Firms in Competitive Markets

FIRMS IN COMPETITIVE MARKETS

Chapter Objectives (1 of 2)

• By the end of this chapter, you should be able to:

  • Graph a firm's supply curve for a good, given a graph of a competitive firm's marginal cost curve.

  • Describe the characteristics of a perfectly competitive market.

  • Identify a market as perfectly competitive, monopolistically competitive, monopolistic, or oligopolistic.

  • Given the market price of a good, compute a competitive firm's average revenue at various quantities.

  • Compute a competitive firm's marginal revenue at various quantities using the market price of a good.

Chapter Objectives (2 of 2)

• By the end of this chapter, you should be able to:

  • Determine the profit-maximizing outcome of a competitive firm using the market price and the firm's production costs.

  • Determine the shutdown price in the short run for a competitive firm, given a graph of the firm's production costs.

  • Indicate the area on a graph that represents a competitive firm's profit or loss.

  • Given a graph of a competitive firm’s marginal cost curve, derive the firm’s supply curve for that good.

  • Explain why the long-run supply curve in a competitive market is more elastic than the short-run supply curve.

The Meaning of Competition

• Competitive market: A market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.

• Characteristics:

  • The market has many buyers and many sellers.

  • Goods offered by the various sellers are identical.

  • Firms can freely enter or exit the market.

The Revenue of a Competitive Firm (1 of 2)

• The firm aims to maximize profit.

• Average revenue: Total revenue divided by the quantity sold.

• Marginal revenue: Change in total revenue from an additional unit sold.

The Revenue of a Competitive Firm (2 of 2)

• For all types of firms, average revenue equals the price of the good.

• For competitive firms:

  • Total revenue is given by the formula: TR = P imes Q where P is fixed.

  • When quantity (Q) rises by 1 unit, total revenue rises by P dollars.

  • Therefore, marginal revenue equals the price of the good.

Table 1 Total, Average, and Marginal Revenue for a Competitive Firm

Rules for Profit Maximization (1 of 2)

• Goal of a firm:

  • Maximize profit: Profit = TR - TC

• Where:

  • Total Revenue (TR) = Price (P) × Quantity (Q)

  • Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

• To find optimal quantity (Q), compare marginal revenue (MR) and marginal cost (MC) of each unit produced:

  • If MR > MC, the firm should increase its output.

  • If MC > MR, the firm should decrease its output.

  • At the profit-maximizing level of output, MR = MC.

Rules for Profit Maximization (2 of 2)

• The marginal-cost curve:

  • Determines the quantity of the good the firm is willing to supply at any price.

  • It is also the firm’s supply curve.

Table 2 Profit Maximization: A Numerical Example

Figure 1 Profit Maximization for a Competitive Firm

• The figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-variable-cost curve (AVC).

• It also shows the market price (P), which for a competitive firm equals both marginal revenue (MR) and average revenue (AR).

• At quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production increases profit.

• At quantity Q2, marginal cost MC2 is above marginal revenue MR2, thus reducing production increases profit.

• The profit-maximizing quantity, Q_{MAX}, is found where the horizontal line representing price intersects the marginal-cost curve.

The Marginal-Cost Curve and the Firm’s Supply Decision

• The marginal-cost curve is upward sloping.

• The average-total-cost (ATC) curve is U-shaped.

• The marginal-cost (MC) curve intersects the ATC curve at the minimum of the ATC curve.

• At equilibrium in a perfectly competitive market: P = AR = MR.

Figure 2 Marginal Cost as the Competitive Firm’s Supply Curve

• An increase in price from P1 to P2 leads to an increase in the firm’s profit-maximizing quantity from Q1 to Q2.

• The marginal-cost curve shows the quantity supplied at any price, making it the firm’s supply curve.

The Firm’s Short-Run Decision to Shut Down

• Shutdown: A short-run decision not to produce anything during a specific period due to current market conditions.

• The firm must still pay fixed costs.

• Exit: A long-run decision to leave the market, where the firm has zero costs.

Shut Down

• Cost of shutting down:

  • Revenue loss: TR

• Benefit of shutting down:

  • Cost savings: VC

• The firm’s short-run decision rule:

  • Shut down if: TR < VC (or P < AVC).

  • The short-run supply curve consists of the portion of its marginal-cost curve above the average-variable-cost curve (AVC).

Figure 3 The Competitive Firm’s Short-Run Supply Curve

• In the short run, the competitive firm’s supply curve includes only the part of its marginal-cost curve (MC) that lies above its average-variable-cost curve (AVC).

• If the price falls below average variable cost, the firm is in a better position to temporarily shut down.

Spilt Milk and Other Sunk Costs

• Sunk cost: A cost that has already been committed and cannot be recovered; it should be ignored when making decisions.

• In the short run, fixed costs are considered sunk costs.

• Fixed costs should not factor into the decision to shut down.

The Firm’s Long-Run Decision to Exit or Enter a Market

• Cost of exiting the market:

  • Revenue loss: TR

• Benefit of exiting the market:

  • Cost savings: TC

• The long-run decision rule:

  • Exit if: TR < TC (or P < ATC).

  • Enter if: TR > TC (or P > ATC).

• The long-run supply curve consists of the portion of its marginal-cost curve that lies above its average-total-cost curve (ATC).

Figure 4 The Competitive Firm’s Long-Run Supply Curve

• In the long run, the competitive firm’s supply curve includes the portion of its marginal-cost curve (MC) that lies above its average-total-cost curve (ATC).

• If the price falls below the average total cost, the firm should exit the market.

Measuring Profit in Our Graph for the Competitive Firm

• Maximizing profit: If P > ATC, the profit is given by: Profit = TR - TC = (P - ATC) imes Q.

• Minimizing losses: If P < ATC, the loss is given by: Loss = TC - TR = (ATC - P) imes Q.

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

• The shaded box between price and average total cost represents the firm’s profit.

• The height of this box equals price minus average total cost P - ATC, and the width equals the quantity of output Q.

• In panel (a), price exceeds average total cost, indicating positive profit; in panel (b), price falls below average total cost, resulting in a loss.

Table 3 Profit-Maximizing Rules for a Competitive Firm

1. Find quantity (Q) at which P = MC.

2. If P < AVC, shut down immediately and remain out of business.

3. If AVC < P < ATC, operate in the short run but exit in the long run.

4. If ATC < P, stay in business and enjoy your profits!

Active Learning 1: Identifying Profit or Loss

• Determine the firm’s profit or loss:

  • Calculate total revenue (TR), total cost (TC).

  • Calculate profit (or loss).

  • Identify the profit or loss area on the graph.

  • Should the firm shut down? $3

The Short Run: Market Supply with a Fixed Number of Firms

• Assumptions:

  • All existing firms and potential entrants have identical cost curves.

  • Each firm’s costs do not change as others enter or exit the market.

  • Number of firms: Fixed in the short run (due to fixed costs); variable in the long run (due to free entry and exit).

Short Run Market Supply Curve

• As long as P > AVC:

  • Each firm will produce its profit-maximizing quantity, where MR = MC.

  • For P > AVC, the supply curve is the marginal-cost curve.

Figure 6 Short-Run Market Supply

• In the short run, the number of firms in the market is fixed.

• Thus, the market supply curve reflects the sum of individual firms’ marginal-cost curves.

• In a market of 1,000 identical firms, the quantity of output supplied to the market is 1,000 times that of each firm’s output.

The Long Run: Market Supply with Entry and Exit (1 of 2)

• Markets allow entry and exit:

  • If P > ATC, firms realize positive profits, leading to new firms entering the market.

  • If P < ATC, firms incur losses, prompting exit from the market.

The Long Run: Market Supply with Entry and Exit (2 of 2)

• The entry and exit process continues until:

  • Remaining firms make zero economic profit, i.e., price equals average total cost.

• In the long run: P = min(ATC).

  • In the equilibrium of a competitive market, firms operate at their efficient scale.

Figure 7 Long-Run Market Supply

• In the long run, firms will adjust entry or exit until profit is driven to zero.

• Consequently, price equals the minimum of average total cost, ensuring market balance.

• The long-run supply curve is horizontal at this price point.

Why Do Competitive Firms Stay in Business If They Make Zero Profit?

• Profit is calculated as:

  • Total revenue - Total cost; total cost includes all opportunity costs.

• Zero-profit equilibrium:

  • Economic profit is zero; accounting profit remains positive.

A Shift in Demand in the Short Run and Long Run (1 of 2)

• In long-run equilibrium: P = min(ATC).

• When demand increases, demand curve shifts outward:

  • In the short run, results in higher quantity and higher price: P > ATC leading to positive economic profits.

A Shift in Demand in the Short Run and Long Run (2 of 2)

• In the long run:

  • Firms enter the market.

  • Short run supply shifts to the right.

  • Price decreases back to minimum ATC, quantity increases.

  • Due to easier entry and exit in the long run, the long-run supply curve is more elastic than the short-run.

Figure 8 An Increase in Demand in the Short Run and Long Run (1 of 3)

• Panel (a) exhibits a market in long-run equilibrium at point A, with each firm making zero profit and price equating to minimum ATC.

Figure 8 An Increase in Demand in the Short Run and Long Run (2 of 3)

• Panel (b) illustrates a short run response to increased demand from D1 to D2.

• Equilibrium transitions from point A to point B, with price rising from P1 to P2 and quantity sold in the market increasing from Q1 to Q2.

• Price exceeding ATC results in profits, attracting new firm entry.

Figure 8 An Increase in Demand in the Short Run and Long Run (3 of 3)

• Panel (c) indicates the effect of firm entry, shifting the short run supply curve right from S1 to S2.

• The new long-run equilibrium at point C shows price returning to P1 while quantity sold increasing to Q3.

• Profits revert to zero, with price aligning with minimum ATC, but market capacity grows to meet greater demand.

Why the Long-Run Supply Curve Might Slope Upward

• Long-run supply curve is typically horizontal if:

  • All firms have identical costs.

  • Costs remain constant with other firms entering/exiting the market.

• An upward slope may occur if:

  • Firms have differing costs.

  • Costs increase as firms enter the market.

Long-Run Supply Curve (1 of 2)

• Costs may rise as firms enter:

  • Some industries have limited supply of key inputs (e.g., fixed amount of land).

  • Entry of new firms raises demand for this input, consequently increasing its price, leading to higher costs for all firms.

• This necessitates a price increase to boost market quantity supplied, creating an upward-sloping supply curve.

Long-Run Supply Curve (2 of 2)

• Firms have different costs:

  • As price rises, lower-cost firms enter before higher-cost counterparts.

  • Further price hikes entice higher-cost firms to enter, again increasing market quantity supplied.

• Thus, the long-run market supply curve tends to slope upward.

Conclusion

• The tools that have been discussed in this chapter are also beneficial for analyzing firms in less competitive markets.

• The following chapter will delve into the behavior of firms with market power, applying marginal analysis with altered implications on production decisions and market outcomes.

Think-Pair-Share Activity

• A scenario where you and a friend ponder why Walmart operates at 2:00 a.m. despite low foot traffic:

  • A. Consider reasons Walmart stays open overnight.

  • B. Discuss the relevance of costs—including rent, equipment, fixtures, salaries—when making the decision to remain open at night.

  • C. If daytime customer numbers are low, contemplate Walmart's operational viability.

Self-Assessment

• Question: Are market supply curves typically more elastic in the short run or the long run? Explain your reasoning.

Summary

• Refer back to the link to review the objectives for this chapter presentation.