Slide 1

What Is A Competitive Market?

A perfectly competitive market has the

following characteristics:
1) There are many buyers and sellers in the market.
2) The goods offered by the various sellers are the
same (identical).
3) Firms can freely enter or exit the market.
4) Information is perfect. Buyers and sellers know
all prices offered,...

Slide 2

What Is A Competitive Market?

As a result of these characteristics, the
perfectly competitive market has the following
outcomes:
The actions of any single buyer or seller in the
market have no impact on the market price.
Each buyer and seller takes the market price as
given.

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Ex: Gasoline, fish, eggs, pencils, tomatoes, etc.

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Slide 3

What Is A Competitive Market?

Buyers and sellers must accept the price
determined by the market. No single seller
has market power (the power to influence
the market price).

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Slide 4

Demand Faced By A Competitive Firm versus

Market Demand

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Price

Price

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Pm

QTY
(millions)

QTY
(ones)

Demand faced by
one competitive firm

Market Demand

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Slide 5

The Revenue of a Competitive Firm

Total revenue for a firm is the market price
times the quantity sold.

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TR = P Q

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Slide 6

Table 1 Total, Average, and Marginal Revenue for a

Competitive Firm

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Copyright2004 South-Western

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Slide 7

The Revenue of a Competitive Firm

Marginal revenue is the change in total

revenue when an additional unit is sold.

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MR =TR / Q

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Slide 8

The Revenue of a Competitive Firm

Only in a competitive market, marginal revenue equals
the price of the good. This is because a firm in a
competitive market can sell as much as it wants at
the constant market price.

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Slide 9

Profit Maximization and The Competitive Firms

Supply Curve

The goal of a competitive firm is to maximize

profit.
This means that the firm wants to produce the
quantity that maximizes the difference between
total revenue and total cost.

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Slide 10

Table 2 Profit Maximization: A Numerical Example

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Copyright2004 South-Western

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Slide 11

Profit Maximization and The Competitive Firms

Supply Curve

Profit maximization occurs at the quantity

where marginal revenue equals marginal cost.

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Slide 12

Profit Maximization And The Competitive

Firms Supply Curve

When MR > MC, profit is increasing, so must

produce more.
When MR < MC, profit is decreasing, so must
produce less.
When MR = MC, profit is constant, so this is
the point where profit is maximized.

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Slide 13

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.

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MC

MC2

P = MR1 = MR2

P = AR = MR

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MC1

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0

Q1

QMAX

Q2

Quantity
Copyright 2004 South-Western

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Slide 14

Figure 2 Marginal Cost as the Competitive Firms Supply Curve

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Price

P2

This section of the

firms MC curve is
also the firms supply
curve.

MC

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ATC
P1

AVC

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Q1

Q2

Quantity
Copyright 2004 South-Western

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Slide 15

Firms Short-Run
to Shut
Down
The
A shutdown
refers toDecision
a short-run
decision
to stop production temporarily because
the firms revenue cannot even cover
variable costs.
Exit refers to a long-run permanent
decision to leave the market. A firm exits
the market if it makes negative economic
profit in the long-term.

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Slide 16

The Firms Short-term Decision to Shut Down

The firm ignores its fixed costs (= sunk costs)

when deciding to shut down or not in the
short-term, but considers them when deciding
whether to exit or not in the long-term.

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Slide 17

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The Firms Short-Run Decision to

Shut Down

The firm shuts down if its revenue is less than

its variable costs:
Shut down if
TR < VC
Shut down if TR / Q < VC / Q
Shut down if
P < AVC

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Slide 18

Figure 3 The Competitive Firms Short Run Supply

Curve

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

Firms short-run
supply curve

MC

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

AVC

Firm
shuts
down if
P< AVC

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Quantity

Copyright 2004 South-Western

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Slide 19

The Firms Long-Run Decision to Exit or Enter a

Market

In the long run, a firm exits the market if the

profit is negative .
Exit if TR < TC
if TR/Q < TC/Q
if P < ATC

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A new firm Enters the market if profit is

positive, or if: P > ATC

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Slide 20

Figure 4 The Competitive Firms Long-Run Supply

Curve

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Costs
Firms long-run
supply curve

Firm
enters if
P > ATC

MC = long-run S

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ATC

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Firm
exits if
P < ATC

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0

Quantity

Copyright 2004 South-Western

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Slide 21

THE SUPPLY CURVE IN A COMPETITIVE

MARKET
The competitive firms long-run supply curve
is the part of its marginal-cost curve that lies
above average total cost.

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Slide 22

Figure 5 Profit as the Area between Price and Average

Total Cost

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(a) A Firm with Profits

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Price
MC

ATC

Profit

P
ATC

P = AR = MR

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Quantity
Q
(profit-maximizing quantity)

Copyright 2004 South-Western

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Slide 23

Figure 5 Profit as the Area between Price and Average Total

Cost

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(b) A Firm with Losses

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Price

MC

ATC

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ATC

P = AR = MR
Loss

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0

Q
(loss-minimizing quantity)

Quantity
Copyright 2004 South-Western

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Slide 24

FIRM VERSUS MARKET SUPPLY

Market supply equals the sum of the
quantities supplied by all firms in the market.

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Slide 25

The Short Run: Market Supply with a Fixed

Number of Firms

For any given price, each firm supplies a

quantity of output so that its marginal cost
equals price.
The market supply curve adds up the
individual firms marginal cost curves.

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Figure 6: SR Market Supply with a Fixed Number of

Firms

Slide 26

(a) Individual Firm Supply

(b) Short Run Market Supply

Price

Price

Supply
$2.00

1.00

1.00

100

200

Quantity (firm)

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SR

MC

$2.00

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100,000

200,000 Quantity (market)

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Copyright 2004 South-Western

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Slide 27

The Long Run: Market Supply with Entry and Exit

Long run equilibrium is reached when there

are no more entries or exits in the market.
Firms will enter or exit the market until profit
approaches to zero. Then long-run equilibrium
happens when profit equals zero.Then at the
long run equilibrium, price must be equal to
the minimum of average total cost.

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Slide 28

The Long Run: Market Supply with Entry and Exit

Then long-run market supply curve is

horizontal at price = min(ATC).
At the long-run equilibrium, firms operate at
their efficient scale (scale that minimizes ATC).

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Slide 29

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Figure 7 Market Supply with Entry and Exit

(a) Firms Zero-Profit Condition

(b) Long Run Market Supply

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Price

Price

SR

MC

Supply

ATC

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LR

P = minimum
ATC

Supply

Demand, D1

Quantity (firm)

Quantity (market)

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Copyright 2004 South-Western

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Slide 30

Why Do Competitive Firms Stay in Business If

They Make Zero Profit?

Remember that accounting (nominal) profit is

positive even if economic profit is zero.
The firm making zero economic profit means
the firm is doing the best it can and there is no
other alternative that will give better profit. If
there was, current economic profit would be
negative.

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Slide 31

Exercise: A Shift in Demand and Short Run and

Long Run Consequences

An increase in demand raises price and

quantity in the short run.
Firms earn profits because price now exceeds
average total cost.

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Slide 32

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

Run

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(a) Initial Condition

Market

Firm

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Price

Price

MC

ATC

Short-run supply, S1
A

P1

Long-run
supply

P1

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Demand, D1
Quantity (firm)

Quantity (market)

Q1

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

Slide 33

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(b) Short-Run Response

Market

Firm
Price

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Price

Profit

MC

ATC

P2

P2

P1

P1

S1

A
D2

Long-run
supply

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D1
0

Quantity (firm)

Q1

Q2

Quantity (market)

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Copyright 2004 South-Western

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Figure 8 An Increase in Demand in the Short Run and

Long Run

Slide 34

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(c) Long-Run Response

Market

Firm
Price

Price

MC

ATC

P2

S1

S2
C

P1

Long-run
supply

P1

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D2
D1
0

Quantity (firm)

Q1

Q2

Q3 Quantity (market)

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Copyright 2004 South-Western

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Slide 35

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