FIRMS IN [Note to Production: Insert

chapter image, p. 280]

COMPETITIVE
MARKETS
Chapter 14

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 FIRMS IN COMPETITIVE MARKETS
 In this chapter, we examine the behaviour of competitive firms.
 A market is competitive if each buyer and seller is small
compared to the size of the market and, therefore, has little
ability to influence market prices.
 The goal of this chapter is to examine how firms make
production decisions in competitive markets.
 As a background for this analysis, we begin by considering
what a competitive market is.
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 WHAT IS A COMPETITIVE MARKET?
THE MEANING OF COMPETITION
 Competitive market is a market in which there are many
buyers and many sellers so that each has a negligible impact
on the market price (price takers).
 Three characteristics:
1. There are many buyers and many sellers in the market.
2. The goods offered by the various sellers are largely the same.
3. Firms can freely enter or exit the market.
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 WHAT IS A COMPETITIVE MARKET?
THE REVENUE OF A COMPETITIVE FIRM
 A firm in a competitive market tries to maximize profit,
which equals total revenue minus total cost.
P : Price
Q : Quantity
 TR : Total revenue

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 TABLE 14.1
Total, Average, and Marginal Revenue for a Competitive Firm

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 WHAT IS A COMPETITIVE MARKET?
THE REVENUE OF A COMPETITIVE FIRM (CONT’D)
 The fourth column in the table shows average revenue.
 Average revenue tells us how much revenue a firm receives
for the typical unit sold.
 Average revenue (AR) is the total revenue divided by the
quantity sold.

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 WHAT IS A COMPETITIVE MARKET?
THE REVENUE OF A COMPETITIVE FIRM (CONT’D)
 The fifth column in the table shows marginal revenue.
 Marginal revenue (MR) is the change in total revenue from
an additional unit sold.

 For competitive firms, marginal revenue equals the price of

the good.
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 Quick Quiz

1. A perfectly competitive firm 2. When a perfectly competitive firm

increases the quantity it produces and
a. chooses its price to maximize profits. sells by 10 percent, its marginal revenue
_________ and its total revenue rises by
b. sets its price to undercut other firms _________.
selling similar products.
a. falls; less than 10 percent
c. takes its price as given by market
conditions. b. falls; exactly 10 percent
d. picks the price that yields the largest c. stays the same; less than 10 percent
market share.
d. stays the same; exactly 10 percent

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE

 The goal of a firm is to maximize profit, which equals total

revenue minus total cost.
 Let’s examine how a competitive firm maximizes profit and
how that decision determines its supply curve.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
A SIMPLE EXAMPLE OF PROFIT MAXIMIZATION
 Let’s examine how the firm maximizes profit and how that
decision leads to its supply curve.
 The analysis of the firm’s supply decision starts with the
example in Table 14.2.

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 TABLE 14.2
Profit Maximization: A Numerical Example

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
A SIMPLE EXAMPLE OF PROFIT MAXIMIZATION
 One of the ten principles(CONT’D)
of economics in Chapter 1 is that
rational people think at the margin.
 If , then increase milk production.
 If , then decrease milk production.
 If , now the firm is maximizing profits.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE MARGINAL-COST CURVE AND THE FIRM’S SUPPLY
 To extend this analysis DECISION
of profit maximization, consider the
cost curves in Figure 14.1.
 The marginal-cost curve (MC) is upward sloping.
 The average-total-cost curve (ATC) is U-shaped.
 The MC crosses the ATC at the minimum of average total cost.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE MARGINAL-COST CURVE AND
THE FIRM’S SUPPLY DECISION (CONT’D)
 The figure also shows a horizontal line at the market price (P).
 The price line is horizontal because the firm is a price taker.
 For a competitive firm, the firm’s price equals both its average
revenue (AR) and its marginal revenue (MR).

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 FIGURE 14.1
Profit Maximization
for a Competitive Firm

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE MARGINAL-COST CURVE AND
THE FIRM’S SUPPLY DECISION (CONT’D)
 Three rules are key to rational decision making for profit maximization:
1. If marginal revenue is greater than marginal cost, the firm should
increase its output.
2. If marginal cost is greater than marginal revenue, the firm should
decrease its output.
3. At the profit-maximizing level of output, marginal revenue and
marginal cost are exactly equal.
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 FIGURE 14.2
Marginal Cost as the
Competitive Firm’s
Supply Curve

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN
 Under some circumstances, a firm will decide to shut down and not
produce anything at all.
 Shutdown versus exit:
 A shutdown refers to a short-run decision not to produce anything during a
specific period of time because of current market conditions.
 An exit refers to a long-run decision to leave the market.
 The short-run and long-run decisions differ because most firms cannot
avoid their fixed costs in the short run but can do so in the long run.
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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN
(CONT’D)
 What determines a firm’s shutdown decision?
 If the firm shuts down, it loses all revenue from the sale of its
product.
 At the same time, it saves the variable costs of making its product
(but must still pay the fixed costs).
 Thus, the firm shuts down if the revenue that it would earn from
producing is less than its variable costs of production.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S SHORT-RUN DECISION TO SHUT DOWN
(CONT’D)

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 FIGURE 14.3
The Competitive Firm’s
Short-Run Supply Curve

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
SPILT MILK AND OTHER SUNK COSTS
 Sunk cost is a cost that has already been committed and
cannot be recovered.
 Because nothing can be done about sunk costs, they can be
ignored when making decisions about various aspects of life,
including business strategy.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S LONG-RUN DECISION TO EXIT OR ENTER A
 If the firm exits, it againMARKET
will lose all revenue from the sale
of its product, but now it saves on both fixed and variable
costs of production.
 The firm exits the market if the revenue it would get from
producing is less than its total costs.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S LONG-RUN DECISION
TO EXIT OR ENTER A MARKET (CONT’D)

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S LONG-RUN DECISION
TO EXIT OR ENTER A MARKET (CONT’D)
 The exit price coincides with the minimum point on the
average-total-cost curve.
 The shutdown price coincides with the minimum point on
the average-variable-cost curve.

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
THE FIRM’S LONG-RUN DECISION
TO EXIT OR ENTER A MARKET (CONT’D)
 The firm will enter the market if it is profitable, which
occurs if the price of the good exceeds the average total cost
of production.
 The entry criterion is:

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 FIGURE 14.4
The Competitive Firm’s
Long-Run Supply Curve

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 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
MEASURING PROFIT IN OUR
GRAPH FOR THE COMPETITIVE FIRM
 It is useful to analyze the firm’s profit in more detail.

 This way of expressing the firm’s profit allows us to measure profit in

our graphs.
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