Introduction to Economics

Lecture 3: Demand, Supply, and Market

(cont.)
Part 2: Price –taking and Competitive
Firms
Lecturer:
Dr. Nguyen Anh Phuong
PhD, MSc. BA, FHEA
Outline

1. Quiz and Exercises on Lecture 2

2. Revenues and Costs of Competitive Frims

3. Profit Maximisation

4. Short-run Decision to Shut Down and Long-run

Decision to Exit or Enter
Quiz and Exercises on Lecture 2

Please scan the QR code for the Quiz 2

What is a Competitive Market?

Perfectly competitive market:

1. Market with many buyers and sellers
2. Trading identical products
Because of the first two: each buyer and seller is a
price taker (takes the price as given)
3. Firms can freely enter or exit the market
4. Perfect information
5. Perfect mobility of production factors (labour, capital,
etc.)

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Demand Curve for a Competitive Firm
For a firm that is price taker, the demand curve it faces is
perfectly elastic, or horizontal.
On the other hand, the demand curve for a price maker is
similar to a market demand curve, downward sloping. They can
sell more by lower the price.

P P
Demand curve for a Demand curve for a
Price maker Price taker
D

D
Qty Qty
Revenue of a Competitive Firm

Total revenue, TR = P ˣ Q
Average revenue, AR = TR / Q
Marginal revenue, MR = ∆TR / ∆Q
Change in TR from an additional unit sold
For competitive firms
AR = P
MR = P

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Calculating TR, AR, MR

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Answers

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MR = P for a Competitive Firm

A competitive firm
Can keep increasing its output without affecting the
market price.
So, each one-unit increase in Q causes revenue to
rise by P, i.e., MR = P.
MR = P is only true for firms in competitive markets

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Costs of A Competitive Firm
Opportunity costs
Resources are limited, any decision to produce more of one
good means producing less of some other goods
“What could we have done instead of what we chose to do?”
Explicit/ Implicit costs
Explicit costs: What the firm actually pays for use of
resources in business (eg. Salary paid to workers, payments
for raw materials, etc.). These are payments to non-owners of
the firm.
Implicit costs: Opportunity costs of resources used but not
actually paid for by the firm (eg. proprietor's labour &
entrepreneurship, or invested money of business owner).
These are costs for self-owned or self-employed resources.

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Costs of A Competitive Firm

Accounting/Economic profits
Accounting Profit = total revenue - total explicit costs

Economic Profit = total revenue - implicit and explicit costs of

all the resources used by the firm

= total revenue - (total explicit costs + opportunity costs)

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Illustrative Example
COSTS OF RUNNING CAKE BUSINESS VND

Flour, eggs, sugar, other ingredients 10 million

Wages 2 million

Interest payments on loan to buy ovens 0.1 million

Electricity 0.8 million

Rental fee for store 0.5 million
Forgone salary 3 million
Forgone interest 0.2 million

- What are the explicit costs? What are the implicit costs?
- If the total revenue is 15 million, what is the accounting profit of this
business? What is the economic profit?

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Short-run Production & Long-run
Production
Short-run production: is the production in some period
of time that at least there is a fixed input.
The cake production after 1 year:
All ingredients (flour, eggs, sugar,…) & labour are variables
inputs.
Capital (oven, kitchen, and machine) is a fixed input…

Long-run production: is the production for some period

of time that all inputs are variable.
The cake production after 4 year:
Ingredients, labour and even capital are all variable
inputs.
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-
Production function in the short-run

Production function
In the short-run: K
Q = F(K,L)
(capital) is fixed, L
(labour and
ingredients) is variable.

Total product of labor = Total output = Q

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Total Cost in Short-run
Short-run total cost = Total fixed cost + Total variable cost
STC = TFC + TVC
- Fixed cost: a cost that does not vary with the level of output.
- Variable cost: a cost that varies as output varies.

Notice: fixed costs over a short time period can become

variable costs in long-run

Total cost function (SR): TC = FC + wL

(assume Labour (L) is the only variable cost, w: wages for
labour)

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Marginal Cost
Marginal cost (MC): increase in cost resulting from the
production of one extra unit of output.
MC = change in variable cost/ change in output
= change in total cost/ change in output
= ∆VC/ ∆Q
= ∆TC/ ∆Q
= derivative of TC function
𝜕𝑇𝐶
𝑀𝐶 =
𝜕𝑄

MC measures how much it will cost to expand

output by one unit.

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Average Total Cost, Average Fixed Cost &
Average Variable Cost
Average total cost (ATC): firm’s total cost divided by its level of
output.
ATC = TC/Q
Average fixed cost (AFC): is the fixed cost divided by the level of
output.
AFC = FC/Q
Average variable cost (AVC): is the variable cost divided by the
level of output.
AVC = VC/Q

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A firm’s short-run costs - Example
.Rate of Fixed Variable Total Marginal
AFC AVC ATC
Output cost cost cost Cost
0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5

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Profit Maximization for Competitive Firms

What Q maximizes a firm’s profit?

Think at the margin

If Q increases by one unit

Revenue rises by MR, cost rises by MC.

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 Profit Maximization for Competitive Firms

P Q TR TC MR MC Profit

$4 1 4 3 4 3 1

$4 2 8 5 4 2 3

$4 3 12 6.5 4 1.5 5.5

$4 4 16 8.5 4 2 7.5

$4 5 20 11 4 2.5 9

$4 6 24 14 4 3 10

$4 7 28 18.5 4 4.5 9.5

$4 8 32 24.5 4 6 7.5

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 Profit Maximization for Competitive Firms

Profit is going to be the highest where the difference between

TR and TC is the greatest.
The point at which MR is equal to MC is where the profit is
maximised (Q = 6).

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MC and the Firm’s Supply Decision

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MC and the Firm’s Supply Decision

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Shutdown vs. Exit

Shutdown:
A short-run decision not to produce anything
because of market conditions.

Exit:
A long-run decision to leave the market.

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Short-run Decision to Shut Down

In short run, if P < ATC:

Continue producing if P > AVC  at least cover some
of fixed costs.

Shut down if P < AVC; otherwise, the loss would be

even larger.

In the short run, fixed costs or sunk costs are

irrelevant because firms have to pay for them
whatsoever.

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Short-run Decision to Shut Down

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Long-run Decision to Exit or Enter

In long run, if P > ATC

Stay or enter the market
The entrance of new competitors drives P down to
where P = ATC  competitive firms can only make
normal profit (or zero economic profit).

In the long run, if P < ATC

Exit the market
The exits of competitors drives P up (as supply
decreases) until P = ATC  again, competitive
firms can only make normal profit.
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The Competitive Firm’s LR Supply Curve

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Long-Run Supply Curve

Long-run supply curve is horizontal if:

All firms have identical costs, and
And costs do not change as other firms enter or exit
the market
Long-run supply curve might slope upward if:
Firms have different costs
Or costs rise as firms enter the market

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The Zero-Profit Condition

Why do competitive firms stay in business if they make

zero profit?
Profit = total revenue – total cost
Total cost includes all implicit costs like the
opportunity cost of the owner’s time and money
Zero-profit equilibrium
Economic profit is zero
Accounting profit is positive

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Exercise: Identifying a firm’s profit

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Answer

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Exercise: Identifying a firm’s loss

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Answers

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Efficiency of a Competitive Market

Profit-maximization: Q where MC = MR
Perfect competition: P = MR
So, in the competitive equilibrium: P = MC
The competitive equilibrium is efficient
Maximizes total surplus because P = MC
MC is the cost of producing the marginal unit
P is value to buyers of the marginal unit

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Summary
A competitive firm is a price taker
Its revenue is proportional to the amount of
output it produces.
P = MR = AR
The firm’s marginal-cost curve is its supply
curve
Short run: a firm cannot recover its FC
Shut down temporarily if P < AVC
Long run: the firm can recover both FC and VC
Exit if P < ATC
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Summary
In a market with free entry and exit, profit is
driven to zero in the long run.
All firms produce at efficient scale, P = min ATC
The number of firms adjusts to satisfy the
quantity demanded at this price.

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Big Exercise

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References

Mankiw N. G. (2017) Principles of Economics, Cengage Learning, Boston.

The CORE Team (2018) The Economy, CORE Econ, Oxford.

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 Thank you

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