ECONOMICS

HSS 301 Lecture – 13

 Firms in
Competitive Markets
Features of a Perfectly Competitive Market

Many buyers and many sellers in the market

Goods offered by the various sellers are almost identical

Firms can freely enter or exit the market

Firms are price takers

 A Competitive Firm

• Like most other firms in the economy, a firm in a

competitive market tries to maximize profit

• Because the firm is small compared with the whole market,

it takes the price as given by market conditions. This means
that the price of the good does not depend on the number
of goods that a competitive firm produces and sells.
 The Revenue of a Competitive Firm

Competitive firm produces a quantity of ‘Q’, and sells each unit

at the market price, ‘P’.

Their total revenue, TR = P × Q

Average Revenue, AR = TR/Q = (P × Q)/Q = P
Marginal Revenue, MR = 𝑇𝑅 = 𝑃

N.B. here, P is constant. Thus d/dQ (P*Q) results P

The Revenue of a Competitive Firm

Average revenue tells us how much revenue a

firm receives for the typical unit sold

Marginal revenue tells us the change in total

revenue from an additional unit sold
 Demand curve facing a Competitive firm

• A single firm in the competitive environment is

insignificantly small compared to the whole market.
• It can’t change the market price to gain more profit. All the
quantity is demanded from this firm is at that exact price.
• So, the firm will face a demand curve which is
flat/perfectly elastic at the price line
• Therefore, P=MR=AR=D
 Demand curve facing a Competitive firm

• Here the demand curve

Price

faced by the competitive

firm is horizontal at the
market price ‘𝑷𝑴 ’.
𝑷𝑴
D • If the market price increases
or decreases, the demand
facing the competitive firm
will also shift up or down
Quantity
Profit Maximization for the
Competitive Firm

Let’s look at a simple numerical example

 Numerical Example of a dairy firm
producing gallons of milk
MR MC Change
Unit TR Profit
Quantity TC ∆𝑻𝑹 ∆𝑻𝑪 in Profit
Price (P*Q) (TR-TC) ( ) ( )
∆𝑸 ∆𝑸 (MR-MC)
0 6 0 3 -3
1 6 6 5 1 6 2 4
2 6 12 8 4 6 3 3
3 6 18 12 6 6 4 2
4 6 24 17 7 6 5 1
①mas 5 6 30 23 7 6 6 0
6 6 36 30 6 6 7 -1
7 6 42 38 4 6 8 -2
8 6 48 47 1 6 9 -3
• Since the dairy firm produces in a competitive market, unit price for milk
remains the same ($6) for any gallon of milk.
• Hence, marginal revenue (revenue from an extra gallon sold) is also $6 for
each gallon of milk
• Here change in profit is the change in revenue minus the change in cost,
which is MR-MC.
• MC is increasing with production while MR remains constant
• For the initial quantities of production (such as 𝑄 ), MR>MC (MC curve lies
below the MR curve). Thus, change in profit is positive.
• After a certain quantity of production, MC>MR (MC curve will rise above
the MR curve as it is increasing). Thus, change in profit becomes negative.
• Therefore, at a certain quantity MR=MC where the curves will intersect. At
that exact quantity change in profit is 0. That will be the profit maximizing
quantity, 𝑄 . Increasing or decreasing production from that point will
only bring less profit.
Profit Maximization of the Dairy Firm

As long as marginal revenue

exceeds marginal cost
(MR>MC at 𝑄 ), increasing
the produced quantity raises
profit.

If MR<MC (at 𝑄 ), the firm

should decrease production.

At the profit-maximizing
level of output (𝑄 ),
MR=MC
Profit Maximizing Condition

• Profit is maximized at the output where, MR=MC

• For a competitive firm, MR=P
• So, we can say, profit maximizing condition for a
competitive firm is P=MC

• If P>MC, the firm should increase production

• If P<MC, the firm should decrease production
 When market price increases or
decreases, how does firm’s production
decision change? How much should it
produce at a higher or lower price?
 Change in Market Price &
Competitive Firm’s Production Decision
When market price rises to
Price

MC
𝑷𝟏 from 𝑷𝟎 , profit maximization
condition requires that firm
𝑷𝟏 𝑫𝟏 should increase production
from 𝑸𝟎 to 𝑸𝟏 (𝑷𝟏 =MC at 𝑸𝟏 )
𝑷𝟎 𝑫𝟎
Similarly, the firm should
𝑷𝟐 𝑫𝟐 produce 𝑸𝟐 amount of the
product when its market price
falls to 𝑷𝟐 . (𝑷𝟐 =MC at 𝑸𝟐 )
𝑸𝟐 𝑸𝟎 𝑸𝟏 Quantity
 Marginal Cost Curve and the Firm’s
Supply Decision

• When price of the product rises, quantity produced by the

firm also increases. When market price falls, quantity
produced decreases. Which means Quantity has a positive
relationship with price.
• Do you see something familiar here???
• This is the exact relation we found from the law of supply &
in the supply curve.
• Therefore, we can come to an understanding that MC curve is
in fact the firm’s supply curve.
• In essence, the firm’s MC curve determines the quantity of the
good the firm is willing to supply at any price.
 Competitive Firm’s Profit

Price, costs
Profit = TR - TC.
= (TR/Q - TC/Q) × Q MC
= (P - ATC) × Q ATC
𝑷𝟎
• The firm produces 𝑸𝟎 at Profit D
which P=MC ATC
for 𝑸𝟎
• TR= 𝑷𝟎 × 𝑸𝟎 ; TC= ATC× 𝑸𝟎
• Profit= (𝑷𝟎 -ATC) × 𝑸𝟎 , which
is shown by the green area.
𝑸𝟎 Quantity
The Firm’s Short-Run Decision to
Shut Down

• A shutdown refers to a short-run decision not to

produce anything during a specific period of time.

• This decision arises because firms can’t avoid their

fixed costs in the short run. Such fixed costs are
said to be sunk cost. (a cost that has already been
committed and cannot be recovered)
 Case - 2
Profit maximizing quantity is 40 (because P=MC is at Q=40)
If the firm stays operational (Q=40), If the firm shuts down (Q=0),
TR = $ 15 × 40 = $ 600 ;[P=15] TR = $ 15 × 0 = $ 0
TC = $ 25 × 40 = $ 1000 ;[ATC=25] VC = $ 20 × 0 = $ 0
VC = $ 20 × 40 = $ 800 ;[AVC=20] FC = $ 200 (sunk cost)
FC = (1000-800) = $ 200 TC = $ 200 (VC+FC)
Loss = (1000-600) = $ 400 Loss = (200-0) = $ 200

In this case, staying operational creates greater loss. So, the firm
should shut down to cut off excessive variable cost.
• Let’s analyze two cases.
• The firm is making losses in both cases.
• Should they continue their production incurring the
losses or,
• Should the shut down their operations?
• What should be the condition for shutting down?
 Case - 1 Case - 2
P, MC,

P, MC,
ATC

ATC
MC ATC MC ATC
ATC=25
ATC=25 AVC Loss AVC
Loss
𝑷=20 AVC=20
D
AVC=15 𝑷=15
D

𝑸=50 Quantity 𝑸=40 Quantity

 Case - 1
Profit maximizing quantity is 50 (because P=MC is at Q=50)
If the firm stays operational (Q=50), If the firm shuts down (Q=0),
TR = $ 20 × 50 = $ 1000 ;[P=20] TR = $ 20 × 0 = $ 0
TC = $ 25 × 50 = $ 1250 ;[ATC=25] VC = $ 15 × 0 = $ 0
VC = $ 15 × 50 = $ 750 ;[AVC=15] FC = $ 500 (sunk cost)
FC = (1250-750) = $ 500 TC = $ 500 (VC+FC)
Loss = (1250-1000) = $ 250 Loss = (500-0) = $ 500

In this case, shutting down creates greater loss. So, the firm should
stay operational to cut off some of the fixed cost.
 Case - 2
Profit maximizing quantity is 40 (because P=MC is at Q=40)
If the firm stays operational (Q=40), If the firm shuts down (Q=0),
TR = $ 15 × 40 = $ 600 ;[P=15] TR = $ 15 × 0 = $ 0
TC = $ 25 × 40 = $ 1000 ;[ATC=25] VC = $ 20 × 0 = $ 0
VC = $ 20 × 40 = $ 800 ;[AVC=20] FC = $ 200 (sunk cost)
FC = (1000-800) = $ 200 TC = $ 200 (VC+FC)
Loss = (1000-600) = $ 400 Loss = (200-0) = $ 200

In this case, staying operational creates greater loss. So, the firm
should shut down to cut off excessive variable cost.
 • 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
Shut Down that it would earn from producing is less
Condition than its variable costs of production
• Firm should Shut down if
TR < VC
TR/Q < VC/Q
P < AVC
(if price less than average variable cost)
Firm’s Short Run Supply curve is the portion of
its MC curve lying above its AVC Curve

• We have concluded that a competitive firm will

continue production as long as P>AVC. Whenever
P<AVC, the firm will shut down its operations.
• This implies that the firm will not produce any
quantity below its AVC. For any price below the
AVC, quantity produced is 0.
• Therefore, firm’s short run supply curve will be the
portion of MC curve which is above its AVC
Firm’s Short Run Supply curve is the portion
of its MC curve lying above its AVC Curve
Mo AVC Curre 5 P
=

eter firm shutdown z

Price, Costs
MC
zher ore's Root
supply
AVC TE U

Quantity
Entry & Exit Decision in the Long Run

• In the long run, there is no sunk cost (fixed cost). All

costs are variable.
• Exit means shutting down production & leaving the
business altogether.
• If the firm exits, it will lose all revenue from the sale of
its product, but now it will save not only its variable
costs of production but also its fixed costs.
• Thus, the firm exits the market if the revenue it would
get from producing is less than its total cost of
production.
 short run > TC = Ve + FC

long nun > T =

VC Writing mathematically,
· " ATC=AVc the firm will exit if:
𝑇𝑅 < 𝑇𝐶

Exit Rule 𝑇𝑅 𝑇𝐶
<
222 long 55 AT=AVC
run 𝑄 𝑄
& fir get exit condition :
,
𝑷 < 𝑨𝑻𝑪
P ATC Ein
exit condition
short run5 shutdown condition :
P AVe
 A parallel analysis applies to an
entrepreneur who is considering
starting a firm. He will enter the
market if starting the firm would be
profitable, which occurs if the price
Entry Rule of the good exceeds the average
total cost of production. The entry
rule is:

𝑷 > 𝑨𝑻𝑪
 Competitive Firm’s Long-run Supply

• If the price is less than the

Price, Costs

MC
average total cost at that
quantity, the firm chooses to
exit (or not enter) the market.
ATC
• Therefore, the competitive
firm’s long-run supply curve
is the portion of its marginal-
cost curve that lies above the
average-total-cost curve.

Quantity
 Competitive Firm Earns Zero
Economic Profit in the Long Run

• A market begins in long run equilibrium earning 0 economic profit

• Increase in demand raises the market price.
• Since P>ATC, the firm is earning a positive economic profit.
• Profits induce entry of new firms in this market. (no. of sellers
increase)
• Thus, market supply increases resulting a decrease in market price.
• Falling market price again equals firm’s average cost (P=ATC).
• As the short run economic profit diminishes, new firm’s entry
stops. This is how, in the long run, firms earn zero economic profit.