Chapter 5

Perfect Competition

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 Producer’s Theory: Profit maximization
◼ Firms decide how many units of goods or services to produce -- Q.
❑ Benefit: Total revenue

𝑇𝑅 = 𝑃(𝑄)𝑄
❑ P is a function of Q, depending on the property of the market structure.

❑ Cost (inputs): Total cost

◼ Production function: the relationship that describes how inputs like

capital and labor are transformed into output.
❑ For example, Capital (K) and Labor (L) 𝑄 = 𝐹(𝐾, 𝐿)
◼ Given the rental rate r and the wage rate w

𝑇𝐶 = 𝑟𝐾 + 𝑤𝐿
◼ which implies
𝑇𝐶 = 𝐶(𝑄)
❑ Goal: Maximize profits
𝑀𝑎𝑥 𝜋 = 𝑇𝑅 − 𝑇𝐶 = 𝑃(𝑄)𝑄 − 𝐶(𝑄)
𝑄
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Market Structure
◼ Perfect Competition--many sellers of a standardized product,
◼ Monopolistic Competition--many sellers of a differentiated
product,
◼ Oligopoly--few sellers of a standardized or a differentiated product,
◼ Monopoly--a single seller of a product for which there is no close
substitute.

Perfect Competition Monopolistic Competition Oligopoly Monopoly

Less competitive
 Market Structure
Perfect Monopolistic
Oligopoly Monopoly
Competition Competition
number of firms Very large Many Few One

extent of standardized differentiated standardized or no close

product differentiated substitute
substitutability
ease of entry Very easy Relatively easy Significant Substantial
and exit “barriers to entry” “barriers to
entry”
control over Price taker Limited Mutual Price maker
price interdependence
example Agricultural Market, Restaurants, Automobiles, Public Service
Financial Market Clothing, Shoes, Supermarkets, (Electricity, Water,
(stock, currency, Service industries in Banking industry …)
bond) large cities
(Insurance brokers,
Estate agents,
Hairdressers, …)

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 What is a Competitive Market?

• Competitive market: perfectly competitive market

– Market with many buyers and sellers
– Trading identical products
– Each buyer and seller is a price taker
– Firms can freely enter or exit the market

• Firm in a competitive market

– Tries to maximize profit
• Profit
– Total revenue minus total cost
• Total revenue, TR = P ˣ Q
– Price times quantity
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 What is a Competitive Market?

• Average revenue, AR = TR / Q
– Total revenue divided by the quantity sold
• Marginal revenue, MR = ∆TR / ∆Q
– Change in total revenue from an additional unit sold
• For competitive firms
– AR = P
– MR = P

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 Table 1
Total, Average, and Marginal Revenue for a Competitive Firm

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 Profit Maximization: MR = MC
Maximize profit
𝑀𝑎𝑥 𝜋 = 𝑇𝑅 − 𝑇𝐶
𝑄

Compare marginal revenue with marginal cost

If MR > MC: increase production
If MR < MC: decrease production
Maximize profit where MR = MC
continuous choice

discrete choice
MR ≥ MC for the last unit of production
MR < MC for one more unit of production

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 Table 2
Profit Maximization: A Numerical Example

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 Profit Maximization
• The marginal-cost curve and the firm’s supply decision
– MC curve is upward sloping
– ATC curve is U-shaped
– MC curve crosses the ATC curve at the minimum of
ATC curve
– The price line is horizontal: P = AR = MR

• Marginal-cost curve
– Determines the quantity of the good the firm is willing to
supply at any price
– supply curve

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 Figure 1
Profit Maximization for a Competitive Firm
Costs
The firm maximizes profit by producing
and the quantity at which marginal cost
Revenue equals marginal revenue.
MC

MC2 ATC
P=AR=MR
P=MR1=MR2
AVC

MC1

0 Q1 QMAX Q2 Quantity
This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-
variable-cost curve (AVC). It also shows the market price (P), which for a competitive firm equals both
marginal revenue (MR) and average revenue (AR). At the quantity Q1, marginal revenue MR1 exceeds
marginal cost MC1, so raising production increases profit. At the quantity Q2, marginal cost MC2 is
above marginal revenue MR2, so reducing production increases profit. The profit-maximizing quantity
QMAX is found where the horizontal line representing the price intersects the marginal-cost curve.
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 Figure 2
Marginal Cost as the Competitive Firm’s Supply Curve

Price
MC

P2
ATC

P1 AVC

0 Q1 Q2 Quantity

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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 Profit Maximization
• Shutdown: short-run decision not to produce anything
– During a specific period of time
– Because of current market conditions
– Firm still has to pay fixed costs
• Exit: long-run decision to leave the market
– Firm doesn’t have to pay any costs

• The firm’s short-run decision to shut down

– TR = total revenue VC = variable costs
– Firm’s decision: Shut down if TR < VC (P < AVC)
• Competitive firm’s short-run supply curve
– The portion of its marginal-cost curve that lies above
average variable cost 13
 Figure 3
The Competitive Firm’s Short-Run Supply Curve

Costs 1. In the short run, the

firm produces on the MC MC
curve if P>AVC,...

ATC

AVC
2. ...but
shuts down
if P<AVC.

0 Quantity

In the short run, the competitive firm’s supply curve is its marginal-cost curve (MC)
above average variable cost (AVC). If the price falls below average variable cost, the
firm is better off shutting down temporarily.
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 Profit Maximization
• Sunk cost: a cost that has already been committed and
cannot be recovered
– Should be ignored when making decisions
• “Don’t cry over spilt milk”
• “Let bygones be bygones”
– In the short run, fixed costs are sunk costs

• Restaurant – stay open for lunch?

– Fixed costs: not relevant; are sunk costs in short run
– Variable costs – relevant Staying
open can be
– Shut down if revenue from lunch < variable costs profitable,
– Stay open if revenue from lunch > variable costs even with
many tables
empty. 15
 Near-empty restaurants & off-season miniature golf
• Operator of a miniature-golf course
– Ignore fixed costs
– Shut down if
• Revenue < variable costs
– Stay open if
• Revenue > variable costs

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 Profit Maximization
• Firm’s long-run decision
– Exit the market if Total revenue < total costs; TR < TC
– Same as: P < ATC
– Enter the market if Total revenue > total costs; TR > TC
– Same as: P > ATC
• Competitive firm’s long-run supply curve: the portion of its
marginal-cost curve that lies above average total cost
• Measuring profit
– If P > ATC
• Profit = TR – TC = (P – ATC) ˣ Q
– If P < ATC
• Loss = TC - TR = (ATC – P) ˣ Q
• = Negative profit 17
 Figure 4
The Competitive Firm’s Long-Run Supply Curve

Costs 1. In the long run, the firm

produces on the MC curve MC
if P>ATC,...
ATC

2. ...but
exits if
P<ATC

0 Quantity

In the long run, the competitive firm’s supply curve is its marginal-cost
curve (MC) above average total cost (ATC). If the price falls below average total cost,
the firm is better off exiting the market.

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 Figure 5
Profit as the Area between Price and Average Total Cost
(a) A firm with profits (b) A firm with losses
Price Price
MC
MC

Profit ATC ATC

Loss
P
ATC P=AR=MR ATC
P
P=AR=MR

0 Q Quantity 0 Q Quantity
(profit-maximizing quantity) (loss-minimizing quantity)
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 – 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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 (market) Supply Curve

• Short run: market supply with a fixed number of firms

– Short run: number of firms is fixed
– Each firm supplies quantity where P = MC
• For P > AVC: supply curve is MC curve
– Market supply
• Add up quantity supplied by each firm

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 Figure 6
Short-Run Market Supply
(a) Individual firm supply (b) Market supply
Price Price
MC Supply

$2.00 $2.00

1.00 1.00

0 100 200 Quantity 0 100,000 200,000 Quantity

(firm) (market)

In the short run, the number of firms in the market is fixed. As a result, the market
supply curve, shown in panel (b), reflects the individual firms’ marginal-cost curves,
shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied
to the market is 1,000 times the quantity supplied by each firm.
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 (Long run) Supply Curve
• Long run
– Firms can enter and exit the market
– If P > ATC, firms make positive profit
• New firms enter the market
– If P < ATC, firms make negative profit
• Firms exit the market

– Process of entry and exit ends when

• Firms still in market make zero economic profit (P =
ATC)
• Because MC = ATC: Efficient scale
– Long run supply curve is perfectly elastic
• Horizontal at minimum ATC 22
 Figure 7
Long-Run Market Supply
(a) Firm’s Zero-Profit Condition (b) Market supply
Price Price

MC
ATC

P=
minimum Supply
ATC

0 Quantity 0 Quantity
(firm) (market)
In the long run, firms will enter or exit the market until profit is driven to zero. As a
result, price equals the minimum of average total cost, as shown in panel (a). The
number of firms adjusts to ensure that all demand is satisfied at this price. The long-
run market supply curve is horizontal at this price, as shown in panel (b).
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 Supply Curve

• Why do competitive firms stay in business if they make zero

profit?
– Profit = total revenue – total cost
– Total cost includes all opportunity costs
– Zero-profit equilibrium
• Economic profit is zero
• Accounting profit is positive

“We’re a nonprofit
organization - we
don’t intend to
be, but we are!”
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 Supply Curve
• Market in long run equilibrium
– P = minimum ATC
– Zero economic profit
• Increase in demand: Demand curve shifts outward
– Short run
• Higher quantity
• Higher price: P > ATC – positive economic profit
• Positive economic profit in short run
– Long run – firms enter the market
– Short run supply curve – shifts right
– Price – decreases back to minimum ATC
– Quantity – increases -- more firms in the market
– Efficient scale 25
 Figure 8
An Increase in Demand in the Short Run and Long Run (a)
(a) Initial Condition
Market Firm
Price Price
1. A market begins in 2. …with the firm
long-run equilibrium… earning zero profit.
Short-run supply, S1 MC
ATC

A Long-run
P1 P1
supply

Demand, D1

0 Q1 Quantity 0 Quantity
(market) (firm)
The market starts in a long-run equilibrium, shown as point A in panel (a). In this
equilibrium, each firm makes zero profit, and the price equals the minimum average
total cost.
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 Figure 8
An Increase in Demand in the Short Run and Long Run (b)
(b) Short-Run Response
Market Firm
Price Price
3. But then an increase in
4. …leading to
demand raises the price…
short-run profits.
S1 MC
ATC
B
P2 P2
A Long-run
P1 P1
supply

D2
D1

0 Q1 Q2 Quantity 0 Quantity
(market) (firm)
Panel (b) shows what happens in the short run when demand rises from D1 to D2. The
equilibrium goes from point A to point B, price rises from P1 to P2, and the quantity sold
in the market rises from Q1 to Q2. Because price now exceeds average total cost, each
firm now makes a profit, which over time encourages new firms to enter the market.
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 Figure 8
An Increase in Demand in the Short Run and Long Run (c)
(c) Long-Run Response
Market Firm
Price Price 6. …restoring long-run
5. When profits induce entry, supply
increases and the price falls,… equilibrium.

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

D2
D1

0 Q 1 Q2 Q 3 Quantity 0 Quantity
(market) (firm)
This entry shifts the short-run supply curve to the right from S1 to S2, as shown in panel
(c). In the new long-run equilibrium, point C, price has returned to P1 but the quantity
sold has increased to Q3. Profits are again zero, and price is back to the minimum of
average total cost, but the market has more firms to satisfy the greater demand.
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 Supply Curve

• Long-run supply curve might slope upward

– Some resource used in production may be available only
in limited quantities
• Increase in quantity supplied – increase in costs –
increase in price
– Firms may have different costs
• Some firms earn profit even in the long run

• Long-run supply curve

– More elastic than short-run supply curve

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