FIRMS IN THE

COMPETITIVE
MARKET
Jimenez|Lansang|Malabanan

What is a Competitive
Market?
a market with many buyers and sellers
trading identical products so that each buyer
and seller is a price taker
Characteristics:
There are many buyers and many sellers in the
market.
The goods offered by the various sellers are largely
the same.
Firms can freely enter or exit the market.

Result
The actions of any single buyer or seller
in the market have a negligible impact
on the market price.
Each buyer and seller takes the market
price as it given.

The Revenue of a
Competitive Firm
Total Revenue for a firm is the selling
price multiplied by the quantity sold.
TR = (P Q)
is proportional to the amount of
output.

Average Revenue vs. Marginal

Revenue
Average revenue tells us how much
revenue a firm receives for the
typical unit sold.
T o ta l re v e n u e
A v e ra g e R e v e n u e =
Q u a n tity
P ric e Q u a n tity

Q u a n tity
P ric e

Average Revenue vs. Marginal

Revenue
Marginal revenue is the change in
total revenue from an additional unit
sold.
MR =TR/ Q

Table 1 Total, Average, and Marginal

Revenue for a Competitive Firm

Copyright2004 South-Western

PROFIT MAXIMIZATION AND THE

COMPETITIVE FIRMS SUPPLY CURVE

TheTotal
goal of a
Revenue
competitive
firm is
Total Cost profit.
to maximize
_______________
Profit

Table 2 Profit Maximization: A Numerical

Example

Copyright2004 South-Western

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.

MC

MC2
ATC
P = MR1 = MR2

AVC

P = AR = MR

MC1

Q1

QMAX

Q2

Quantity
Copyright 2004 South-Western

PROFIT MAXIMIZATION AND THE

COMPETITIVE FIRMS SUPPLY CURVE
When MR > MC increase Q
When MR < MC decrease Q
When MR = MC Profit is
maximized.

Figure 2 Marginal Cost as the Competitive Firms

Supply Curve
Price

P2

This section of the

firms MC curve is
also the firms supply
curve.

MC

ATC
P1
AVC

Q1

Q2

Quantity
Copyright 2004 South-Western

The Firms Short-Run Decision to Shut

Down
A shutdown refers to a short-run
decision not to produce anything
during a specific period of time
because of current market
conditions.
Exit refers to a long-run decision to
leave the market.

The Firms Short-Run Decision to

Shut Down
The firm considers its sunk costs
when deciding to exit, but ignores
them when deciding whether to shut
down.
Sunk costs are costs that have already
been committed and cannot be
recovered.

The Firms Short-Run Decision to Shut

Down
The firm shuts down if the revenue it
gets from producing is less than the
variable cost of production.
o Shut down if TR < VC
o Shut down if TR/Q < VC/Q
o Shut down if P < AVC

Figure 3 The Competitive Firms Short Run Supply

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

Firms short-run
supply curve

MC

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

AVC

Firm
shuts
down if
P< AVC
0

Quantity

Copyright 2004 South-Western

Competitive Firms Short-run

Profit-Maximizing Strategy.
If the firm produces anything, it
produces the quantity at which
marginal cost equals the price of the
good. Yet if the price is less than
average variable cost at that
quantity, the firm is better off
shutting down and not producing
anything.

The Firms Long-Run Decision to Exit

or Enter a Market
In the long run, the firm exits if the
revenue it would get from producing
is less than its total cost.
o Exit if TR < TC
o Exit if TR/Q < TC/Q
o Exit if P < ATC

The Firms Long-Run Decision to Exit

or Enter a Market
A firm will enter the industry if such
an action would be profitable.
o Enter if TR > TC
o Enter if TR/Q > TC/Q
o Enter if P > ATC

Figure 4 The Competitive Firms Long-Run Supply

Curve
Costs
Firms long-run
supply curve
Firm
enters if
P > ATC

MC = long-run S

ATC

Firm
exits if
P < ATC

Quantity

Copyright 2004 South-Western

Competitive Firms Long-run Profit-Maximizing

Strategy.

If the firm is in the market, it

produces the quantity at which
marginal cost equals the price of the
good. Yet if the price is less than
average total cost at that quantity,
the firm chooses to exit (or not enter)
the market.

SUPPLY CURVE IN A COMPETITIVE

MARKET
Short-Run Supply Curve
The portion of its marginal cost curve
that lies above average variable cost.

Long-Run Supply Curve

The marginal cost curve above the
minimum point of its average total cost
curve.

MEASURING PROFIT IN OUR GRAPH

FOR THE COMPETITIVE FIRM
Profit TR - TC.
We can rewrite this definition by multiplying and
dividing the right-hand side by Q:
Profit =(TR/Q - TC/Q) Q
But note that TR/Q is average revenue, which is
the price P, and TC/Q is average total cost ATC.
Therefore,
Profit =(P- ATC) Q.
This way of expressing the firms profit allows us
to measure profit in our graphs.

Figure 5 Profit as the Area between Price and

Average Total Cost
(a) A Firm with Profits
Price
MC

ATC

Profit
P
ATC

P = AR = MR

Quantity
Q
(profit-maximizing quantity)
Copyright 2004 South-Western

Figure 5 Profit as the Area between Price and

Average Total Cost
(b) A Firm with Losses
Price

MC

ATC

ATC
P

P = AR = MR
Loss

Q
(loss-minimizing quantity)

Quantity
Copyright 2004 South-Western

THE SUPPLY CURVE IN A

COMPETITIVE MARKET
Short-Run Supply Curve
The portion of its marginal cost curve
that lies above average variable cost.

Long-Run Supply Curve

The marginal cost curve above the
minimum point of its average total cost
curve.

Figure 4 The Competitive Firms Long-Run Supply

Curve
Costs
MC
Firms long-run
supply curve
ATC

Quantity

Copyright 2004 South-Western

THE SUPPLY CURVE IN A

COMPETITIVE MARKET
Market supply is equal to the the
sum of the quantities supplied by the
individual firms in the market.

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 reflects the
individual firms marginal cost
curves.

Figure 6 Market Supply with a Fixed Number of Firms

(a) Individual Firm Supply

(b) Market Supply

Price

Price

MC

Supply

$2.00

$2.00

1.00

1.00

100

200

Quantity (firm)

100,000

200,000 Quantity (market)

Copyright 2004 South-Western

The Long Run: Market Supply

with Entry and Exit
Firms will enter or exit the market
until profit is driven to zero.
In the long run, price equals the
minimum of average total cost.
The long-run market supply curve is
horizontal at this price.

Figure 7 Market Supply with Entry and Exit

(a) Firms Zero-Profit Condition

(b) Market Supply

Price

Price

MC
ATC
P = minimum
ATC

Supply

Quantity (firm)

Quantity (market)

Copyright 2004 South-Western

The Long Run: Market Supply with

Entry and Exit
At the end of the process of entry
and exit, firms that remain must be
making zero economic profit.
The process of entry and exit ends
only when price and average total
cost are driven to equality.
Long-run equilibrium must have firms
operating at their efficient scale.

If Competitive Firms Make Zero Profit,

Why Do They Stay in Business?
Profit = Total Revenue Total Cost
Total cost includes all the opportunity
costs found in the firm.
In the zero-profit equilibrium, the
firms revenue compensates the
owners for the time and money they
expend to keep the business going.

A Shift in Demand in the Short Run and

Long Run

An increase in the demand raises

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

An Increase in demand in the short

run and long run
(a) Initial Condition
Market

Firm
Price

Price

MC

ATC

P1

Short-run supply, S1
P1

Long-run
supply
Demand, D1

Quantity (firm)

Q1

Quantity (market)

An Increase in demand in the short run

and long run
(b) Short-Run Response
Market

Firm
Price

Price

Profit

MC

ATC

P2

P2

P1

P1

S1

A
D2

Long-run
supply

D1
0

Quantity (firm)

Q1

Q2

Quantity (market)

An Increase in demand in the short

run and long run
(c) Long-Run Response
Market

Firm
Price

Price

MC

ATC

P1

P2
P1

S1
S2
C

Long-run
supply
D2

D1
0

Quantity (firm)

Q1

Q2

Q3 Quantity (market)

Reasons why the long-run supply

curve might slope upward
Because some resources that are
used in production may be available
only in limited quantities.
Firms may have different costs.

 A Marginal Firm is a firm that would

exit the market if the price became
any lower.