Module 9 – Firms & Competition

Goal of firms

To maximize profits, which equals total revenue minus total cost

Production technology

The process by which a firm turns inputs into outputs (not just “machines,” but the entire production process).

Fixed costs

Do not change with output (e.g., rent, machinery).

Variable costs

Do change with output (e.g., labor, materials)

Short run

Some costs are fixed; firms can only adjust variable inputs

In the long run

all costs are variable and firms can enter or exit

Short run vs. long run time

depends on business type (a smoothie bar vs. a large factory)

Explicit costs

direct, monetary payments (wages, rent)

Implicit costs

nonmonetary opportunity costs (e.g., income forgone by running your own firm).

Economic costs

explicit + implicit costs

Accounting profit

total revenue − explicit costs

Economic profit

total revenue − (explicit + implicit costs)

Economic profits < accounting profits

but they reflect true firm performance

Marginal cost (MC)

Change in total cost ÷ change in quantity

Marginal cost measures

how much total cost rises when one more unit is produced

Marginal cost example 

• Fixed cost = $62.

• At 10 units, variable cost = $28 → MC = $2.80.

• At 20 units, MC = $2.00; at 30 units, $1.60; at 100 units, $8.00.

MC curve is U-shaped

• At low production, inefficiency → high MC.

• At moderate levels, efficiency rises → MC falls.

• At high levels, resources get overused → MC rises again

Reasoing for U-shaped MC curve

Diminishing returns to variable inputs (labor becomes less productive at higher quantities)

Average total cost (ATC)

total cost ÷ quantity

Average variable cost (AVC)

variable cost ÷ quantity

ATC starts high

falls as fixed costs are spread out, then rises again

AVC always lies below ATC

because ATC includes fixed costs

MC intersects

ATC and AVC at their minimum points

When MC < ATC

average cost falls

When MC > ATC

average cost rises

In the long run

All costs are variable

Economies of scale

Long-run ATC decreases as output increases

Average costs key concept

Firms seek the lowest point on the ATC curve for efficiency

Perfect competition has three conditionsa

• Many small buyers and sellers.

• Identical products.

• No barriers to entry or exit.

Firms are price takers

No control over price; they must accept the market equilibrium price

Individual firm demand curve

is perfectly elastic (horizontal)

Marginal revenue (MR)

Change in total revenue ÷ change in quantity

In perfect competition

MR = Price

Profit maximization rule

• Produce where MR = MC.

• In perfect competition → P = MR = MC

Perfect Competition and Marginal Revenue Example

• Market price = $4 per pack.

• MR = $4 for each unit.

• Profit is maximized where MC = $4 (80 units).

If MR > MC

produce more

If MR < MC

produce less

Optimal output

where MR = MC

Economic profit formula

Profit = (Price − ATC) × Quantity

P > ATC

Economic profit

P = ATC

Break even (zero economic profit)

P < ATC

Economic loss

Profits in the Short Run Example

• P = $4, ATC = $3.30, Q = 80 → Profit = $56.

• If price drops to $2.60 → Loss = −$36.

P > AVC

Even with losses, firms may keep operating (covering variable costs)

P < AVC

shut down immediately (losing on every unit)

Sunk costs

are paid and can’t be recovered → ignore them

Shutdown point

P = AVC

AVC ≤ P < ATC

Operate with loss

If firms earn economic profits

New firms enter, shifting supply right, lowering prices until P = ATC

If firms suffer losses

Firms exit, shifting supply left, raising prices until P = ATC

Long-run equilibrium

• Firms earn zero economic profit (normal profit).

• Still positive accounting profits (covering all opportunity costs)

Profits in the Long Run Result

Perfectly competitive markets always move toward P = MC = ATC

Long-run supply curve

Horizontal (perfectly elastic) at break-even price

If anyone can do it

you can’t make money at it in the long run

Why perfect competition matters

It ensures maximum efficiency

Productive efficiency

• Goods produced at lowest possible cost.

• Firms continually cut costs; entry drives prices down.

Allocative efficiency

• Resources allocated to goods most valued by consumers.

• Occurs when P = MC.

• Consumers’ willingness to pay (P) equals society’s cost of production (MC).

Perfect Competition and Efficiency Result

• Total economic surplus maximized.

• No deadweight loss.

• Firms produce what consumers want at minimal cost.

Perfect competition is a benchmark model

not always realistic, but a standard for measuring market performance