The Firms in
Competitive
Markets
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In this Topic, we will discuss the following :
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
Few years after graduating, you run your own
business.
You have to 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 topic)
• 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) TR = P x Q
TR
Average revenue (AR) AR = =P
Q
Marginal Revenue (MR):
∆TR
The change in TR from MR =
∆Q
selling one more unit.
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You Try1:
Exercise
Fill in the empty spaces of the table.
Q P TR AR MR
0 $10 n.a.
1 $10 $10
2 $10
3 $10
4 $10 $40
$10
5 $10 $50
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1:
You Try
Answers
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n.a.
$10
1 $10 $10 $10
Notice that $10
2 $10 $20 $10
MR = P $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
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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 increase Q 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
(continued from earlier exercise)
Q TR TC Profit MR MC
∆Profit =
At any Q with MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5
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You Try2A:
Identifying a firm’s profit
A competitive firm
Determine Costs, P
this firm’s
MC
total profit.
P = $10 MR
Identify the
ATC
area on the
graph that $6
represents
the firm’s
profit.
Q
50
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2A:
You Try
Answers
A competitive firm
Costs, P
profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6
Total profit
= (P – ATC) x Q
= $4 x 50 Q
= $200 50
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You Try2B:
Identifying a firm’s loss
A competitive firm
Determine Costs, P
this firm’s
MC
total loss.
Identify the
ATC
area on the
graph that $5
represents
the firm’s P = $3 MR
loss.
Q
30
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2B:
You Try
Answers
A competitive firm
Costs, P
MC
Total loss
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR
Q
30
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MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
Costs
So, increase Q
MC
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit. P1 MR
At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q1 Qb
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MC and the Firm’s Supply Decision
If price rises to P2,
then the profit- Costs
maximizing quantity
MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2
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Shutdown vs. Exit
Shutdown:
A short-run (SR) decision not to produce
anything because of market conditions.
Exit:
A long-run (LR) decision to leave the market.
A firm that shuts down temporarily must still pay
its fixed costs. A firm that exits the market does
not have to pay any costs at all, fixed or variable.
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A Firm’s Short-run Decision to Shut Down
If firm shuts down temporarily,
• revenue falls by TR
• costs fall by VC
So, the firm should shut down if TR < VC.
Divide both sides by Q: TR/Q < VC/Q
So we can write the firm’s decision as:
Shut down if P < AVC
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A Competitive Firm’s SR Supply Curve
The firm’s SR
supply curve is
Costs the portion of
its MC curve MC
above AVC.
If P > AVC, then
firm produces Q ATC
where P = MC.
AVC
If P < AVC, then
firm shuts down
(produces Q = 0). Q
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A Firm’s Long-Run Decision to Exit
If firm exits the market,
• revenue falls by TR
• costs fall by TC
So, the firm should exit if TR < TC.
Divide both sides by Q to rewrite the firm’s
decision 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 SR Market Supply Curve
Example: 1000 identical firms.
At each P, market Qs = 1000 x (one firm’s Qs)
One firm Market
P MC P S
P3 P3
P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)
10,000 20,000 30,000
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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 curve shifts right.
• P falls, reducing firms’ profits.
• Entry stops when firms’ economic profits have
been driven to zero.
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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 incur losses,
• Some will exit the market.
• SR market supply curve shifts left.
• P rises, reducing remaining firms’ losses.
• Exit stops when firms’ economic losses have
been driven to zero.
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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 equilibrium 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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Problems and Applications
In the long-run equilibrium of a competitive
market with identical firms, what is the
relationship between price P, marginal cost MC
and average total cost ATC?
a P > MC and P > ATC
b P > MC and P = ATC
c P = MC and P > ATC
d P = MC and P = ATC
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Problems and Applications
Bob’s lawn-mowing service is a profit-
maximising, competitive firm. Bob mows lawns
for $27 each. His total cost each day is $280, of
which $30 is a fixed cost. He mows 10 lawns a
day.
What can you say about Bob’s short-run
decision regarding shutdown and his long-run
decision regarding exit? 41
Problems and Applications
Consider total cost and total revenue given in
the following table:
a Calculate profit for each quantity. How much should
the firm produce to maximise profit?
b Calculate marginal revenue and marginal cost for each
quantity. How does this relate to your answer to part (a)?
c Can you tell whether this firm is in a competitive
industry? If so, can you tell whether the industry is in a
long-run equilibrium?
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