Perfect Competition
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14
Perfectly Competitive Market
•
•
•
•
•
Many buyers and sellers
Identical goods
Free entry/exit
No market power
Price takers
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Revenue of a Competitive Firm
TR = (P  Q)
• TR is proportional to the amount of output.
• Quick Quiz #1: When a competitive firm
doubles the amount it sells, what happens to the
price of its output and total revenue?
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Revenue of a Competitive Firm
• Average revenue = how much rev. firm receives
for typical unit sold
Total revenue
Average Revenue =
Quantity
Price  Quantity

Quantity
 Price
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The Revenue of a Competitive Firm
• Marginal revenue = change in TR from an
additional unit sold
MR =TR/ Q
• For competitive firms, MR = P
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Table 1 Total, Average, and Marginal Revenue for a
Competitive Firm
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Profit Maximization
• Firm’s goal is
to maximize
profit
• Firm will want
to produce at
the level that
maximizes the
difference
between TR
and TC
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PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE
• Profit maximization occurs at the quantity
where marginal revenue equals marginal cost.
• When MR > MC, increase Q
• When MR < MC, decrease Q
• When MR = MC, profit is maximized
• Add graph to your notes
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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
P = AR = MR
AVC
MC1
0
Q1
QMAX
Q2
Quantity
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Firm’s Short-Run Decision to Shut Down or
Exit
• Shutdown = short-run decision not to produce
anything during specific period of time b/c of
current market conditions
• Exit = long-run decision to leave market
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Firm’s 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 firm shuts down if the revenue it gets from
producing is less than the variable cost of production.
• Shut down if TR < VC
• Shut down if TR/Q < VC/Q
• Shut down if P < AVC
Add graph to your notes
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Figure 3 The Competitive Firm’s Short Run Supply Curve
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s 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
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Firm’s Long-Run Decision to Exit
• In the long run, the firm exits if the revenue it
would get from producing is less than its total
cost.
• Exit if TR < TC
• Exit if TR/Q < TC/Q
• Exit if P < ATC
Add graph to your notes
• Entrepreneur will enter market if P > ATC
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Figure 4 The Competitive Firm’s Long-Run Supply Curve
Costs
Firm’s long-run
supply curve
Firm
enters if
P > ATC
MC = long-run S
ATC
Firm
exits if
P < ATC
0
Quantity
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Figure 4 The Competitive Firm’s Long-Run Supply Curve
Costs
MC
Firm’s long-run
supply curve
ATC
0
Quantity
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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.
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Quick Quiz #2
• How does a competitive firm determine its
profit-maximizing level of output? Explain.
• When does a profit-maximizing competitive
firm decide to shut down?
• When does it decide to exit a market?
• Provide a graph that visually summarizes your
responses.
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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
0
Quantity
Q
(profit-maximizing quantity)
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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
0
Q
(loss-minimizing quantity)
Quantity
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The Short Run: Market Supply with a Fixed
Number of Firms
• Market supply equals the sum of the quantities
supplied by the individual firms in the market.
• 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.
Add graphs to your notes
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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
0
100
200
Quantity (firm)
0
100,000
200,000 Quantity (market)
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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, P = minimum ATC (efficient scale)
• Long-run market supply curve is horizontal at this
price.
• After process of entry and exit ends, remaining firms
must be making zero economic profit.
• Recall that total cost includes opportunity costs. In zeroprofit equilibrium, firm’s revenue compensates owners for
time and money they expend running business.
Add graphs to your notes
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Figure 7 Market Supply with Entry and Exit
(a) Firm’s Zero-Profit Condition
(b) Market Supply
Price
Price
MC
ATC
P = minimum
ATC
0
Supply
Quantity (firm)
0
Quantity (market)
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A Shift in Demand in the Short Run and
Long Run
• An increase in demand raises price and quantity
in the short run.
• Firms earn profits because price now exceeds
average total cost.
• Entry and exit occurs until firms are operating
back at efficient scale.
• Add graphs to your notes
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Figure 8 An Increase in Demand in the Short Run and Long
Run
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
Short-run supply, S1
A
P1
Long-run
supply
P1
Demand, D1
0
Quantity (firm)
0
Q1
Quantity (market)
Figure 8 An Increase in Demand in the Short Run and Long
Run
(b) Short-Run Response
Market
Firm
Price
Price
Profit
MC
ATC
P2
B
P2
S1
A
P1
P1
D2
Long-run
supply
D1
0
Quantity (firm)
0
Q1
Q2
Quantity (market)
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Figure 8 An Increase in Demand in the Short Run and Long
Run
(c) Long-Run Response
Market
Firm
Price
Price
MC
ATC
B
P2
S1
S2
C
A
P1
Long-run
supply
P1
D2
D1
0
Quantity (firm)
0
Q1
Q2
Q3 Quantity (market)
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Constant, Increasing, and
Decreasing Costs
•
Perfectly elastic long-run supply is good assumption for many industries; implies
constant costs across the industry
•
•
•
Some industries have increasing costs; as the industry expands, the price of
productive inputs increases due to increased demand for those inputs.
•
•
•
Each firm faces the same cost structure; perfectly elastic supply of inputs (i.e. agriculture,
bakeries, etc.)
ATC curve does not shift when firms enter or exit the industry
ATC curve shifts upwards as more firms enter the industry
i.e. beach front resort hotels that must compete for limited quantity of prime beachfront
property.
Some industries have decreasing costs: as the industry expands, the price of
productive inputs decreases due to economies of scale
•
•
ATC curve shifts downwards as more firms entire the industry
i.e. electric car industry; economies of scale in the production of lithium batteries lowers
input prices
• Revisit part (d) and (e) on the 2011 Form B FRQ. How would your
responses compare for a firm with constant costs, a firm with increasing
costs, and a firm with decreasing costs.
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Practice AP FRQ: 2011 Form B
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Quick Quiz!
• Martin Tomatoes is a perfectly competitive firm in the constant
cost industry for tomatoes. Currently, the company is operating
at an economic loss, but at a point where the price is greater
than average variable costs.
• Draw correctly labeled side-by-side graphs for the industry and for
Martin Tomatoes that show the current situation.
• Label the area of economic loss.
• Identify and explain why Martin Tomatoes should or should not shut
down.
• Explain what will occur in this market and to Martin Tomatoes after all
long-run adjustments are made.
• Graph the firm and Martin Tomatoes after all long-run adjustments have
taken place in the industry.
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