0. Chapter 13: Firms in Competitive Markets
Econ 2100
FIRMS IN COMPETITIVE MARKETS

1. What works in the public sector?
Course Outline
What; why; who?
How markets work?
Are markets good?
How firms behave?
Chapters
Why are you hired?
What works in the public sector?

2. Chapter 14 Outline What is a Perfectly Competitive Market?
Marginal vs Total vs Average Revenue
Profit Maximizing Output
SR Decision: Shut Down
LR Decision: Exit/Enter
Market Supply: SR & LR
FIRMS IN COMPETITIVE MARKETS

3. 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.
“Firms can freely enter or exit the market” means there are no barriers or impediments to entry or exit. E.g., the government does not restrict the number of firms in the market.
FIRMS IN COMPETITIVE MARKETS 3

4. Chapter 14 Outline What is a Perfectly Competitive Market?
Marginal vs Total vs Average Revenue
Profit Maximizing Output
SR Decision: Shut Down
LR Decision: Exit/Enter
Market Supply: SR & LR
FIRMS IN COMPETITIVE MARKETS

5. 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 = P x Q TR Q
AR =
= P
∆TR ∆Q
MR =
These revenue concepts are analogous to the cost concepts (TC, ATC, MC) in the previous chapter.
FIRMS IN COMPETITIVE MARKETS 5

6. 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.
FIRMS IN COMPETITIVE MARKETS 6

7. Chapter 14 Outline What is a Perfectly Competitive Market?
Marginal vs Total vs Average Revenue
Profit Maximizing Output
SR Decision: Shut Down
LR Decision: Exit/Enter
Market Supply: SR & LR
FIRMS IN COMPETITIVE MARKETS

8. FIRMS IN COMPETITIVE MARKETS
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.
FIRMS IN COMPETITIVE MARKETS 8

9. Profit Maximization Profit = MR – MC
(continued from earlier exercise) Q TR TC
Profit MR MC
Profit = MR – MC
At any Q with MR > MC, increasing Q raises profit. $0 45 33 23 15 9 $5 5 7 1
–$5
$10 12 10 8 6 $4 –2 2 4 $6 1 10 10 2 20
At any Q with MR < MC, reducing Q raises profit. 10
(The table on this slide is similar to Table 2 in the textbook.)
For most students, seeing the complete table all at once is too much information. So, the table is animated as follows:
Initially, the only columns displayed are the ones students saw at the end of the exercise in Active Learning 1: Q, TR, and MR.
Then, TC appears, followed by MC. It might be useful to remind students of the relationship between MC and TC.
Then, the Profit column appears. Students should be able to see that, at each value of Q, profit equals TR minus TC.
The last column to appear is the change in profit.
When the table is complete, we use it to show
it is profitable to increase production whenever MR > MC, such as at Q = 0, 1, or 2.
it is profitable to reduce production whenever MC > MR, such as at Q = 5. 3 30 10 4 40 10 5 50
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10. MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
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 Qb P1 MR Qa Q1
This slide is similar to Figure 1 in the chapter. I’ve omitted the AVC and ATC curves (which appear in Figure 1 in the chapter) because they are not needed at this point.
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11. 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,
Costs MC P2
MR2 Q2 P1 MR Q1
the MC curve is the firm’s supply curve. Q
FIRMS IN COMPETITIVE MARKETS 11

12. Chapter 14 Outline What is a Perfectly Competitive Market?
Marginal vs Total vs Average Revenue
Profit Maximizing Output
SR Decision: Shut Down
LR Decision: Exit/Enter
Market Supply: SR & LR
FIRMS IN COMPETITIVE MARKETS

13. FIRMS IN COMPETITIVE MARKETS
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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14. 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:
The shutdown rule, in plain English, says:
If the cost of shutting down is less than the benefit, the firm should shut down.
Shut down if P < AVC
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15. A Competitive Firm’s SR Supply Curve
The firm’s SR supply curve is the portion of its MC curve above AVC. Q
Costs
AVC
If P > AVC, then firm produces Q where P = MC. MC
ATC
In edit mode, it looks like the text boxes are on top of each other. But in presentation mode, the text boxes display only one at a time.
If P < AVC, then firm shuts down (produces Q = 0).
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16. 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.
A sunk cost
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17. Chapter 14 Outline What is a Perfectly Competitive Market?
Marginal vs Total vs Average Revenue
Profit Maximizing Output
SR Decision: Shut Down
LR Decision: Exit/Enter
Market Supply: SR & LR
FIRMS IN COMPETITIVE MARKETS

18. 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:
The decision rule for whether to exit says:
If the cost of exiting is greater than the benefit, the firm should exit.
Exit if P < ATC
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19. 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
Similarly, a prospective entrant compares the benefits of entering the market (TR) with the costs (TC), and enters if the benefits exceed the costs.
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20. The Competitive Firm’s Supply Curve
The firm’s LR supply curve is the portion of its MC curve above LRATC. Q
Costs MC
LRATC
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21. A C T I V E L E A R N I N G 2 Identifying a firm’s profit
A competitive firm
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
Rather than tell students that profit equals (P – ATC) x Q, this exercise requires students to figure it out for themselves.
If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file. 21

22. A C T I V E L E A R N I N G 2 Answers
A competitive firm Q
Costs, P
Profit per unit = P – ATC = $10 – 6 = $4 MC
ATC
P = $10 MR 50
profit $6
The height of the rectangle is P – ATC, profit per unit.
The width of the rectangle is Q, the number of units.
The area of the rectangle
= height x width
= (profit per unit) x (number of units)
= total profit.
Total profit = (P – ATC) x Q = $4 x 50 = $200 22

23. A C T I V E L E A R N I N G 3 Identifying a firm’s loss
A competitive firm
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 $5
Students that didn’t figure out the answer to the previous exercise should be able to get this one.
If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file.
Note that the statement “assuming AVC < $3” is needed to prevent shut-down, i.e. to insure that the firm produces Q=30 instead of Q=0. 30
P = $3 MR 23

24. A C T I V E L E A R N I N G 3 Answers
A competitive firm Q
Costs, P
Total loss = (ATC – P) x Q = $2 x 30 = $60 MC
ATC $5
The height of the rectangle is ATC – P, loss per unit.
The width of the rectangle is Q, the number of units.
The area of the rectangle
= height x width
= (loss per unit) x (number of units)
= total loss. 30
loss
loss per unit = $2 MR
P = $3 24

25. Chapter 14 Outline What is a Perfectly Competitive Market?
Marginal vs Total vs Average Revenue
Profit Maximizing Output
SR Decision: Shut Down
LR Decision: Exit/Enter
Market Supply: SR & LR
FIRMS IN COMPETITIVE MARKETS

26. 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)
In the real world, there are many markets in which assumptions (1) and (2) do not hold. We make them here for simplicity. Later in the chapter, we will see how our results change if we drop either of these assumptions.
Assumption (3) is more reasonable: In the real world, it is much easier for firms to enter or exit in the long run than in the short run.
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27. 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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28. The SR Market Supply Curve
Example: identical firms
At each P, market Qs = x (one firm’s Qs)
AVC
One firm Q P
(firm)
Market Q P
(market) MC S P3 P3 30
30,000 P2 P2 20
20,000
“Identical” means all firms have the same cost curves.
Note: P1 is minimum AVC. At any price below P1, each firm will shut down, and market quantity supplied will equal zero.
Hence, the market supply curve begins at price = P1 and Q = 10,000. P1 P1 10
10,000
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29. 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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30. 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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31. 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
Students often wonder why firms bother to stay in business if they make zero profit. The textbook gives a nice discussion of this, briefly summarized on this slide.
FIRMS IN COMPETITIVE MARKETS 31

32. The LR Market Supply Curve
In the long run, the typical firm earns zero profit.
The LR market supply curve is horizontal at P = minimum ATC.
One firm Q P
(firm)
Market Q P
(market) MC
LRATC
P = min. ATC
That the LR market supply curve is horizontal at P = min ATC will become more clear shortly, when students see the SR and LR effects of an increase in demand.
long-run
supply
FIRMS IN COMPETITIVE MARKETS 32

33. SR & LR Effects of an Increase in Demand
One firm
Market Q P
(market) Q P
(firm) S1 MC
ATC 3 S2
Profit D2 4 B P2 P2 Q2 D1 A C 5 P1
long-run
supply P1
This slide replicates Figure 8 from the textbook. In edit mode, the text boxes in the top part of the slide appear to be on top of each other. But in slide-show mode, the text boxes display one at a time.
If students did not previously understand why the LR market supply curve is horizontal, this slide may help. 2 Q1 Q3 1
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34. 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.
Here are two of the assumptions we made previously, when we began the process of deriving the LR market supply curve.
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35. 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.
The marginal firm is the firm that would exit the market if the price were any lower.
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36. 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.
Another example: There’s a limited amount of beachfront property. An expansion of the beach resort industry will bid up the price of such property, and raises costs in the industry.
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37. 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.
In the next chapter, monopoly: pricing & production decisions, deadweight loss, regulation.
Recall from Chapter 7: a competitive market equilibrium is efficient. This chapter has shown why: P = MR under perfect competition, so P = MC in the competitive market equilibrium.
Reviewing these concepts now sets the stage for the next few chapters, where firms with market power set their price above marginal cost, leading to market inefficiencies and a potential role for government intervention.
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38. FIRMS IN COMPETITIVE MARKETS
Test Bank Questions
FIRMS IN COMPETITIVE MARKETS

39. FIRMS IN COMPETITIVE MARKETS
Questions 6 & 18
A market is competitive if
18. In a competitive market, no single producer can influence the market price because
(i)
firms have the flexibility to price their own product.
(ii)
each buyer is small compared to the market.
(iii)
each seller is small compared to the market. a.
many other sellers are offering a product that is essentially identical. b.
consumers have more influence over the market price than producers do. c.
government intervention prevents firms from influencing price. d.
producers agree not to change the price. a.
(i) and (ii) only b.
(i) and (iii) only c.
(ii) and (iii) only d.
(i), (ii), and (iii)
FIRMS IN COMPETITIVE MARKETS

40. FIRMS IN COMPETITIVE MARKETS
Questions 29, 30 & 31
29. Refer to Table For a firm operating in a competitive market, the price is
Quantity
Total Revenue $0 1 $7 2
$14 3
$21 4
$28 a.
$0. b.
$7. c.
$14. d.
$21.
30. Refer to Table For a firm operating in a competitive market, the marginal revenue is
31. Refer to Table For a firm operating in a competitive market, the average revenue is a.
$0. b.
$7. c.
$14. d.
$21. a.
$21. b.
$14. c.
$7. d.
$0.
FIRMS IN COMPETITIVE MARKETS

41. FIRMS IN COMPETITIVE MARKETS
Questions 20 & 21
20. Refer to Table The firm will produce a quantity greater than 4 because at 4 units of output, marginal cost
Quantity
Total Revenue
Total Cost $0 $3 1 $7 $5 2
$14 $8 3
$21
$12 4
$28
$17 5
$35
$23 6
$42
$30 7
$49
$38 a.
is less than marginal revenue. b.
equals marginal revenue. c.
is greater than marginal revenue. d.
is minimized.
21. Refer to Table What is the firm’s profit-maximizing strategy? a.
produce 1 unit of output because marginal cost is minimized b.
produce 4 units of output because marginal revenue exceeds marginal cost c.
produce 6 units of output because marginal revenue equals marginal cost d.
produce 8 units of output because total revenue is maximized
FIRMS IN COMPETITIVE MARKETS

42. FIRMS IN COMPETITIVE MARKETS
Questions 88, 89 & 90
88.. If the market price is P2, in the short run, the perfectly competitive firm will earn a.
positive economic profits. b.
negative economic profits but will try to remain open. c.
negative economic profits and will shut down. d.
zero economic profits.
89. If the market price is P3, in the short run, the perfectly competitive firm will earn
90. If the market price is P4, in the short run, the perfectly competitive firm will earn a.
positive economic profits. b.
negative economic profits but will try to remain open. c.
negative economic profits and will shut down. d.
zero economic profits. a.
positive economic profits. b.
negative economic profits but will try to remain open. c.
negative economic profits and will shut down. d.
zero economic profits.
FIRMS IN COMPETITIVE MARKETS

43. FIRMS IN COMPETITIVE MARKETS
Questions 95, 96 & 98
95. If the market price is $10, what is the firm’s short-run economic profit? a. $9 b.
$15 c.
$30 d.
$50
96. If the market price is $10, what is the firm’s total cost? a.
$15 b.
$30 c.
$35 d.
$50
98. The firm will earn zero economic profit if the market price is a. $0 b. $6 c. $7 d.
$10
FIRMS IN COMPETITIVE MARKETS

44. FIRMS IN COMPETITIVE MARKETS
Questions 56 & 60
56. Assume that the market starts in equilibrium at point A in panel (b). An increase in demand from D0 to D1 will result in
60. Suppose a firm in a competitive market, like the one depicted in panel (a), observes market price rising from P1 to P2. Which of the following could explain this observation? a.
a new market equilibrium at point D. b.
an eventual increase in the number of firms in the market and a new long-run equilibrium at point C. c.
rising prices and falling profits for existing firms in the market. d.
falling prices and falling profits for existing firms in the market. a.
The entry of new firms into the market. b.
The exit of existing consumers from the market. c.
An increase in market supply from S0 to S1. d.
An increase in market demand from D0 to D1.
FIRMS IN COMPETITIVE MARKETS