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14

Firms in Competitive
Markets
WHAT IS A COMPETITIVE
MARKET?
In a perfectly competitive market
There are many buyers
There are many sellers
Firms can freely enter or exit the market, in the long
run.
In the short run, the number of firms is assumed
fixed (constant).
All sellers sell the same product.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
WHAT IS A COMPETITIVE
MARKET?
As a result:
The actions of any single buyer or seller have
a negligible impact on the market price.
That is, the market price is unaffected by the
amount bought by a buyer or the amount sold by a
seller
Therefore, every buyer and every seller takes
the market price as given.
Everybody is a price taker
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Price takers
A firm in a perfectly competitive market cannot stay in
business if its price is higher than what the other firms are
charging
No firm would be able to raise the market price by
reducing production and attempting to create a shortage.
Conversely, there is no danger that a firm would drive the
market price down by producing too much.
Therefore, no firm would want to charge a price lower
than what the others are charging.
In short, each firm takes the prevailing market price as a
givenlike the weatherand charges that price.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Total Revenue of a Competitive Firm
Total revenue for a firm is the selling price
times the quantity sold.
TR = P Q

We saw this in Chapters 5 and 13
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Average Revenue of a Competitive Firm
Average revenue is the revenue per unit sold
P = AR.
This is simply because all units sold are sold at the
same price.
Average Revenue =
Total revenue
Quantity
Price Quantity
Quantity
Price

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Marginal Revenue of a Competitive Firm
Marginal Revenue is the increase () in
total revenue when an additional unit is
sold.
MR = TR / Q
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Revenue of a Competitive Firm
In perfect competition, marginal revenue
equals price: P = MR.
We saw earlier that P = AR
Therefore, for all firms in perfect
competition, P = AR = MR
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Table 1 Total, Average, and Marginal Revenue for
a Competitive Firm
Note:
(a) P = AR = MR
(b) P does not fall as Q increases
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Demand curves for the firm and the market (industry)
Jones and Peters, a firm
Quantity (firm) 0
Price
Market
Quantity (market)
Price
0
Demand, P = AR
P
The market demand curve is
negatively sloped, as usual. That
is, the market price, which is the
lowest prevailing price, is
inversely related to the quantity
demanded.
The market price is P. No matter
what amount Jones and Peters
produces, the market price will not
change. Therefore, J&P will be
able to sell any feasible output if it
charges the price P.
Demand, P = AR = MR
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Supply
We have just seen
the demand curves
for a firm and for the
entire industry
Next, we need to
work out what the
supply curves look
like
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
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Supply: short run and long run
The analysis of supply in perfect
competition depends on whether it is the
short run or the long run.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Short run and long run: assumptions
The quantity of a resource used by a firm
may be fixed in the short run but not in the
long run.
Example: If a firm currently has three custom-made
machines and if it takes six months to get new
machines, then the firm is stuck with its three machines
for the next six months.
All fixed costs are sunk costs in the short
run but not in the long run
The number of firms in an industry is fixed
in the short run but not in the long run
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Shut Down and Exit
Before a firm decides how much to supply,
it must decide whether or not to stay in
business
A shutdown refers to a short-run decision to
stop production temporarily, perhaps
because of poor market conditions.
Exit refers to a long-run decision to end
production permanently.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firms Short-Run Decision to Shut Down
A firm will shut down (temporarily) if its
variable costs exceed its total revenue, no
matter what quantity it produces
Its fixed costs do not matter!
This is because
Fixed costs are sunk costs in the short run
sunk costs are defined as costs that will have to be
paid even if the firm shuts down.
Therefore, FC cannot affect a firms decision
on whether to stay open or shut down
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Sunk Costs
Sunk costs will have to be paid even when
a firm is in a temporary shutdown.
Examples:
If the firm signs a long-term contract with its
landlord, the rent will have to be paid even when the
firm is temporarily shut down.
Some maintenance costs will have to be incurred
even when the firm is shut down.
The firm may be under contract to provide customer
service to past customers even after it shuts down.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firms Short-Run Decision to Shut Down
Total Revenue = $1000 per month
Variable Cost = $800 per month
Fixed Cost = $400 per month
Profit = $200 per month (a loss)
Q: Should this firm stay in business or should it shut
down for the time being?
A: It should stay in business
If it shuts down, the fixed cost (say, rent owed to the landlord)
will still have to be paidbecause it is sunk!and the loss will
then be even higher, $400 per month.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firms Short-Run Decision to Shut Down
Total Revenue = $1000 per month
Variable Cost = $1200 per month
Fixed Cost = $400 per month
Profit = $600 per month (a loss)
Q: Should this firm stay in business or should it
shut down for the time being?
A: It should shut down.
The lesson from this and the previous slide
is that
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firms Short-Run Decision to Shut Down
A firm shuts down if total revenue is less
than variable cost, no matter what quantity
the firm produces. That is,
A firm shuts down if
TR < VC, no matter what Q is, or
TR/Q < VC/Q, no matter what Q is, or
P < AVC, no matter what Q is.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
A Firms Shut Down Decision
Quantity
AVC
0
$
The firm shuts down
because P <Minimum AVC
The firm stays open
because P >Minimum AVC
Minimum AVC Minimum AVC
P
H

P
L

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Table 2 Profit Maximization: A Numerical Example
Is it possible
to figure out
the profit-
maximizing
output from
just the MR
and MC
numbers?
Yes, it is where
MR = MC.
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Figure 1 Profit Maximization for a Competitive Firm
Quantity 0
Costs
and
Revenue
MC
ATC
AVC
MC
1
Q
1
MC
2
Q
2
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
Q
MAX
P = MR
1
= MR
2
P = AR = MR
22 CHAPTER 14
Therefore, P = AR =
MR = MC is the
fingerprint of perfect
competition
We have seen before
that, as firms are price
takers in perfect
competition, P = AR =
MR.
We have also seen
that, profit
maximization implies
MR = MC.
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRMS SUPPLY CURVE
Profit maximization occurs at the
quantity where marginal revenue equals
marginal cost.
This is a crucial principle in understanding the
behavior of firms
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRMS SUPPLY CURVE
When MR > MC increase Q
When MR < MC decrease Q
When MR = MC Profit is maximized;
stick with this Q.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Recall: The Supply Curve
Quantity 0
Price
Supply
P
1
Q
1
P
2
Q
2
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Figure 2 Marginal Cost as the Competitive Firms
Supply Curve
Quantity 0
Price
MC
ATC
AVC
P
1
Q
1
P
2
Q
2
This section of the
firms MC curve is
also the firms supply
curve.
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Figure 3 The Competitive Firms Short Run Supply
Curve
MC
Quantity
ATC
AVC
0
Costs
Firm
shuts
down if
P < AVC
Firm s short-run
supply curve
If P > AVC, firm will
continue to produce
in the short run.
If P > ATC, the firm
will continue to
produce at a profit.
27 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
What can shift the supply
curve to the right?
The Short Run: Market Supply with a Fixed
Number of Firms
The market supply curve is the horizontal
sum of the individual firms short run supply
curves.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply
Quantity (firm) 0
Price
MC
1.00
100
$2.00
200
(b) Market Supply (# of firms fixed)
Quantity (market) 0
Price
Supply
1.00
100,000
$2.00
200,000
Q: What is the number of firms?
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Short-Run Equilibrium: back where we began!
(a) Individual Firm Supply
Quantity (firm) 0
Price
MC
1.00
100
$2.00
200
(b) Market Supply (# of firms fixed)
Quantity (market) 0
Price
Supply
1.00
100,000
$2.00
200,000
30 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Demand
L
Demand
H
THE LONG RUN
Price = Minimum ATC; profit = zero; demand has no effect on price,
and no effect on the quantity produced by a firm; demand does
affect the quantity produced by the industry, and the number of
firms in the industry
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The Firms Long-Run Decision to Exit or
Enter a Market
In the long run, the firm exits if it sees that
its total revenue would be less than its total
cost no matter what quantity (Q) it might
produce
That is, a firm exits if
TR < TC, no matter what Q is.
TR/Q < TC/Q , no matter what Q is.
P < ATC , no matter what Q is.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
The Firms Long-Run Decision to Exit or
Enter a Market
A new firm will enter the industry if it can
expect to be profitable.
That is, a new firm will enter if
TR > TC for some value of Q
TR/Q > TC/Q for some value of Q
P > ATC for some value of Q

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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Entry and Exit of Firms in the Long-Run
Quantity
ATC
0
$
Minimum ATC Minimum ATC
Existing firms will exit
because P <Minimum ATC
The number of firms will
stabilize when P =Minimum
ATC. This is the long run price!
New firms will enter
because P >Minimum ATC
P
H

P
L

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This is the efficient scale output.
This is each firms long-run
equilibrium output!
Figure 4 The Competitive Firms Long-Run Supply
Curve
MC = long-run S
Firm
exits if
P < ATC
Quantity
ATC
0
Costs
Firm s long-run
supply curve
Firm
enters if
P > ATC
35 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
ATC
THE SUPPLY CURVE IN A
COMPETITIVE MARKET
A Firms Short-Run
Supply Curve
The portion of its (short
run) marginal cost curve
that lies above the (short
run) average variable cost
curve.
A Firms Long-Run Supply
Curve
The portion of its (long run)
marginal cost curve that
lies above the (long run)
average total cost curve.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
MC
ATC
AVC
Long-Run Equilibrium

This is it, as far as long-run equilibrium is concerned!
How many firms are there in long-run equilibrium?
What would happen if demand moves left (decreases)?
What could cause prices to increase?
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ATC
Price Price
Quantity
(industry)
Quantity
(firm)
6,000 200
(efficient
scale)
$1.50
$1.50
P = Minimum ATC =
Market
Demand
P = AR = MR = MC = ATC is the
fingerprint of perfect competition in
the long run.
A Firms Profit
Profit equals total revenue minus total
costs.
Profit = TR TC
Profit/Q = TR/Q TC/Q
Profit = (TR/Q TC/Q) Q
Profit = (P ATC) Q
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 5 Profit as the Area between Price and Average
Total Cost
(a) A Firm with Profits
Quantity 0
Price
P = AR = MR
ATC MC
P
ATC
Q
(profit-maximizing quantity)
Profit
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Figure 5 Profit as the Area between Price and Average
Total Cost
(b) A Firm with Losses
Quantity 0
Price
ATC MC
(loss-minimizing quantity)
P = AR = MR P
ATC
Q
Loss
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The Long Run: Market Supply with Entry and
Exit
Firms will enter or exit the market until profit
is driven to zero.
Price equals the minimum of average total
cost.
The long-run market supply curve is a
horizontal line at this price.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 7 Market Supply with Entry and Exit
(a) Firm s Zero-Profit Condition
Quantity (firm) 0
Price
(b) Market Supply (# of firms variable)
Quantity (market)
Price
0
P = minimum
ATC
Supply
MC
ATC
42 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Why Do Competitive Firms Stay in Business
If They Make Zero Profit?
Profit = TR TC
Total cost = explicit cost + implicit cost.
Profit = 0 implies TR = explicit cost +
implicit cost
In the zero-profit equilibrium, the firm earns
enough revenue to compensate the owners
for the time and money they spend to keep
the business going.
So, dont feel sorry for the owners!
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Recap: Economic and Accountants
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
How an Accountant
Views a Firm
Revenue
Economic
profit
Implicit
costs
Explicit
costs
Explicit
costs
Accounting
profit
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Application
We will now work through what happens
when the demand for a product increases.
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Short Run and Long Run Effects of a Shift in
Demand: an application
An increase in demand raises price and quantity
(for each firm and the industry) in the short run.
Firms earn positive profits
because price now exceeds average total cost.
New firms enter
Market supply increases (shifts right)
Price decreases; gradually returns to minimum ATC
Profits decrease; gradually return to zero
So, the long-run effect of an increase in demand is
as follows: the price is unchanged, each firms
output is unchanged, the number of firms
increases, industry output increases.
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Figure 8 An Increase in Demand in the Short Run and
Long Run
Firm
(a) Initial zero-profit long-run equilibrium
Quantity (firm) 0
Price
Market
Quantity (market)
Price
0
D Demand,
1
S Short-run supply,
1
P
1
ATC
Long-run
supply
P
1
1 Q
A
MC
q
1
47 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 8 An Increase in Demand in the Short Run and
Long Run
Market
Firm
(b) Short-Run Response to an increase in demand
Quantity (firm) 0
Price
MC
ATC
Profit
P 1
Quantity (market)
Long-run
supply
Price
0
D
1
D
2
P 1
S 1
P
2
Q
1
A
Q 2
P
2
B
q
1
q
2
48 CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Figure 8 An Increase in Demand in the Short Run and
Long Run
P 1
Firm
Quantity (firm) 0
Price
MC
ATC
Market
Quantity (market)
Price
0
P 1
P
2
Q
1
Q 2
Long-run
supply
B
D 1
D 2
S 1
A
S
2
Q 3
C
(c) Long-Run Response to positive short-run profits: new firms enter,
pushing the short-run market supply to the right.
An increase in demand leads to an increase in price in the short run. But this
price increase will not last. New firms will enter and push the price back to P
1
,
the minimum ATC. Each firms output will return to q
1
. The only long-run effect of
demand will be to increase the number of firms.
q
1
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Any Questions?

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Summary
Because a competitive firm is a price taker,
its revenue is proportional to the amount of
output it produces.
The price of the good equals both the firms
average revenue and its marginal revenue.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Summary
To maximize profit, a firm chooses the
quantity of output such that marginal
revenue equals marginal cost.
This is also the quantity at which price
equals marginal cost.
Therefore, the firms marginal cost curve is
its supply curve.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Summary
In the short run, when a firm cannot recover
its fixed costs, the firm will choose to shut
down temporarily if the price of the good is
less than average variable cost.
In the long run, when the firm can recover
both fixed and variable costs, it will choose
to exit if the price is less than average total
cost.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS
Summary
In a market with free entry and exit, profits
are driven to zero in the long run and all
firms produce at the efficient scale.
Changes in demand have different effects
over different time horizons.
In the long run, the number of firms adjusts
to drive the market back to the zero-profit
equilibrium.
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CHAPTER 14 FIRMS IN COMPETITIVE MARKETS

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