3/1/2023

Chapter 8: Competitive firms

and markets

The Assumptions of Perfect

Competition
Objective of Firm: Profit Maximization
◦ Firms select an output level so as to maximize profit, defined
as the difference between revenue and cost
Assumptions:
◦ Large number of buyers and sellers
◦ Perfect information
◦ Product Homogeneity
◦ Free Entry and Exit
◦ Transaction costs, the expenses of finding a trading partner and
completing the trade above and beyond the price, are low
◦ Identical firms (each firm has homogenous inputs and
production functions) (will relax this assumption in some
discussion)

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The Demand Curve for a Competitive Firm

Price taker – a firm that takes prices as given and does not expect its
output decisions to affect price
=>horizontal demand curve
Total revenue (TR) – price times the quantity sold
Average revenue (AR) – total revenue divided by output
Marginal revenue (MR) – the change in total revenue when there is a
one-unit change in output

The Competitive Firm’s

Demand Curve

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Profit Maximization: Output

Rules
A firm can use one of three equivalent output rules to
choose how much output to produce:

1. A firm sets its output where its profit is maximized

2. A firm sets its output where its marginal profit is zero
3. A firm sets its output where its marginal revenue equals
its marginal cost

Profit Maximization Output

Level

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Profit Maximization: Output

Rules
Mathematically, if we take the derivative of π(q) = R(q) – C(q) with
respect to output and set it equal to zero, we find:

In addition, sufficiency requires, that the second-order condition hold:

𝑑 2 𝜋(𝑞 ∗ )
<0
𝑑𝑞 2

That is, for profit to be maximized at 𝑞 ∗ ,when output is increased

beyond 𝑞 ∗ , marginal profit must drop (i.e. <0)

Profit Maximization: Shutdown

Rule
A firm shuts down only if it can reduce its loss by doing so
• Shutting down means that the firm stops producing (and thus
stops receiving revenue) and stops paying avoidable costs
• Only fixed costs are unavoidable because they are sunk costs
• Firms compare revenue to variable cost when deciding whether
to stop operating

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Short-Run Profit Maximization

(when there is a fixed cost)
Profit maximization in this class always refers to economic profit,
which is revenue minus cost
Maximizing profit involves two important questions:
1.Output decision: If the firm produces, what output level (q*)
maximizes its profit or minimizes its loss?
2.Shutdown decision: Is it more profitable to produce q* or to
shut down and produce no output?

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Short-Run Profit Maximization:

Total Curves

Short-Run Profit Maximization

Profit is maximized at the output level where MR=MC
◦ If MR>MC, profits would increase if output were increased
◦ If MR<MC, profits would increase if output were decreased

◦ The above does not guarantee that profit must be positive

when output is at where MR=MC however

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Short-Run Profit Maximization

Operating at a Loss in the

Short-Run
If ATC>AR at the output-level where MC=MR => profit is negative

Two choices:
◦ Temporarily staying in operation
◦ Going out of business

Question: Which choice will yield smaller loss?

𝑇𝑉𝐶(𝑞)
The shutdown condition: 𝐴𝑉𝐶 𝑞 = >𝑝
𝑞

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Operating at a Loss in the

Short-Run

A Competitive Firm’s Short-

Run Supply Curve

Shutdown point – the minimum level of average variable cost below

which the firm will cease operations

Supply curve = MC curve where MC > minimum point on AVC

curve

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In-class Question
Given that a competitive firm’s short run cost function is
𝐶 𝑞 = 100𝑞 − 4𝑞 2 + 0.2𝑞 3 + 450
What is the firm’s short-run supply curve?
If the price=$115, how much output does the firm supply?

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Long-Run Competitive
Equilibrium
Characteristics:
◦ The firm is maximizing profit and producing where LMC=price.
◦ Each firm makes no profit (under identical firm assumption)
◦ There is no incentive for firms to enter or leave the industry

Zero Profit When Firms’ Cost

Curves Differ?
When all firms in a competitive industry have identical cost curves,
each firm earns zero economic profit in long-run equilibrium.
What happens if cost curves differ among firms?
◦ Firms are not identical
◦ They might possess heterogeneous inputs

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Infra-Marginal, Marginal and

Potential Entrants (Not in textbook)
Infra-marginal firms:
◦ Produce at P=LMC>LAC. They earn “imputed rent” even in the long run (i.e.
the return for possessing superior factors of production)

Marginal firms:
◦ Produce at P=LMC=min LAC
◦ “Last” firm in the industry: zero profit (First to go out of business when
market price falls)

Potential Entrance
◦ Currently their LAC>P. Only if P rises high enough so that P>LAC would these
producers enter the industry

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The Long-Run Supply Curve of a Firm

The long-run supply function for the firm measures how much the firm
would optimally produce when allowed to adjust plant size (and other
factors fixed in the short-run. The long-run supply curve is given by:
𝑝 = 𝑀𝐶(𝑦, 𝑘 𝑦 )
Where y=output
While the short-run supply curve:
𝑝 = 𝑀𝐶(𝑦, 𝑘)

The Long-Run Supply Curve of a Firm

Since in the long-run the firm can always get zero profit by going out of
business, the profits that the firm makes in the long-run equilibrium
must be at least zero, therefore:
𝑝𝑦 − 𝑐(𝑦) ≥ 0
Where 𝑐(𝑦)represents the total cost, as a function of y
This means:
𝑐(𝑦)
𝑝≥
𝑦

Meaning: the long-run price has to be at least as large as average cost

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The Long-Run Supply Curve of a Firm

Long-Run Market Supply with

Identical Firms
In the long run, if all the firms are identical, the market supply is horizontal
at the point of minimum long-run average costs

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Recall the Cost Function of a Cobb-

Douglas Production Function

Effects of Increase in Demand in the

Short Run and Long Run: Boom
Suppose initially the market condition is given by 𝐷0 and 𝑆0 (so no firms
make profit initially). There is an increase in demand such that the
demand curve shifts from 𝐷0 to 𝐷1 . So now the existing firms make
profit
As a result more firms will enter until they cannot profit from their
entry. ->back to zero profit
The new equilibrium is given by the intersection of 𝑆1 and 𝐷1

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Long-Run Supply (for Identical Firms) When

Demand Increases

What about when demand permanently decreases?

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In-class exercise
Suppose the number of firms in the market in the short run is 50. And
the supply function of each firm is given by: p = 8q + 100, what is the
market supply?

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