ECON:3350:INDUSTRY ANALYSIS: BROOK

Chapter

Competitive Firm and Market

Behavior
Perfect Competition
Perfectly competitive market structure contains the following characteristics. First, many
firms exist in the market, with no firm being able to influence the industry price. Another
way to think about this is that economies of scale are small relative to the size of the
market. Consequently, the size of the market is large with each consumer demanding a small
percentage of total demand. Second, the perfectly competitive industry produces a
homogenous or standardized product. The interpretation of homogeneous output is that
consumers cannot distinguish between products produced by different firms. Third, the
perfectly competitive market has complete information, so all firms are fully informed about
production techniques, and consumers are fully aware of substitutes. As a corollary to this
characteristic, I will state that each firm has identical production costs. This just makes some
of the analysis easier, although the results are basically the same, even if each firms cost are
different. Fourth, the market contains no barriers to entry or barriers to exit.
As a result of the first three characteristics, firms in a perfectly competitive market act or
behave as price-takers. What this means is that firm believe that no matter how much they
sell or buy, they do so without affecting the market price.
Can you think of an example of a market that exhibit the four characteristics listed out
above? Let me know what you have come up with: stacey-brook@uiowa.edu. I will give
you a few suggestions later, but I want you to think about this. Let's see what we come up
with, and see if the suggestions meet all of the perfectly competitive characteristics.
Benefits of the Perfectly Competitive Model
Given the few examples of perfectly competitive markets, why spend any time at all on this
type of market structure? Good question. The answer lies in that perfect competition is the
easiest of the market structure models to start out with. In perfect competition, we can look
at the principles and ideas that cover most aspects of market structure, without adding too
much initial complexity. Then we will determine how much output the firm produces,

ECON:3350:INDUSTRY ANALYSIS: BROOK

whether the firm should produce that amount of output and whether the firm makes a profit
or a loss.
I like to liken starting with the competitive model in economics, as starting in physics with
the analysis of a world with no friction. Do we exist in a world with no friction? No. But
starting from this point, much of the principle ideas in physics are easier to see, and then
friction is added, to make the model much more representative to the world in which we live
in. In the same way, we will start with the competitive model first, and then add some
friction (price setting) behavior to make our market models more realistic.
Demand as faced by the Perfectly Competitive Firm
In the characteristics given above, we said that perfectly competitive firms act as price
takers. In other words, regardless of how much the firm sells, the firm has no ability to
charge a price other than the current market price. With that in mind, what do you think the
demand curve as faced by the perfectly competitive firm would look like on a graph, with
price (P) on the vertical axis and quantity (Q) on the horizontal axis?
Would it be downward-sloping? No. Why not? Well a downward-sloping curve, (reading
from left to right), refers to a relationship between price and quantity that is negatively
related. But our characteristic of the perfectly competitive market says that price is the same
from the viewpoint of the perfectly competitive firm no matter how much output the firm
produces. So downward-sloping from left to right is eliminated. For our analysis, demand
curves are not upward-sloping, reading from left to right.
On a graph, with price (P) on the vertical axis and quantity (Q) on the horizontal axis, the
demand curve as faced by a perfectly competitive firm is horizontal, or perfectly
elastic. Why? Well let's think about it. The demand curve as faced by the perfectly
competitive firm is a relationship between the amount of output that is demanded by
consumers (Q), and the price that it sells the output (P). If the firm behaves as selling the
output for the same price, no matter what amount of output it produces, then charting this
out results in the following hypothetical table:
Price (P) Quantity (Q)
$10
0
$10
1
$10
2
$10
3
$10
4
Thus on a graph, the demand curve as faced by the perfectly competitive firm is horizontal,
parallel to the horizontal axis, or the demand curve as faced by the perfectly competitive firm
is perfectly elastic.
The demand curve as faced by a perfectly competitive firm is perfectly elastic, and therefore
we concluded that the demand curve was equal to price, and was equal to average revenue,
and equal to marginal revenue. About now you might be thinking, "No offense Dr. Brook,

ECON:3350:INDUSTRY ANALYSIS: BROOK

but I do not believe you." What? OK, let's try an example to work us through the story of
why price = average revenue = marginal revenue in the perfectly competitive market.
Total revenue (TR) is defined as the amount you sell (Q) times the price at which you sell it
(P), so TR = P*Q. Average revenue (AR) is then total revenue divided by quantity, or AR =
TR / Q. Finally marginal revenue (MR) is the additional revenue from producing additional
output, or MR = TR / Q. For this class, let's just think of the additional output as equal
to 1, so that marginal revenue is just the change in total revenue. So with these definitions in
hand, let's suppose that the perfectly competitive price is $10, and let's calculate Total
Revenue, Average Revenue, and Marginal Revenue.
Price
(P)
$10
$10
$10
$10
$10

Quantity
(Q)
0
1
2
3
4

Total
(TR)

Revenue Average
(AR)
$0
$10
$20
$30
$40

Revenue Marginal
(MR)
$10
$10
$10
$10
$10

Revenue
----$10
$10
$10
$10

The relationship of price equaling marginal revenue is very helpful, but only occurs in
models that uses price taking behavior, such as the perfectly competitive model.
The Four Key Questions
The key questions are:
1. How much should the firm produce in order to maximize profits? (i.e. we are trying to
figure out Q*)
2. What is the profit-maximizing price?

(i.e. we are trying to figure out P*)

3. Should the firm produce Q* or should the firm shut down?

4. Did the firm make a profit or a loss, or did the firm break-even?
The good news is that we will have simple rules to determine the answers to these
questions.
Short-Run Profit Maximization or Loss Minimization
Now, knowing that the firm must equate its MR and its MC to maximize its profits we can
start answering each of the four questions above.
Solving for the profit maximizing level of output (Q*) Question #1
I just showed you that for the perfectly competitive firm, that price and marginal revenue are
the same. Thus P = MR. Since profit maximization is where MR = MC, I can substitute
3

ECON:3350:INDUSTRY ANALYSIS: BROOK

price for marginal revenue (MR) in the previous equation to end up with P = MC. This is
referred to as marginal cost pricing. On a graph, with price (P) on the vertical axis and
quantity (Q) on the horizontal axis, the demand curve as faced by a perfectly competitive
firm is perfectly elastic (horizontal) and the marginal cost shaped as discussed in chapter one,
the profit maximizing level of output (Q*) is the point where price and marginal cost cross
each other. Find the point on your graph, and draw a dashed line directly down to the
horizontal axis. This is the profit maximizing level of output. Neat eh? Our rule to
determine Q* is, in perfect competition: Set price equal to marginal cost, or I will just type it
out as P = MC.
Solving for the profit maximizing price (P*) (Question #2)
OK. In the perfectly competitive case, this is easy. The profit maximizing price is the
market given price. For later market structures, we will have to solve for P*, but in perfect
competition, P* is given. On a graph, with price (P) on the vertical axis and quantity (Q) on
the horizontal axis, the demand curve as faced by a perfectly competitive firm as perfectly
elastic (horizontal), P* is where the perfectly elastic demand curve crosses the vertical axis.
Solving for the profit/loss (Question #4)
I know, I skipped question #3. I am just too impatient and cannot wait to find out whether
this firm is making a profit or a loss. No, actually, I do this for a reason, which may or may
not be apparent when we get to the third question.
Profits, which I denote as , is the difference between total revenue (TR) and total cost
(TC). As an equation, = TR - TC. We can also write this equation as: = [P * Q] - [ATC
* Q], since total revenue = P * Q, and ATC = TC / Q, so multiplying ATC by Q yields TC,
which is what we started with.
Since, = [P * Q] - [ATC * Q], we can factor out a Q from the right hand side of the
equation, which leaves us with = [P - ATC] * Q. Now we have an equation that we can
use, since all of the information in the profit equation in bold, is found on our graph. Let's
check: P, yes! (it is the demand curve), ATC, yes! once we draw the curve on the graph of
the form talked about in the last chapter and Q, yes!, in fact we have one unique Q, which
we solved for in question #1, which is denoted as Q*. Notice, that the firm cannot produce
a negative output (i.e. Q* cannot be negative), thus if P > ATC, the firm is making an
economic profit, if P < ATC, the firm is making a loss, and if P = ATC, the firm is making
zero economic profits. Thus our rule to determine if the firm is making a profit is to
compare price and ATC.
In summary the rule in regard to profit is: if P > ATC then firm is making a profit; if P <
ATC then firm is making a loss; if P = ATC then firm is making zero profit.
So armed with our perfectly competitive firm information we can run through three (3)
scenarios. They are: firm makes a profit, firm makes a loss, and the firm makes zero
economic profit, (accounting profit = opportunity cost).

ECON:3350:INDUSTRY ANALYSIS: BROOK

Let's start out with the firm making a profit. On a graph, with price (P) on the vertical axis
and quantity (Q) on the horizontal axis, the demand curve as faced by a perfectly
competitive firm is perfectly elastic (horizontal), the marginal cost curve is shaped like a
check-mark, and the ATC curve is U-shaped, and remember that the marginal cost curve
crosses the minimum of the ATC curve. In order for the firm to make a profit, at the profitmaximizing level of output (Q*) that we solved for in Question #1, price must be greater
than ATC(Q*), which would read in words, the average total cost of producing the profit
maximizing level of output. An easy way to remember this on a graph for perfect
competition, and only for perfect competition, is if the ATC curve is below the demand
curve at any point, then the firm will make a profit, assuming it is maximizing its
profits. How? I knew you would want to know. On your graph, the first thing (always) that
you solve for is Q*. This is where the MC curve crosses the demand or price line. All of the
cost curves are in reference to the level of output at Q*!! So, if the ATC curve is below the
demand curve, then at the profit maximizing level of output, ATC(Q*) is less than P*. Thus
the firm is making a profit. How much? Well, our equation for profit is = [P - ATC] * Q,
so the term in brackets is average profit, times the amount demanded (Q*). Thus profit is
equal to the rectangle of length (Q*) times the height [P - ATC] on the graph.
Next, let's look at the perfectly competitive firm making a loss. On a graph, with price (P) on
the vertical axis and quantity (Q) on the horizontal axis, the demand curve as faced by a
perfectly competitive firm is perfectly elastic (horizontal), the marginal cost curve is shaped
like a check-mark, and the ATC curve is U shaped. To draw the firm making a loss, the
ATC curve must be above the demand curve at every point. If the firms per unit total costs
(ATC) are always greater than price, then the firm will be spending more to produce the
product than it will receive in selling the product. The loss by the firm will look on a graph
as the distance between ATC(Q*) and price, which is negative, times the amount produced
(Q*). It is again a rectangle solved exactly like at the end of the previous paragraph.
Our last scenario is the firm making zero economic profit. On a graph, with price (P) on the
vertical axis and quantity (Q) on the horizontal axis, the demand curve as faced by a perfectly
competitive firm would make zero economic profits if at its profit maximizing level of
output (Q*) the price set in the market is just equal to the firms ATC. This would happen if
the ATC just rested on the demand curve. (Think of it as a bowl placed on a flat
surface). Remember that the marginal cost curve crosses the minimum of the ATC, and
since the minimum of the ATC is "resting" on the demand curve, it is equal to the demand
curve. So at Q* (where P = MC), price also equals the minimum of ATC. Since P = ATC,
economic profits must be equal to zero.
Solving for shut-down case (Question #3)
OK. Now let's look at whether the firm should produce Q* or whether the firm should
shut-down. We again have three scenarios. The first scenario is quite simple to analyze. If
P > ATC, then the firm is making an economic profit, so the firm should produce Q*. The
next two will not be as trivial.
Suppose that the firm knows that if it produces, it will incur a loss. Should a firm always
shut-down (i.e. Q = 0) if it will make a loss? Well since we still have two scenarios, the

ECON:3350:INDUSTRY ANALYSIS: BROOK

answer must me no! In fact there are times when it is rational for a firm which forecasts a
loss to continue its operations in the short-run. So what is the dividing line to determine
whether the firm shuts down or produces?
Remember that a firms total cost is divided up into two main components, fixed cost and
variable cost? Great! The underlying idea if that a firm should continue to produce its
output if the firm losses are less than its total fixed costs. Another way of thinking about
this is if the firm can make enough in total revenue to cover its production costs. This is the
way we will look at the firm.
Our next two scenarios can be referred to as loss minimizing scenarios. If by producing the
firm loses less money than by shutting down, the firm should produce. For this to be true,
by producing if the firm can cover its per unit production costs (AVC) then the firm should
produce, even though it is making a loss, because its loss of producing is less than its loss of
not producing. On a graph, with price (P) on the vertical axis and quantity (Q) on the
horizontal axis, the demand curve as faced by a perfectly competitive firm is perfectly elastic
(horizontal), the marginal cost curve is shaped like a check-mark, and the ATC curve is Ushaped, and remember that the marginal cost curve crosses the minimum of the ATC curve,
and now finally, the AVC curve which is also U shaped, and below the ATC curve. Under
these two scenarios that follow, the ATC curve is always above the demand curve!
Scenario 2 is when the AVC curve is below the demand curve at any point. If the AVC
curve is below the demand curve, then the firm should produce, even if it is going to make a
loss. Why? If the AVC curve is below the demand curve, then at AVC(Q*), P > AVC. In
other words, the firm is covering its variable costs of production, and some of its fixed
costs. How do you show that on a graph? Well first solve for the profit maximizing level of
output (Q*). At Q*, the firm is making a loss of the rectangle [P - ATC] *Q. But in order to
determine with confidence why the firm should still produce, we need to compare the loss
of producing with the loss of not producing. The loss of not producing is just the firms
total fixed costs. Unfortunately we do not have total fixed costs on our graph. But we can
figure it out. Remember that ATC = AVC + AFC (average fixed cost). So the vertical
difference between the ATC and AVC curve is the AFC. At Q*, is the vertical distance
between ATC and AVC greater than the vertical distance between ATC and Price. Under
this scenario - yes. Thus the AFC and therefore the total fixed cost are greater than the
average loss and therefore the total loss to the firm. Thus the firm loses less money by
producing than by shutting down.
Scenario 3 is when the AVC curve is above the demand curve at every point. If the AVC
curve is above the demand curve, the firm should shut down, since the firm cannot cover
their per unit production costs (i.e. P < AVC). Why? First let's calculate the firm's loss of
producing Q*. It is the rectangle of length Q*, and height [P - ATC(Q*)], and this will be a
negative number. OK, since AFC is the difference between the ATC curve and the AVC
curve, notice on the graph that the distance between ATC and AVC is less than the distance
between ATC and P. You could interpret that as that AFC is less than the average loss of
producing. Multiplying AFC by Q* equals Total Fixed Costs, and Multiplying [P ATC(Q*)] by Q* equals the loss of producing. When the AVC curve is above the demand

ECON:3350:INDUSTRY ANALYSIS: BROOK

curve at every point, the firm incurs a greater loss by producing than by shutting
down. Thus if P < AVC, we conclude that the firm should rationally shut-down.
In summary: If P AVC, produce Q*, and if P < AVC, shut-down.
Key Questions and Solutions
Let's put our rules developed so far together with the four questions listed out above. I
think this summary will be very helpful, especially with the monopoly market structure to
follow.
1. How much should the firm produce in order to maximize profits? (i.e. we are trying to
figure out Q*) Rule: Set Price = Marginal Cost (only in perfect competition, otherwise set
marginal revenue = marginal cost).
2. What is the profit-maximizing price?
will have to solve for this in the future.

(i.e. we are trying to figure out P*) Given. We

3. Should the firm produce Q* or should the firm shut down? Yes, if P > AVC; No, if P
< AVC.
4. Did the firm make an economic profit or a loss, or did the firm break-even? Firm
makes an economic profit if P > ATC; firm makes an economic loss if P < ATC;
firm earns zero economic profit (break-even) if P = ATC.
Numerical Example
Suppose you were given the following information: the firms cost equation is C(Q) = 5 +
Q2, and the price = $20, what is the answer to each of the four questions above?
I will give the solution to the above problem in class, but I want you to use the material in
this chapter, and the math rules in order to come up with a solution for the four questions
listed out above.