14

The Big Picture

Firms in Competitive Markets

PRINCIPLES OF

ECONOMICS

Chapter 13: The cost of production

Now, we will look at firms revenue
But revenue depends on market structure

1.
2.
3.
4.

FOURTH EDITION

N. G R E G O R Y M A N K I W
Premium PowerPoint Slides
by Ron Cronovich
2008 update
Modified by Joseph Tao-yi Wang

Competitive market (this chapter)

Monopoly (chapter 15)
Oligopoly (chapter 16)
Monopolistic Composition (chapter 17)
Are there other types of markets? Yes, not now

2008 South-Western, a part of Cengage Learning, all rights reserved

Introduction: A Scenario

In this chapter, look for the answers to

these questions:

What is a perfectly competitive market?

Three years after graduating, you run your own

business.

You must decide how much to produce, what price

What is marginal revenue? How is it related to

to charge, how many workers to hire, etc.

total and average revenue?

What factors should affect these decisions?

How does a competitive firm determine the

Your costs (studied in preceding chapter)

How much competition you face

quantity that maximizes profits?

When might a competitive firm shut down in the

We begin by studying the behavior of firms in

short run? Exit the market in the long run?

perfectly competitive markets.

What does the market supply curve look like in the

short run? In the long run?
CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

The Revenue of a Competitive Firm

Characteristics of Perfect Competition

Total revenue (TR)

TR = P x Q

This
This is
is typically
typically resulted
resulted from:
from:

Average revenue (AR)

AR =

TR
=P
Q

1.
1. The
The goods
goods offered
offered for
for sale
sale are
are largely
largely the
the same.
same.

Marginal Revenue (MR):

MR =

TR
Q

Perfect
Perfect Competition:
Competition: There
There are
are Perfect
Perfect Substitutes
Substitutes
(if
(if dont
dont buy
buy from
from you,
you, can
can buy
buy from
from her
her instead)
instead)

The change in TR from

selling one more unit.

2.
2. Many
Many buyers
buyers and
and many
many sellers
sellers (how
(how many?)
many?)
3.
3. Firms
Firms can
can freely
freely enter
enter or
or exit
exit the
the market.
market.

Because of 1 & 2, each buyer and seller is a

price taker takes the price as given.
CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

ACTIVE LEARNING

Exercise

1:

ACTIVE LEARNING

Answers

Fill in the empty spaces of the table.

$10

$10

TR

1:

Fill in the empty spaces of the table.

TR

TR = P x Q

n.a.

$10

$0

n.a.

$10

$10

$10

$10

$10

$10

$20

$10

$10

$30

$10

$10

$40

$10

$40

$10

$10

$50

$10

$50

$10

AR

MR

AR =

MR =

TR
Q

$10

Notice
Notice that
that$10
MR
MR == P
P

$10
$10
$10

$10

$10
6

MR = P for a Competitive Firm

Profit Maximization

A competitive firm can keep increasing its output

without affecting the market price.

So, each one-unit increase in Q causes revenue

Think at the margin.

to rise by P, i.e., MR = P.

If increase Q by one unit,

revenue rises by MR,
cost rises by MC.

MR
MR == P
P is
is only
only true
true for
for
firms
firms in
in competitive
competitive markets.
markets.

CHAPTER 14

If MR > MC, then increase Q to raise profit.

If MR < MC, then reduce Q to raise profit.

FIRMS IN COMPETITIVE MARKETS

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Profit Maximization

MC and the Firms Supply Decision

(continued from earlier exercise)

Rule: MR = MC at the profit-maximizing Q.

At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.
CHAPTER 14

What Q maximizes the firms profit?

To find the answer,

Profit =
Profit MR MC
MR MC

TR

TC

$0

$5

$5

10

20

15

30

23

40

33

50

45

FIRMS IN COMPETITIVE MARKETS

At Qa, MC < MR.

So, increase Q
to raise profit.

$10 $4

$6

At Qb, MC > MR.

10

10

So, reduce Q
to raise profit.

10

10

At Q1, MC = MR.

10

12

Changing Q
would lower profit.
10

CHAPTER 14

Costs
MC

MR

P1

Qa Q1 Qb

FIRMS IN COMPETITIVE MARKETS

Q
11

MC and the Firms Supply Decision

Shutdown vs. Exit

Shutdown:

If price rises to P2,

then the profitmaximizing quantity
rises to Q2.
The MC curve
determines the
firms Q at any price.

A short-run decision not to produce anything

because of market conditions.

Costs
MC
P2

MR2

P1

MR

Hence,
the MC curve is the
firms supply curve.
Q1
CHAPTER 14

Q2

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.

FIRMS IN COMPETITIVE MARKETS

12

A Firms Short-run Decision to Shut Down

Cost of shutting down:

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, firms decision rule is:

13

FIRMS IN COMPETITIVE MARKETS

A Competitive Firms SR Supply Curve

MC
ATC
AVC

If P < AVC, then

firm shuts down
(produces Q = 0).

Shut down if P < AVC

FIRMS IN COMPETITIVE MARKETS

CHAPTER 14

The firms SR
Costs
supply curve is
the portion of
its MC curve
If P > AVC, then
above AVC.
firm produces Q
where P = MC.

revenue loss = TR

CHAPTER 14

Exit:

14

The Irrelevance of Sunk Costs

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Q
15

A Firms Long-Run Decision to Exit

Cost of exiting the market:

Sunk cost: a cost that has already been

committed and cannot be recovered

revenue loss = TR

Benefit of exiting the market:

Sunk costs should be irrelevant to decisions;

cost savings = TC
(zero FC in the long run)

you must pay them regardless of your choice.

FC is a sunk cost: The firm must pay its fixed

So, firm exits if TR < TC.

Divide both sides by Q to write the firms

costs whether it produces or shuts down.

So, FC should not matter in the decision to shut

decision rule as:

down.

Exit if P < ATC

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

16

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

17

A New Firms Decision to Enter Market

The Competitive Firms Supply Curve

In the long run, a new firm will enter the market if

The firms
LR supply curve
is the portion of
its MC curve
above LRATC.

it is profitable to do so: if TR > TC.

Divide both sides by Q to express the firms

entry decision as:
Enter if P > ATC

Costs
MC
LRATC

Q
CHAPTER 14

18

FIRMS IN COMPETITIVE MARKETS

2 A:
Identifying a firm
firms profit
ACTIVE LEARNING

CHAPTER 14

ACTIVE LEARNING

Identify the
area on the
graph that
represents
the firms
profit.

2 A:

Answers

A competitive firm

Determine
this firms
total profit.

19

FIRMS IN COMPETITIVE MARKETS

A competitive firm

Costs, P

Costs, P
MC

profit per unit

= P ATC
= $10 6
= $4

MR
ATC

P = $10

MC
MR
ATC

P = $10

profit

$6

$6
Total profit
= (P ATC) x Q
= $4 x 50
= $200

50

50

20

2 B:
Identifying a firm
firms loss
ACTIVE LEARNING

21

ACTIVE LEARNING

A competitive firm

Determine
this firms
total loss,
assuming
AVC < $3.
Identify the
area on the
graph that
represents
the firms
loss.

2 B:

Answers
A competitive firm

Costs, P

Costs, P
MC

MC

Total loss
= (ATC P) x Q
= $2 x 30
= $60

ATC

$5

ATC

$5

P = $3

MR

30

P = $3

loss

loss per unit = $2

MR

30
22

23

The SR Market Supply Curve

Market Supply: Assumptions

1) All existing firms and potential entrants have
identical costs.

As long as P AVC, each firm will produce its

2) Each firms costs do not change as other firms

enter or exit the market.

Recall from Chapter 4:

profit-maximizing quantity, where MR = MC.

At each price, the market quantity supplied is
the sum of quantities supplied by all firms.

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)

CHAPTER 14

24

FIRMS IN COMPETITIVE MARKETS

The SR Market Supply Curve

entry & exit.

If existing firms earn positive economic profit,

Market

New firms enter, SR market supply shifts right.

P falls, reducing profits and slowing entry.

P3

P3
P2

P2

AVC

P1

If existing firms incur losses,

P1
10 20 30

Q
(firm)

Q
(market)
10,000

CHAPTER 14

25

In the LR, the number of firms can change due to

At each P, market Qs = 1000 x (one firms Qs)

One firm
MC

FIRMS IN COMPETITIVE MARKETS

Entry & Exit in the Long Run

Example: 1000 identical firms.

CHAPTER 14

some firms exit, SR market supply shifts left.

P rises, reducing remaining firms losses.

20,000 30,000

FIRMS IN COMPETITIVE MARKETS

26

The Zero-Profit Condition

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

27

Why Do Firms Stay in Business if Profit = 0?

Long-run equilibrium:

Recall, economic profit is revenue minus all

The process of entry or exit is complete

remaining firms earn zero economic profit.

costs including implicit costs, like the

opportunity cost of the owners time and money.

In the zero-profit equilibrium,

firms earn enough revenue to cover these costs
accounting profit is positive

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.
CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

28

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

29

SR & LR Effects of an Increase in Demand

The LR Market Supply Curve

A firm begins in
but then an increase
profits
to zero
leading
todriving
SR
Over time,
profits
induce
entry,
in
demand
raises
P,
long-run eqm
andfirm.
restoring
long-run
eqm.
profits for the
shifting
S to the
right, reducing P

The LR market supply

curve is horizontal at
P = minimum ATC.

In the long run,

the typical firm
earns zero profit.

One firm

P
P
P=
min.
ATC

One firm
MC

Market
Profit

LRATC
long-run
supply

Q
(firm)
CHAPTER 14

30

P1

long-run
supply
D1

Q
(firm)
CHAPTER 14

Q1 Q2

Q3

D2

Q
(market)
31

FIRMS IN COMPETITIVE MARKETS

1) Firms Have Different Costs

As P rises, firms with lower costs enter the market

The LR market supply curve is horizontal if

before those with higher costs.

1) all firms have identical costs, and

Further increases in P make it worthwhile

2) costs do not change as other firms enter or

exit the market.

for higher-cost firms to enter the market,

which increases market quantity supplied.

If either of these assumptions is not true,

Hence, LR market supply curve slopes upward.

then LR supply curve slopes upward.

FIRMS IN COMPETITIVE MARKETS

S2
B

P2

P2
P1

Why the LR Supply Curve Might Slope Upward

CHAPTER 14

S1

ATC

Q
(market)

FIRMS IN COMPETITIVE MARKETS

Market

MC

At any P,

32

For the marginal firm,

P = minimum ATC and profit = 0.

For lower-cost firms, profit > 0.

CHAPTER 14

33

FIRMS IN COMPETITIVE MARKETS

CONCLUSION: The Efficiency of a

Competitive Market

2) Costs Rise as Firms Enter the Market

In some industries, the supply of a key input is

limited (e.g., theres a fixed amount of land
suitable for farming).

The entry of new firms increases demand for this

input, causing its price to rise.

Profit-maximization:

Perfect competition:

So, in the competitive eqm:

MC = MR
P = MR
P = MC

Recall, MC is cost of producing the marginal unit.

This increases all firms costs.

Hence, an increase in P is required to increase

P is value to buyers of the marginal unit.

So, the competitive eqm is efficient, maximizes

the market quantity supplied, so the supply curve

is upward-sloping.

total surplus.

In the next chapter, monopoly: pricing &

production decisions, deadweight loss, regulation.

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

34

CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

35

Perfect Competition

CHAPTER SUMMARY

For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.

If P > AVC, a firm maximizes profit by producing

the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.

If P < ATC, a firm will exit in the long run.

In the short run, entry is not possible, and an

Firms enter if P > ATC; exit if P < ATC

increase in demand increases firms profits.

Homework: Mankiw, Ch.14, pp. 308-309,

Problem 3, 5, 9, 11, 12.

With free entry and exit, profits = 0 in the long run,

and P = minimum ATC.
CHAPTER 14

FIRMS IN COMPETITIVE MARKETS

Products are Perfect Substitutes

Result: Price Taking
P = MR = MC
SR: Will operate if P > AVC (FC is sunk)
LR: Will operate at P = ATC

36