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Microeconomics
Dali Laxton
Firms in
Competitive Markets
Lecture
6

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Reading
Mankiw Principles of Microeconomics 4th edition - Chapter 14

In this chapter,
look for the answers to these questions
•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
§Three years after graduating, you run your own business.
§You must decide how much to produce, what price to charge, how many workers to hire, etc.
§What factors should affect these decisions?
§Your costs (studied in preceding chapter)
§How much competition you face
§We begin by studying the behavior of firms in perfectly competitive markets.
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Characteristics of Perfect Competition
§1. Many buyers and many sellers.
§2. The goods offered for sale are largely the same.
§3. Firms can freely enter or exit the market.
§Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given.
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The Revenue of a Competitive Firm
§Total revenue (TR)
§Average revenue (AR)
§Marginal revenue (MR):
The change in TR from
selling one more unit.
∆TR
∆Q
MR =
TR = P x Q
TR
Q
AR =
= P
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ACTIVE LEARNING   1
Calculating TR, AR, MR
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Fill in the empty spaces of the table.
$50
$10
5
$40
$10
4
$10
3
$10
2
$10
$10
1
n/a
$10
0
TR
P
Q
MR
AR
$10

ACTIVE LEARNING   1
Answers
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or in part, except for use as permitted in a license distributed with a certain product or service
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Fill in the empty spaces of the table.
$50
$10
5
$40
$10
4
$10
3
$10
$10
$10
$10
$10
2
$10
$10
1
n/a
$30
$20
$10
$0
$10
0
TR = P x Q
P
Q
∆TR
∆Q
MR =
TR
Q
AR =
$10
$10
$10
$10
$10
Notice that
MR = P

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MR = P  for a Competitive Firm
§A competitive firm can keep increasing its output without affecting the market price.
§So, each one-unit increase in Q causes revenue to rise by P, i.e.,  MR = P.
MR = P  is only true for
firms in competitive markets.
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Profit Maximization
§What Q maximizes the firm’s profit?
§To find the answer, “think at the margin.”
§ If Q increases by one unit,
revenue rises by MR,
cost rises by MC.
§If MR > MC, then increase Q to raise profit.
§If MR < MC, then reduce Q to raise profit.
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Profit Maximization
50
5
40
4
30
3
20
2
10
1
45
33
23
15
9
$5
$0
0
∆Profit = MR – MC
MC
MR
Profit
TC
TR
Q
At any Q with MR > MC,
increasing Q raises profit.
5
7
7
5
1
–$5
10
10
10
10
–2
0
2
4
$6
12
10
8
6
$4
$10
(continued from earlier exercise)
At any Q with MR < MC,
reducing Q raises profit.
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P1
MR
MC and the Firm’s Supply Decision
§At Qa, MC < MR.
§So, increase Q
to raise profit.
§At Qb, MC > MR.
§So, reduce Q
to raise profit.
§At Q1, MC = MR.
§Changing Q
would lower profit.
Q
Costs
MC
Q1
Qa
Qb
Rule:  MR = MC at the profit-maximizing Q.
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P1
MR
P2
MR2
MC and the Firm’s Supply Decision
§If price rises to P2,
§then the profit-maximizing quantity rises to Q2.
§The MC curve determines the
firm’s Q at any price.
§Hence,
Q
Costs
MC
Q1
Q2
the MC curve is the firm’s supply curve.
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Shutdown vs. Exit
§Shutdown:
A short-run decision not to produce anything because of market conditions.
§Exit:
A long-run decision to leave the market.
§A key difference:
§If shut down in SR, must still pay FC.
§If exit in LR, zero costs.
§
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A Firm’s Short-run Decision to Shut Down
§Cost of shutting down:  revenue loss = TR
§Benefit of shutting down:  cost savings = VC
  (firm must still pay FC)
§So, shut down if   TR  <  VC
§Divide both sides by Q:     TR/Q  <  VC/Q
§So, firm’s decision rule is:
Shut down if  P < AVC
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§The firm’s SR supply curve is the portion of
its MC curve above AVC.
Q
Costs
A Competitive Firm’s SR Supply Curve
MC
ATC
AVC
If P > AVC, then firm produces Q where P = MC.
If P < AVC, then firm shuts down (produces Q = 0).
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The Irrelevance of Sunk Costs
§Sunk cost:  a cost that has already been committed and cannot be recovered
§Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
§FC is a sunk cost:  The firm must pay its fixed costs whether it produces or shuts down.
§So, FC should not matter in the decision to shut down.
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A Firm’s Long-Run Decision to Exit
§Cost of exiting the market:  revenue loss = TR
§Benefit of exiting the market:  cost savings = TC
   (zero FC in the long run)
§So, firm exits if  TR  <  TC
§Divide both sides by Q  to write the firm’s decision rule as:
Exit if  P < ATC
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A New Firm’s Decision to Enter Market
§In the long run, a new firm will enter the market if it is profitable to do so:  if TR > TC.
§Divide both sides by Q  to express the firm’s entry decision as:
Enter if  P > ATC
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§The firm’s
LR supply curve is the portion of
its MC curve above LRATC.
Q
Costs
The Competitive Firm’s Supply Curve
MC
LRATC
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ACTIVE LEARNING   2
Identifying a firm’s profit
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Determine
this firm’s
total profit.
Identify the area on the graph that represents
the firm’s profit.
Q
Costs, P
MC
ATC
P = $10
MR
50
$6
A competitive firm

ACTIVE LEARNING   2
Answers
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or in part, except for use as permitted in a license distributed with a certain product or service
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profit
Q
Costs, P
MC
ATC
P = $10
MR
50
$6
A competitive firm
Profit per unit
= P – ATC
= $10 – 6
= $4
Total profit
= (P – ATC) x Q = $4 x 50
= $200

ACTIVE LEARNING   3
Identifying a firm’s loss
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Determine
this firm’s
total loss, assuming AVC < $3.
Identify the area on the graph that represents
the firm’s loss.
Q
Costs, P
MC
ATC
A competitive firm
$5
P = $3
MR
30

ACTIVE LEARNING   3
Answers
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loss
MR
P = $3
Q
Costs, P
MC
ATC
A competitive firm
loss per unit = $2
Total loss
= (ATC – P) x Q = $2 x 30
= $60
$5
30

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Market Supply:  Assumptions
§1) All existing firms and potential entrants have identical costs.
§2) Each firm’s costs do not change as other firms enter or exit the market.
§3) The number of firms in the market is
§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
§As long as P ≥ AVC, each firm will produce its profit-maximizing quantity, where MR = MC.
§Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.
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The SR Market Supply Curve
MC
P2
Market
Q
P
(market)
One firm
Q
P
(firm)
S
P3
Example:  1000 identical firms
At each P,  market Qs  =  1000 x (one firm’s Qs)
AVC
P2
P3
30
P1
20
10
P1
30,000
10,000
20,000
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Entry & Exit in the Long Run
§In the LR, the number of firms can change due to entry & exit.
§If existing firms earn positive economic profit,
§new firms enter, SR market supply shifts right.
§P  falls, reducing profits and slowing entry.
§If existing firms incur losses,
§some firms exit, SR market supply shifts left.
§P  rises, reducing remaining firms’ losses.
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The Zero-Profit Condition
§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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Why Do Firms Stay in Business
if Profit = 0?
§Recall, economic profit is revenue minus all costs, including implicit costs like the opportunity
cost of the owner’s time and money.
§In the zero-profit equilibrium,
§firms earn enough revenue to cover these costs
§accounting profit is positive
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The LR Market Supply Curve
MC
Market
Q
P
(market)
One firm
Q
P
(firm)
In the long run,
the typical firm
earns zero profit.
LRATC
long-run
supply
P = min. ATC
The LR market supply curve is horizontal at
P = minimum ATC.
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S1
Profit
D1
P1
long-run
supply
D2
SR & LR Effects of an Increase in Demand
MC
ATC
P1
Market
Q
P
(market)
One firm
Q
P
(firm)
P2
P2
Q1
Q2
S2
Q3
A firm begins in long-run eq’m…
…but then an increase in demand raises P,…
…leading to SR profits for the firm.
Over time, profits induce entry,
shifting S to the right, reducing P…
…driving profits to zero
and restoring long-run eq’m.
A
B
C
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Why the LR Supply Curve Might Slope Upward
§The LR market supply curve is horizontal if
§1) all firms have identical costs, and
§2) costs do not change as other firms enter or exit the market.
§If either of these assumptions is not true,
then LR supply curve slopes upward.
§
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1)  Firms Have Different Costs
§As P rises, firms with lower costs enter the market before those with higher costs.
§Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
§Hence, LR market supply curve slopes upward.
§At any P,
§For the marginal firm,
P = minimum ATC  and  profit = 0.
§For lower-cost firms,  profit > 0.
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2)  Costs Rise as Firms Enter the Market
§In some industries, the supply of a key input is limited (e.g., amount of land suitable for
farming is fixed).
§The entry of new firms increases demand for this input, causing its price to rise.
§This increases all firms’ costs.
§Hence, an increase in P is required to increase the market quantity supplied, so the supply curve
is upward-sloping.
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CONCLUSION:
The Efficiency of a Competitive Market
§Profit-maximization: MC = MR
§Perfect competition:   P = MR
§So, in the competitive eq’m:   P = MC
§Recall, MC is cost of producing the marginal unit.
§ P  is value to buyers of the marginal unit.
§So, the competitive eq’m is efficient, maximizes total surplus.
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Summary
•For a firm in a perfectly competitive market,
price = marginal revenue = average revenue. •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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