Firms in Perfectly Competitive Markets: Lecture 3.2 Chapter 7

Lecture 3.
2 Chapter 7
Firms in Perfectly
Competitive Markets
Learning Objectives
1.
Explain what a perfectly competitive market is and why a

perfect competitor faces a horizontal demand curve.
2.
Explain how a firm maximises profits in a perfectly competitive

market.
3.
Use graphs to show a firms profit or loss.
4.
Explain why firms may shut down temporarily.
5.
Explain how entry and exit ensure that firms earn zero
economic profit in the long run.
6.
Explain how perfect competition leads to economic efficiency.
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Market structures
Economists group industries into four market
structures:
Perfect competition
Monopolistic competition
Oligopoly
Monopoly
The four market structures

Characteristic
Perfect
competition
Monopolistic
competition
Oligopoly
Monopoly
Number of
firms
Many
Many
Few
One
Type of
product
Identical
Differentiated
Identical or
differentiated
Unique
Ease of entry
High
High
Low
Entry
blocked
Examples of
industries
Apples
Wheat
Selling DVDs Banking

Restaurants Manufacturing
cars
Letter
delivery
Tap water
Perfectly competitive markets

The conditions that make a market perfectly
competitive are:
1. There are many buyers and sellers, all of whom are
small relative to the market.
2. All firms sell identical products.
3. There are no barriers to new firms entering the
market or to existing firms leaving the market.
5
Perfectly competitive markets

A perfectly competitive firm cannot affect the
market price
Price taker: A buyer or seller that is unable to affect
the market price.
The demand curve for a price taker is horizontal, or
perfectly elastic.
How a firm maximises profit in a

perfectly competitive market
Profit: Total revenue (TR) minus total cost (TC).
Profit = TR - TC
Market demand and individual firm demand: Figure 7.2

Price of oats
(dollars per
bushel)
1. The intersection of market

supply and market demand
determines the equilibrium price of
oats...
Price of oats
(dollars per
bushel)
Supply of oats
$4
2. which must be
accepted by Farmer
Jones and every other
seller of oats.
Demand for
Farmer Jones
oats
$4
Demand for oats

0
80 000 000
Quantity of oats (bushels per year)
(a) Market for oats

8
7500
Quantity of oats (bushels per year)
(b) Demand for an individual farmers

oats
LEARNING OBJECTIVE 2

Revenue for a firm in a perfectly competitive
market
Average revenue (AR): Total revenue divided by the
number of units sold.
TR
AR
Q
P Q
so, AR
P
Q
Marginal revenue (MR): Change in total revenue from

selling one more unit.
Change in total revenue
TR
Marginal revenue
or, MR
Change in quantity
Q
9
Farmer Jones revenue from oats farming
10
Number of
bushels (Q)
Market price per

bushel ($P)
Total revenue
(TR)
Average
revenue (AR)
Marginal
revenue (MR)
$4
$0
$4
$4
12
16
20
24
28
32
36
10
40

Determining the profit-maximising level of output
Since producers in a perfectly competitive market can
sell as much produce as they wish to at the same
constant price:
Average revenue (AR) = Marginal revenue (MR)
Price = AR = MR
11

Determining the profit-maximising level of output,
cont.
The profit-maximising level of output is where the
difference between total revenue and total cost is the
greatest.
The profit-maximising level of output is also where
marginal revenue equals marginal cost, or MR = MC.
12
Farmer Jones profits from oats farming: Table 7.3

Quantity
(bushels)(Q)
Total revenue
(TR)
Total cost
(TC)
Profit (TR
TC)
Marginal
revenue (MR)
Marginal
cost (MC)
$0
$1.00
- $1.00
4.00
4.00
0.00
$4.00
$3.00
8.00
6.00
2.00
4.00
2.00
12.00
7.50
4.50
4.00
1.50
16.00
9.50
6.50
4.00.
2.00
20.00
12.00
8.00
4.00
2.50
24.00
15.00
9.00
4.00
3.00
28.00
19.50
8.50
4.00
4.50
32.00
25.50
6.50
4.00
6.00
36.00
32.50
3.50
4.00
7.00
10
40.00
40.50
- 0.50
4.00
8.00
13
The profit-maximising level of output: Figure 7.3
14
Illustrating profit or loss on the cost curve

graph
Profit = (P x Q) TC
Profit (P Q) TC
Q
Q
Q
Profit per unit =
or
Profit
P ATC
Q
Total profit = (P ATC) x Q

15
The area of maximum profit: Figure 7.4

Price and
cost (dollars
per bushel)
MC
Total profit =
(P ATC) x Q
ATC
Market
P
price
Demand =
marginal
revenue
Profit per unit of
output (P ATC)
0
16 Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd)
9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Q
Profit-maximising
level of output
Quantity
Illustrating profit or loss on the cost curve

graph
Illustrating when a firm is breaking even or
operating at a loss
If P > ATC; the firm makes a profit.
If P = ATC; the firm breaks even (its per unit cost
equals per unit revenue; thus, the firms total cost
equals its total revenue).
17
If P < ATC; the firm experiences losses.
A firm breaking even: Figure 7.5a

Price and
cost
MC
Break-even
point
Demand =
marginal
revenue
0
18 Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty
Ltd) 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
ATC
Q
Profit-maximising
level of output
Quantity
A firm experiencing losses: Figure 7.5b

Price and
cost
MC
ATC
Losses
ATC
P
0
19
Copyright 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd)
9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Demand =
marginal
revenue
Q
Loss minimising
level of output
Quantity
Deciding whether to produce or to

shut down in the short run
In the short run, a firm suffering losses has two
choices:
Continue to produce
Stop production by shutting down temporarily
Sunk cost: A cost that has already been paid and

cannot be recovered.
20

The supply curve of a firm in the short run
For any given price, the marginal cost curve shows
the quantity of output that a firm will supply.
Therefore, the perfectly competitive firms marginal
cost curve is also its supply curvebut only for
prices at or above average variable cost.
21

The supply curve of a firm in the short run, cont.
Even if a firm suffers losses, it should continue to
operate as long as P > AVC.
Shutdown point: The minimum point on a firms
average variable cost curve; if the price falls below
this point, the firm shuts down production in the
short run.
Shutdown point: P < AVC
22
The firms short-run supply curve: Figure 7.6

Price and
cost
The supply curve for

the firm in the short run
MC
ATC
AVC
The minimum
price at which the
firm will continue
to produce
PMIN
Shutdown point
0
23
QSD
Quantity

The market supply curve in a perfectly competitive
industry
The market supply curve is derived from individual
firms marginal cost curves.
24
Firm supply and market supply: Figure 7.7

Price (dollars
per bushel)
Price (dollars
per bushel)
One oats farmer
Oats market
Supply
MC
$4
$4
8000
Quantity (bushels)
(a) Individual firm supply

25
80 000 000
Quantity (bushels)
(b) Market supply
The entry and exit of firms in the

long run
Economic profit and the entry or exit decision
Economic profit: A firms revenues minus all its
costs, implicit and explicit.
Economic profit in a perfectly competitive industry is
only a short-run occurrence.
Economic profit leads to the entry of new firms into
the industry.
26
Costs per year for Anne Morenos organic food farm: Table 7.4
Explicit costs
Water
$10 000
Wages
$15 000
Organic fertiliser
$10 000
Electricity
$ 5 000
Payment on bank loan
$45 000
Implicit costs
27
Foregone salary
$30 000
Opportunity cost of the $100 000

she has invested in her farm
$10 000
Total cost
$125 000
The effect of entry on economic profits: Figure 7.8
28

long run
Economic profit and the entry or exit decision, cont.
Economic loss: The situation in which a firms total
revenue is less than its total cost, including all implicit
costs.
Economic loss in a perfectly competitive industry is
only a short-run occurrence.
Economic loss leads to the exit of some firms from the
industry.
29
The effect of exit on economic losses: Figure 7.9,

panels (a) and (b)
30
The effect of exit on economic losses: Figure 7.9,

panels (c) and (d)
31

long run
Long-run equilibrium in a perfectly competitive
market
Long-run competitive equilibrium: The situation
in which the entry and exit of firms has resulted in
the typical firm breaking even.
The long-run equilibrium market price is at the
minimum point on the typical firms average total
cost curve.
32

long run
market, cont.
Long-run supply curve: A curve showing the
relationship in the long run between market price and
the quantity supplied.
The long-run supply curve will be horizontal at the
market price.
33

long run
market, cont.
In the long run, a perfectly competitive market will
supply whatever amount of a good consumers
demand at a price determined by the minimum
point on the typical firms average total cost curve.
34
The long-run supply curve in a perfectly competitive industry:

Figure 7.10
35

long run
Increasing-cost and decreasing-cost industries
Constant-cost industry: An industry in which a firms
average costs do not change as the industry expands
(horizontal long-run supply curve).
Increasing-cost industry: An industry in which a firms
average costs rise as the industry expands (upwardsloping long-run supply curve).
Decreasing-cost industry: An industry in which a firms
average costs fall as the industry expands (downwardsloping long-run supply curve).
36
Perfect competition and efficiency

Productive efficiency: When a good or service is
produced using the least amount of resources.
Allocative efficiency:Firms will supply all those goods that

provide consumers with a marginal benefit at least as great as
the marginal cost of producing them:
The price of a good represents the marginal benefit
consumers receive from the last unit of the good consumed.
Perfectly competitive firms produce up to the point where the
price of the good equals the marginal cost of producing the
last unit.
Therefore, firms produce up to the point where the last unit
provides a marginal benefit to consumers equal to the
marginal cost of producing it.
37

Allocative efficiency
Firms will supply all those goods that provide
consumers with a marginal benefit at least as great
as the marginal cost of producing them:
The price of a good represents the marginal benefit
consumers receive from the last unit of the good consumed.
Perfectly competitive firms produce up to the point where
the price of the good equals the marginal cost of producing
the last unit.
Therefore, firms produce up to the point where the last unit
provides a marginal benefit to consumers equal to the
marginal cost of producing it.
38

Dynamic efficiency: Occurs when new technologies and
innovation are adopted over time, and when firms adapt
their product to changes in consumer preferences and
tastes.
When striving for dynamic efficiency, firms will use new
technology and thereby reduce production costs (productive
efficiency).
By adapting their product to changes in consumer
preferences, firms will produce goods and services
consumers value the most (allocative efficiency).
39

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Lecture 3.

Explain what a perfectly competitive market is and why a

Explain how a firm maximises profits in a perfectly competitive

Use graphs to show a firms profit or loss.

Explain why firms may shut down temporarily.

Explain how perfect competition leads to economic efficiency.

The four market structures

Selling DVDs Banking

Perfectly competitive markets

Perfectly competitive markets

How a firm maximises profit in a

Market demand and individual firm demand: Figure 7.2

1. The intersection of market

Demand for oats

(a) Market for oats

(b) Demand for an individual farmers

How a firm maximises profit in a

Marginal revenue (MR): Change in total revenue from

Farmer Jones revenue from oats farming

Market price per

How a firm maximises profit in a

How a firm maximises profit in a

Farmer Jones profits from oats farming: Table 7.3

The profit-maximising level of output: Figure 7.3

Illustrating profit or loss on the cost curve

Total profit = (P ATC) x Q

The area of maximum profit: Figure 7.4

Illustrating profit or loss on the cost curve

If P < ATC; the firm experiences losses.

A firm breaking even: Figure 7.5a

A firm experiencing losses: Figure 7.5b

Deciding whether to produce or to

Sunk cost: A cost that has already been paid and

Deciding whether to produce or to

Deciding whether to produce or to

The firms short-run supply curve: Figure 7.6

The supply curve for

Deciding whether to produce or to

Firm supply and market supply: Figure 7.7

One oats farmer

(a) Individual firm supply

(b) Market supply

The entry and exit of firms in the

Payment on bank loan

Opportunity cost of the $100 000

The effect of entry on economic profits: Figure 7.8

The entry and exit of firms in the

The effect of exit on economic losses: Figure 7.9,

The effect of exit on economic losses: Figure 7.9,

The entry and exit of firms in the

The entry and exit of firms in the

The entry and exit of firms in the

The long-run supply curve in a perfectly competitive industry:

The entry and exit of firms in the

Perfect competition and efficiency

Allocative efficiency:Firms will supply all those goods that

Perfect competition and efficiency

Perfect competition and efficiency

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