Perfectly Competitive Ma

rket

ETP Economics 101

Characteristics
A perfectly competitive market has the followi

ng characteristics:
There are many buyers and sellers in the mark
et.
The goods offered by the various sellers are la
rgely the same.
Firms can freely enter or exit the market.

Outcomes
As a result of its characteristics, the perfectly

competitive market has the following outcome

s:
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 a
s given.

Price Takers
A competitive market has many buyers and s

ellers trading identical products so that each

buyer and seller is a price taker.

Buyers and sellers must accept the price deter

mined by the market.

Total Revenue
Total revenue for a firm is the selling price times t
he quantity sold.

TR = (P Q)
Total revenue is proportional to the amount of
output.

Average Revenue
Average revenue tells us how much revenue

a firm receives for the typical unit sold.

Average revenue is total revenue divided by t
he quantity sold.
In perfect competition, average revenue equa
ls the price of the good.

Average Revenue=Price
T o ta l re v e n u e
A v e ra g e R e v e n u e =
Q u a n tity
P ric e Q u a n tity

Q u a n tity
P ric e

Marginal Revenue
Marginal revenue is the change in total reven

ue from an additional unit sold.

MR =TR/ Q
For competitive firms, marginal revenue equal

s the price of the good.

P=AR=MR
For competitive firms,

Price (P)= Average Revenue (AR)

= Marginal Revenue (MR)

Numerical Example

Goal of a Competitive Firm: Profit

Maximization
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 bet
ween total revenue and total cost.
Profit maximization occurs at the quantity whe
re marginal revenue equals marginal cost.

Conditions for Profit Maximization

When MR > MC, increase Q
When MR < MC, decrease Q
When MR = MC, Profit is maximized.

Numerical Example: MR=MC

Figure 1 Profit Maximization for a Competitive Firm

Costs
and
Revenue

The firm maximizes

profit by producing
the quantity at which
marginal cost equals
marginal revenue.

MC

MC2
ATC
P = MR1 = MR2

AVC

P = AR = MR

MC1

Q1

QMAX

Q2

Quantity
Copyright 2004 South-Western

Shutdown or Exit?
A shutdown refers to a short-run decision not

to produce anything during a specific period o

f time because of current market conditions.
Exit refers to a long-run decision to leave the
market.

Sunk Costs
The firm considers its sunk costs when decidi

ng to exit, but ignores them when deciding wh

ether to shut down.

Sunk costs are costs that have already been c

ommitted and cannot be recovered.

Short-Run Shut Down Decision

The firm shuts down if the revenue it gets fro

m producing is less than the variable cost of p

roduction.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC

Figure 3 The Competitive Firms Short Run Supply Curve

Costs
If P > ATC, the firm
will continue to
produce at a profit.

Firms short-run
supply curve

MC

ATC
If P > AVC, firm will
continue to produce
in the short run.

AVC

Firm
shuts
down if
P< AVC
0

Quantity

Copyright 2004 South-Western

Short-Run Supply Curve

The portion of the marginal-cost curve that lie

s above average variable cost is the competiti

ve firms short-run supply curve.

Long-Run Exit Decision

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

A firms Entry Decision

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 Firms Long-Run Supply Curve

Costs
Firms long-run
supply curve
Firm
enters if
P > ATC

MC = long-run S

ATC

Firm
exits if
P < ATC

Quantity

Copyright 2004 South-Western

Long-Run Supply Curve

The competitive firms long-run supply curve i

s the portion of its marginal-cost curve that lie

s above average total cost.

Summary
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 p

oint of its average total cost curve.

Figure 5 Profit as the Area between Price and Average Total Co

st
(a) A Firm with Profits
Price
MC

ATC

Profit
P
ATC

P = AR = MR

Quantity
Q
(profit-maximizing quantity)
Copyright 2004 South-Western

Figure 5 Profit as the Area between Price and Average Total Co

st
(b) A Firm with Losses
Price

MC

ATC

ATC
P

P = AR = MR
Loss

Q
(loss-minimizing quantity)

Quantity
Copyright 2004 South-Western

Short-Run Market Supply with a fi

xed number of firms
For any given price, each firm supplies a qua

ntity of output so that its marginal cost equals

price.
The market supply curve reflects the individu
al 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

$2.00

$2.00

1.00

1.00

100

200

Quantity (firm)

100,000

200,000 Quantity (market)

Copyright 2004 South-Western

Long-Run Market Supply Curve

Firms will enter or exit the market until profit i

s driven to zero.
In the long run, price equals the minimum of a
verage total cost.
The long-run market supply curve is horizonta
l at this price.

Figure 7 Market Supply with Entry and Exit

(a) Firms Zero-Profit Condition

(b) Market Supply

Price

Price

MC
ATC
P = minimum
ATC

Supply

Quantity (firm)

Quantity (market)

Copyright 2004 South-Western

Long-Run Equilibrium
At the end of the process of entry and exit, fir

ms that remain must be making zero economi

c profit.
The process of entry and exit ends only when
price and average total cost are driven to equ
ality.
Long-run equilibrium must have firms operati
ng at their efficient scale.

Why do competitive firms stay in b

usiness if zero profit?
Profit equals total revenue minus total cost.
Total cost includes all the opportunity costs of

the firm.
In the zero-profit equilibrium, the firms reven
ue compensates the owners for the time and
money they expend to keep the business goi
ng.

Short-Run and Long-Run Effects o

f a Shift in Demand
An increase in demand raises price and quan

tity in the short run.

Firms earn profits because price now exceed
s average total cost.

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

n

(a) Initial Condition

Market

Firm
Price

Price

MC

ATC

P1

Short-run supply, S1
P1

Long-run
supply
Demand, D1

Quantity (firm)

Q1

Quantity (market)

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

n

(b) Short-Run Response

Market

Firm
Price

Price

Profit

MC

ATC

P2

P2

P1

P1

S1

A
D2

Long-run
supply

D1
0

Quantity (firm)

Q1

Q2

Quantity (market)

Copyright 2004 South-Western

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

n

(c) Long-Run Response

Market

Firm
Price

Price

MC

ATC

P1

P2
P1

S1
S2
C

Long-run
supply
D2

D1
0

Quantity (firm)

Q1

Q2

Q3 Quantity (market)

Copyright 2004 South-Western

Why a Long-Run Supply Curve Mi

ght Slope Upward?
Some resources used in production may be available

only in limited quantities.

Price of resources rises (falls) when production scale
or number of firms increases (decreases).
Firms may have different costs.
Firms average cost curve is higher (or lower) when p
roduction scale or number of firms increases (decrea
ses).