand curve shifts up (demand
increases) in a market in long-run equilibrium
• The shift in the demand curve will raise the
equilibrium price and quantity in the short run
• Firms earn profits because price now exceeds
average total cost
• A fall in demand reduces price and quantity in the
short run causes losses because price is now below
the average total cost
• If demand falls so much that price falls below
average variable cost some firms will shut down
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Initial condition: firm and market

at long run equilibrium
Firm Market
Price Price

MC ATC S1
A
P1 P1 Long-run
supply

D1

0 Quantity 0 Q1 Quantity
(firm) (market)
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Increase in demand: short run

Firm Market
Price Price

Profit MC ATC B S1
P2 P2 A
P1 P1 Long-run
supply
D2
D1

0 Quantity 0 Q1 Q2 Quantity
(firm) (market)
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Change in demand in the long run

• Let us continue with the example the long run
• Over time the short run supply curve shifts
• Increase in demand:
– Short run profits encourage new firms to enter the
market
– Price fall as supply curve shifts to right
• Fall in demand:
– Short run losses force firms to exit from market
– Price increases as supply curve shits left
• For both cases, in the new long run equilibrium
profits return to zero and price returns to minimum
average total cost but
• The number of firms in the market has changed
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Increase in demand: long run

Firm Market
Price Price

MC ATC B S1
S2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity 0 Q1 Q2 Q3 Quantity
(firm) (market)
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(a) Initial Condition Market

Firm
Price Price

MC ATC Short-run supply

A
P1 P P1 Long-run
supply
Demand

0 Quantity (firm) 0 Q1 Quantity (market)

(b) Short-Run Response

Firm Market
Price Price

Profit MC ATC B S1
P2 P2
A
P1 P Long-run
1 supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Quantity (market)

(c) Long-Run Response

Firm Market
Price Price

MC S1
ATC B S2
P2
A C
P1 P1 Long-run
supply
D2
D1
0 Quantity (firm) 0 Q 1 Q 2 Q 3 Quantity (market)

Figure 14-8 The firm and the market: short and long run
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The slope of the long run supply

curve
• In perfect competition, usually all firms should have
the optimal size (remember: economies of scale)
• Therefore the long run supply curve should be flat
• However this may not always be true
• Some resources used in production may be available
only in limited quantities for some industries
• As demand for the product goes up the price of these
resources will increase
• Also, if firms don’t have identical cost structures the
supply curve represents their average cost structure
• In such cases the increase output may come from
more or less efficient firms
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Conclusion
• We now apply our knowledge of costs to markets
with different levels of competition
• We begin with a perfectly competitive market
– Many seller and buyers each with a small share of
the market
– Homogenous products
– Free entry and exit
• The firm becomes a price taker in competitive
markets: the price of the product equals both the
firm’s average revenue and its marginal revenue
• The competitive firm’s total revenue is therefore
proportional to its output
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Conclusion
• To maximise profits the firm chooses the quantity of
output where marginal revenue equals marginal cost
• By definition, at this quantity price is also equals
marginal cost, i.e the cost of producing one
additional output of that product
• P = MR = MC is the golden rule for the equilibrium
of the the firm in perfectly competitive markets
• In the short run, the firm will choose to shut down
temporarily if the price of the good is less than
average variable cost
• In the long run, it will choose to exit if the price is
less than average total cost
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Conclusion
• Profits (losses) of the firm is the difference between
total revenue and total costs
• In the long run, equilibrium price will be such that
the price will also equal the lowest average total cost
of production
• This is achieved by firms who enter and exit the
market by looking at the profits in that industry
• Therefore in the long run the adjustment in supply
happens through changes in the number of optimal
sized firms
• Freedom to enter and exit imply zero economic
profits in the long run for perfectly competitive
markets