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Chapter 5

FIRMS IN COMPETITIVE MARKET

Competitive Market

1. Competitive Market

Competitive market
• a market with many buyers and sellers trading identical
products so that each buyer and seller is a price taker

• A competitive market = perfectly competitive market,

• 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.

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2. Competitive Firm

• Market’s quantity is Q, a firm’s quantity is q

• Market’s demand is D, a firm’s demand is d

• Marginal Revenue MR curve is a horizontal line at

the market price.

2. Competitive Firm

Market Firm

P P
S

(D) = AR = MR
PE

D
Q Q

Q P TR AR MR 6

1 5 5 5 5

2 5 10 5 5

3 5 15 5 5

4 5 20 5 5

5 5 25 5 5

6 5 30 5 5

7 5 35 5 5

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2. Competitive Firm

• Firm’s demand curve: is a horizontal line at the

market price.
▫ The company sells all products at a market price
of P, regardless of how much the firm’s production
level is.
▫ Firms do not want to sell products at prices lower
than P, but they can not sell products at prices
higher than P because no one want to buy them.
▫ Buyers do not want to buy at prices higher than P,
but they can not buy at prices lower than P

Short-run and Long-run

• Equilibrium
▫ Short run:
▫ The period of time is not enough for new firms enter
the market or the old one leaving the market.
• Production scale of each enterprise is unchanged.
• The number of enterprises in the industry remains
unchanged.
▫ Long run:
The period of time is enough for new firms enter the
market or the old one leaving the market
• Target of firms:
• Get the output that:
▫ Maximum profits
▫ Minimum losses

4. Choice of output in the short term

TR, TC
TC TR

Q
Q1 Q* Q2

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4. Choice of output in the short term

• Total profit:

∏ = TRQ – TCQ

∏max ó ∂∏/∂Q = 0
ó(TR – TC)’Q = 0
óMR – MC = 0
óMR = MC

Because: MR = P, so:
P = MR = MC

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The Marginal-Cost Curve and the Firm’s Supply Decision

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The Marginal-Cost Curve and the Firm’s Supply Decision

• If marginal revenue is greater than marginal

cost, the firm should increase its output.
• If marginal cost is greater than marginal
revenue, the firm should decrease its output.
• At the profit-maximizing level of output,
marginal revenue and marginal cost are exactly
equal.

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Distinguish between a temporary shutdown of a firm and

the permanent exit of a firm from the market
• A shutdown refers to a short-run decision not to produce
anything during a specific period of time because of cur-
rent market conditions.
• 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.
• Afirm that shuts down temporarily still has to pay its
fixed costs, whereas a firm that exits the market does not
have to pay any costs at all, fixed or variable.

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4. Choice of output in the short term

MR, MC, AC
MC

AC

P (D) = MR
AC

Q
Q1 Q* Q2

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Measuring Profit in Graph for the Competitive Firm

• Profit = TR – TC
ó Profit = (TR/Q - TC/Q) x Q.
óProfit = (P - ATC) x Q.

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Firm’s choice of output in the short term

MR, MC, AC Break-even point
(P = ACmin) MC
Shutdown Point
(P = AVCmin) AC

P1 (D) = MR1
P2 AVC
(D) = MR2
P3 (D) = MR3
P4 (D) = MR4
P5 (D) = MR5
Q
Q5 Q4 Q3 Q2 Q1

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Firm’s choice of output in the short term

• The quantity of products which firm maximize
profits and minimize losses: MR = MC = P

▫ If P > ACmin: firm get profits

▫ If AVCmin < P < ACmin: firm continue
producing althought it is lossed
▫ If P < AVCmin: firm shutdown
▫ At P = ACmin: break-even point
▫ At P = AVCmin: shutdown point

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The Firm’s Short-Run Decision to Shut Down

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The Firm’s Short-Run Decision to Shut Down

• Marginal Cost as the Competitive Firm’s Supply

Curve
An increase in the price from P1 to P2 leads to an
increase in the firm’s profit-maximizing quantity
from Q1 to Q2.
• Because the marginal-cost curve shows the quantity
supplied by the firm at any given price, it is the
firm’s supply curve.

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The Firm’s Short-Run Decision to Shut Down

• The firm shuts down if the revenue that it would
earn from producing is less than its variable
costs of production.

• Shut down if TR < VC.

ó TR/Q < VC/Q.
ó P< AVC.
The firm’s shutdown rule can be restated as: P <
AVC.

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The Firm’s Short-Run Decision to Shut Down

• A firm chooses to shut down if P of the good is less than
AVC of production.
• When choosing to produce, the firm compares P it receives
for the unit to AVC that it must incur to produce the unit.
• If P doesn’t cover the AVC, the firm is better off stopping
production altogether.
• The firm still loses money (because it has to pay fixed
costs), but it would lose even more money by staying
open.
• The firm can reopen in the future if conditions change so
that price exceeds average variable cost.

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The competitive firm’s short-run supply curve is the portion

of its marginal-cost curve that lies above average variable
cost.

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The Firm’s Long-Run Decision to Exit or Enter a Market

• A firm’s long-run decision to exit a market is similar to its
shutdown decision.
• If the firm exits, it will again 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.
• Exit if TR < TC ó ó TR/Q < TC/Q.
óP < ATC
• Enter if P > ATC.
• The competitive firm’s long-run supply curve is the portion
of its marginal-cost curve that lies above average total cost.

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In the long run, the competitive firm’s supply

curve is its marginal cost curve (MC) above average total
cost (ATC).

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The Firm’s Long-Run Decision to Exit or Enter a Market

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The Firm’s Long-Run Decision to Exit or Enter a Market

• The area of the shaded box between price and average

total cost represents the firm’s profit.
• The height of this box is price minus average total cost (P
2 ATC), and the width of the box is the quantity of output
(Q).
• In panel (a), price is above average total cost, so the firm
has positive profit.
• In panel (b), price is less than average total cost, so the
firm incurs a loss.

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The Firm’s 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.
▫ Exit if TR < TC
▫ Exit if TR/Q < TC/Q
▫ Exit if P < ATC

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The Firm’s Long-Run Decision to Exit or

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

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The Competitive Firm’s Long-Run Supply Curve

Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity

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THE SUPPLY CURVE IN A COMPETITIVE MARKET

• The competitive firm’s long-run supply curve is the

portion of its marginal-cost curve that lies above
average total cost.

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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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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 Q Quantity
(profit-maximizing quantity)

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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 Quantity
(loss-minimizing quantity)

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THE SUPPLY CURVE IN A COMPETITIVE MARKET

• Market supply equals the sum of the quantities

supplied by the individual firms in the market.

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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.

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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, price equals the minimum of average
total cost.
• The long-run market supply curve is horizontal at this
price.

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Market Supply with Entry and Exit

(a) Firm’s Zero-Profit Condition (b) Market Supply

Price Price

MC

ATC

P = minimum Supply
ATC

0 Quantity (firm) 0 Quantity (market)

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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.

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Why Do Competitive Firms Stay in Business

If They Make Zero Profit?
• Profit equals total revenue minus total cost.
• Total cost includes all the opportunity costs of the
firm.
• In the zero-profit equilibrium, the firm’s revenue
compensates the owners for the time and money they
expend to keep the business going.

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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.

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An Increase in Demand in the Short Run and Long Run

(a) Initial Condition

Firm Market
Price Price

MC ATC Short-run supply, S1

A
P1 P1 Long-run
supply

Demand, D1

0 Quantity (firm) 0 Q1 Quantity (market)

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An Increase in Demand in the Short Run and Long Run

(b) Short-Run Response

Firm Market
Price Price

Profit MC ATC S1
B
P2 P2
A
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Quantity (market)

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An Increase in Demand in the Short Run and Long Run

(c) Long-Run Response

Firm Market
Price Price

MC S1
ATC B S2
P2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market)

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Why the Long-Run Supply Curve Might

Slope Upward
• Some resources used in production may be available
only in limited quantities.
• Firms may have different costs.

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Why the Long-Run Supply Curve Might

Slope Upward
• Marginal Firm
▫ The marginal firm is the firm that would exit the market
if the price were any lower.

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Summary
• Because a competitive firm is a price taker, its
revenue is proportional to the amount of output it
produces.
• The price of the good equals both the firm’s average
revenue and its marginal revenue.

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Summary
• To maximize profit, a firm chooses the quantity of
output such that marginal revenue equals marginal
cost.
• This is also the quantity at which price equals
marginal cost.
• Therefore, the firm’s marginal cost curve is its supply
curve.

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Summary
• In the short run, when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily
if the price of the good is less than average variable
cost.
• In the long run, when the firm can recover both fixed
and variable costs, it will choose to exit if the price is
less than average total cost.

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Summary
• In a market with free entry and exit, profits are driven
to zero in the long run and all firms produce at the
efficient scale.
• Changes in demand have different effects over
different time horizons.
• In the long run, the number of firms adjusts to drive
the market back to the zero-profit equilibrium.

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