Firms in Competitive Markets

(Chapter 14, Mankiw)

BCOR 120
WHAT IS A COMPETITIVE MARKET?
 A perfectly competitive market has the following
characteristics:
 There are many buyers and sellers in the market
 The goods offered by the various sellers are largely the same
 Firms can freely enter or exit the market
WHAT IS A COMPETITIVE MARKET?
 As a result of its characteristics, the perfectly competitive
market has the following outcomes:
 The actions of any single buyer or seller in the market have a
negligible impact on the market price
 Each buyer and seller takes the market price as given
 Buyers and sellers are called price takers
The Revenue of a Competitive Firm
 Main objective of any firm is to maximize its profits
 Profit= Total Revenue-Total Cost

 Total revenue for a firm is the selling price times the

quantity sold
 TR = (P Q)

 Total revenue is proportional to the amount of output

The Revenue of a Competitive Firm
 Average revenue tells us how much revenue a firm
receives for the typical unit sold

 Marginal revenue tells us how much additional revenue a

firm receives for one additional unit produced
The Revenue of a Competitive Firm
 Average revenue is total revenue divided by the quantity
sold
 In perfect competition, average revenue equals the price
of the good
Total revenue
Average Revenue =
Quantity

Price Quantity
Quantity

Price
The Revenue of a Competitive Firm
 Marginal revenue is the change in total revenue from an
additional unit sold

MR TR P* Q
Q Q
P
The Revenue of a Competitive Firm
 For competitive firms, marginal revenue equals the price
of the good
Table 1 Total, Average, and Marginal
Revenue for a Competitive Firm
Quantity Total Average Marginal
Price
(in gallons) Revenue Revenue Revenue
Q P TR= P * Q AR= TR/Q MR=∆TR/∆Q

1 Tnd6 6 Tnd6

2 6 12 6 Tnd6

3 6 18 6 6

4 6 24 6 6

5 6 30 6 6

6 6 36 6 6

7 6 42 6 6

8 6 48 6 6
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
 The goal of a competitive firm is to maximize profit
 This means that the firm will want to produce the
quantity that maximizes the difference between total
revenue and total cost
Table 2 Profit Maximization: A Numerical
Example
Quantity
Total Marginal Marginal
(in Total Cost Profit
Revenue Revenue Cost
gallons)
Q TR= P * Q TC TR-TC MR=∆TR/∆Q MC=∆TC/∆Q
0 Tnd0 Tnd3 -Tnd3
1 6 5 1 Tnd6 Tnd2
2 12 8 4 6 3
3 18 12 6 6 4
4 24 17 7 6 5
5 30 23 7 6 6
6 36 30 6 6 7
7 42 38 4 6 8
8 48 47 1 6 9
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
 When MR > MC
 Increasing the quantity produced raises profits
 When MR < MC
 Decreasing the quantity produced raises profits
 When MR = MC
 Profit is maximized
 Figure 1 Profit Maximization for a
Competitive Firm
Costs
and The firm maximizes
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue
MC2

ATC
P = MR1 = MR2 P = AR = MR
AVC

MC1

0 Q1 QMAX Q2 Quantity

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PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
 At Q1 :
 MR1 > MC1
Profit
 increase Q raises Profit maximization
 At Q2: occurs at the
 MR 2 < MC 2 quantity where
 decrease Q raises Profit marginal revenue
equals marginal cost
 At Qmax:
 MR = MC
 Profit is maximized
Figure 2 Marginal Cost as the Competitive
Firm’s Supply Curve
Price
The firm’s MC curve is
also the firm’s supply MC
curve
P2

ATC
P1
AVC

0 Q1 Q2 Quantity
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Marginal Cost as the Competitive Firm’s
Supply Curve
 Competitive firm is price taker
 MR is equal to the market price
 Profit maximizing quantity of the firm occurs at the
intersection between the different market prices and the
marginal cost curve of the firm
 For any given market price, the marginal cost will tell you the
quantity that the firm is willing to supply
 Marginal cost curve is the firm’s supply curve
The Firm’s Short-Run Decision to Shut
Down
 A shutdown refers to a short-run decision not to
produce anything during a specific period of time because
of current market conditions
 Exit refers to a long-run decision to leave the market
The Firm’s Short-Run Decision to Shut
Down
 In the short run
 Firms can not avoid their fixed cost
 A firm that shut down temporary still has to pay its fixed cost
 In the long run
 Firms can avoid their fixed costs
 A firm that exit the market saves both its fixed and its variable
costs
The Firm’s Short-Run Decision to Shut
Down
 The firm considers its fixed costs when deciding to exit,
but ignores them when deciding whether to shut down
 Salima’s cookies factory: Salima bought many specialized robots and
machines plus the factory. If Salima decides to shutdown temporarily.
She will not use them for several months
 However, she will sell everything if she wants to exit the market
The Firm’s Short-Run Decision to Shut
Down
 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
Figure 3 The Competitive Firm’s Short Run
Supply Curve
Costs
Firm’s short-run
If P > ATC, the firm supply curve MC
will continue to
produce at a profit

ATC

If P > AVC, firm will

continue to produce AVC
in the short run

Firm
shuts
down if
P < AVC
0 Quantity

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The Firm’s Short-Run Decision to Shut
Down
 The portion of the marginal-cost curve that lies above
average variable cost is the competitive firm’s short-run
supply curve
The Firm’s Long-Run Decision to Exit or
Enter a Market
 In the long run, the firm exits if the revenue it would get
from producing is less than its total cost
 Exit if TR < TC
 Exit if TR/Q < TC/Q
 Exit if P < ATC
The Firm’s Long-Run Decision to Exit or
Enter a Market
 A firm will enter the industry if such an action would be
profitable
 Enter if TR > TC
 Enter if TR/Q > TC/Q
 Enter if P > ATC
Figure 4 The Competitive Firm’s Long-Run
Supply Curve
Costs

MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity

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THE SUPPLY CURVE IN A COMPETITIVE
MARKET
 The competitive firm’s long-run supply curve is the
portion of its marginal-cost curve that lies above average
total cost
Figure 4 The Competitive Firm’s Long-Run
Supply Curve
Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity

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THE SUPPLY CURVE IN A COMPETITIVE
MARKET
 Short-Run Supply Curve
 The portion of its marginal cost curve that lies above average
variable cost
 Long-Run Supply Curve
 The marginal cost curve above the minimum point of its
average total cost curve
Measuring Profit in our Graph for the
Competitive Firm

Pr ofit TR TC
(TR / Q TC / Q ) Q
( P ATC ) Q
Figure 5 Profit as the Area between Price
and Average Total Cost
(a) A Firm with Profits
Price

MC ATC
Profit

ATC P = AR = MR

0 Q Quantity
(profit-maximizing quantity)
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Figure 5 Profit as the Area between Price
and Average Total Cost
(b) A Firm with Losses
Price

MC ATC

ATC

P P = AR = MR

Loss

0 Q Quantity
(loss-minimizing quantity)
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THE SUPPLY CURVE IN A COMPETITIVE
MARKET
 Market supply equals the sum of the quantities supplied
by the individual firms in the market
 Short run market supply
 Fixed number of firms
 Long run market supply
 Number of firms car change as old firms exit the market and new
firms enter
The Short Run: Market Supply with a Fixed
Number of Firms
 For any given price, each firm supplies a quantity of
output so that its marginal cost equals price
 The market supply curve reflects the individual firms’
marginal cost curves
 Figure 6 Market Supply with a Fixed
Number of Firms

(a) Individual Firm Supply (b) Market Supply

Price Price

MC Supply

TND2.00 Tnd2.00

1.00 1.00

0 100 200 Quantity (firm) 0 100,000 200,000 Quantity (market)

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The Long Run: Market Supply with Entry
and Exit
 Suppose that all firms and potential firms have the same
cost curves
1. If firms in the market are making profits, new firms will
enter the market
 Number of firms will expand
 Quantity supplied will increase
 Price and profits will decrease
2. If firms in the market are making losses, some existing
firms will exit the market
 Number of firms will decrease
 Quantity supplied will decrease
 Price and profits will increase
The Long Run: Market Supply with Entry
and Exit
 Firms will enter or exit the market until profit is driven
to zero
 In the long run, price equals the minimum of average total
cost

Pr ofit ( P ATC ) * Q 0
P ATC

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

 Figure 7 Market Supply with Entry and Exit

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

Price Price

MC

ATC

P = minimum Supply
ATC

0 Quantity (firm) 0 Quantity (market)

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The Long Run: Market Supply with Entry
and Exit
 At the end of the process of entry and exit, firms that
remain must be making zero economic profit
 The process of entry and exit ends only when price and
average total cost are driven to equality
 Long-run equilibrium must have firms operating at their
efficient scale
Why Do Competitive Firms Stay in Business
If They Make Zero Profit?
 To understand the zero profit condition, we need to
differentiate between the accounting profit and the
economic profit
 accounting profit is equal to the firm’s total revenue minus only
the firm’s explicit costs
 economic profit is equal to total revenue minus total cost,
including both explicit and implicit costs
Why Do Competitive Firms Stay in Business
If They Make Zero Profit?
 Explicit and Implicit Costs
 A firm’s cost of production include explicit costs and implicit
costs.
 Explicit costs are input costs that require a direct outlay of money by
the firm
 Implicit costs are input costs that do not require an outlay of money
by the firm
 Economic profit is smaller than accounting
profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
costs

Explicit Explicit
costs costs

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Why Do Competitive Firms Stay in Business
If They Make Zero Profit?
 Profit equals total revenue minus total cost
 Total cost includes all total costs of the firm
 In the zero-profit equilibrium, the firm’s revenue
compensates the owners for the time and money they
expend to keep the business going
A Shift in Demand in the Short Run and
Long Run
 An increase in demand raises price and quantity in the
short run
 Firms earn profits because price now exceeds average
total cost
 Figure 8 An Increase in Demand in the
Short Run and Long Run

(a) Initial Condition

Firm Market
Price Price

MC ATC Short-run supply, S1

A
P1 P1 Long-run
supply

Demand, D1

0 Quantity (firm) 0 Q1 Quantity (market)

 Figure 8 An Increase in Demand in the
Short Run and Long Run

(b) Short-Run Response

Firm Market
Price Price

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

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

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 Figure 8 An Increase in Demand in the
Short Run and Long Run

(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 Q1 Q2 Q3 Quantity (market)

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