Lecture 6A

FIRMS IN
COMPETITIVE MARKETS

PRINCIPLES OF MICROECONOMICS

Prepared by: Minh Huynh, M.Econ

M.Econ..

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In this lecture
lecture,, look for the answers to these
questions:
• What is a perfectly competitive market?
• What is marginal revenue? How is it related to total
and average revenue?
• How does a competitive firm determine the quantity
that maximizes profits?
• When might a competitive firm shut down in the
short run? Exit the market in the long run?
• What does the market supply curve look like in the
short run? In the long run?
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 Contents
1 What is a Competitive Market?
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2 The Revenue of a Competitive Firm

3 Profit Maximization

4 The Firm
Firm’’s Short-Run Decision to Shut Down

5 The Firm
Firm’’s Long-Run Decision to Exit or Enter
a Market
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 A perfectly competitive market has the
�A
characteristics::
following characteristics

1. There are many buyers and sellers in the market.

2. The goods offered by the various sellers are largely
the same.
3. Firms can freely enter or exit the market.

no power market is the consequence of these characteristics.

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 As a result of its characteristics, the perfectly
�As
competitive market has the following outcomes
outcomes::
● The actions of any single buyer or seller in the
market have a negligible impact on the
not affect
market price.
● Each buyer and seller takes the market price
as given � price taker r

Perfect information no transaction cost

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 Definition of competitive market:
�Definition
● a market with many buyers and sellers
trading identical products so that each buyer
and seller is a price taker.

Give some examples?

�Give

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Agricultural
Products

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� Total Revenue for a firm is the selling price
times the quantity sold.

�TR = (P × Q)

�TTotal revenue is proportional to the amount

of output.

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� Average Revenue tells us how much revenue
a firm receives for the typical unit sold.

�AAverage revenue is total revenue divided by

the quantity sold.

�IIn perfect competition, average revenue

equals the price of the good. AR=P
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� Average revenue
Total revenue
Average Revenue =
Quantity

Price × Quantity
=
Quantity

= Price

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� Marginal Revenue is the change in total
revenue from an additional unit sold.

�TR/ �Q
MR ==�
�M

�FFor competitive firms, marginal revenue

equals the price of the good.
MR = TR
oMR TR’’ = (P
(P**Q)
Q)’’ = P P=AR=MR
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Let’’s consider a dairy farm
Let

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A C T I V E L E A R N I N G 1:
Exercise
Fill in the empty spaces of the table.

Q P TR AR MR

0
0 $10 n.a.

1 $10 10
$10

2 $10 20 10

3 $10 30 10

10
4 $10 $40
$10
5 $10 $50 10

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� What Q maximizes the firm
firm’’s profit?
To find the answer, “Think at the margin”
�To
If the firm increases Q by one unit,
revenue rises by MR,
cost rises by MC.
If MR > MC, then increase Q to raise profit.
�If
If MR < MC, then reduce Q to raise profit.
�If

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 (continued from earlier exercise)

Q TR TC Profit MR MC
∆ Profit =
�At any Q with MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
�At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

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 Rule: MR = MC at the profit-maximizing Q.
*At Qa, MC < MR. Costs
So, increase Q
to raise profit. MC

*At Qb, MC > MR.

So, reduce Q
to raise profit. P1 MR
*At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q1 Qb
max profit

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 MC=S curve
P=MR=AR=D curve
*If price rises to P2,
Costs
then the profit-
maximizing quantity MC
rises to Q2.
P2 MR2
*The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,

the MC curve is the

Q
firm’s supply curve. Q1 Q2

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 Figure: Profit Maximization for a Competitive Firm

Costs
and The firm maximizes
Revenue profit by producing
the quantity at which
marginal cost equals MC
marginal revenue.
MC 2

ATC
P = MR 1 = MR 2 P = AR = MR
AVC

MC 1

0 Q1 Q MAX Q2 Quantity
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Copyright © 2004 South-Western
Marginal Cost as the Competitive Firm
Firm’’s Supply Curve

Price
This section of the
firm’s MC curve is MC
also the firm’s supply
curve.
P2

ATC
P1
AVC

0 Q1 Q2 Quantity
Copyright © 2004 South-Western
 Profit maximization occurs at the quantity
�Profit
where marginal revenue equals marginal cost.
When MR > MC � increase Q
�When
When MR < MC � decrease Q
�When
When MR = MC � Profit is maximized.
�When

Can you prove the formula MR = MC by the

�Can
method of algebra?

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� Shutdown : a short-run decision not to produce
anything during a specific period of time because of
current market conditions.
�AA firm that shuts down temporarily must still pay its fixed
costs.

� Exit : a long-run decision to leave the market.

�AA firm that exits the market does not have to pay any
costs at all, fixed or variable.

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 The firm considers its sunk costs when deciding to
�The
exit, but ignores them when deciding whether to shut
down.
�Sunk costs are costs that have already been
committed and cannot be recovered. Ex: TFC

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 The firm shuts down if the revenue it gets from
�The
producing is less than the variable cost of production.

Shut down if TR < TVC

�Shut
Shut down if TR/Q < TVC/Q
�Shut
Shut down if P < AVC
�Shut

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The firm’s SR supply Costs
curve is the portion of MC
its MC curve above AVC.
If P ≥ AVC, then ATC
firm produces Q
where P = MC. AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

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 Figure: The Firm
Firm’’s Short-Run Decision to Shut Down

Costs
Firm ’s short-run
If P > ATC, the firm supply curve MC
will continue to
produce at a profit.

ATC
If P > AVC, firm will
continue to produce AVC
in the short run.

Firm
shuts
down if
P < AVC
0 Quantity

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Copyright © 2004 South-Western
� In the long run, the firm exits if the revenue
it would get from producing is less than its total
cost..
cost

Exit if TR < TC
�Exit
Exit if TR/Q < TC/Q
�Exit
Exit if P < ATC
�Exit

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� A firm will enter the industry if such an
action would be profitable.

Enter if TR > TC
�Enter
Enter if TR/Q > TC/Q
�Enter
Enter if P > ATC
�Enter

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 Figure 13 The Firm
Firm’’s Long-Run Decision
to Exit or Enter a Market

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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Copyright © 2004 South-Western
ACTIVE LEARNING 2A:

Identifying a firm
firm’’s profit
A competitive firm
Determine Costs, P
this firm’s
MC
total profit.
P = $10 MR
Identify the
area on the ATC
graph that $6
represents
the firm’s
profit.
Q
50

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ACTIVE LEARNING 2B:

Identifying a firm
firm’’s loss
A competitive firm
Determine Costs, P
this firm’s
MC
total loss.
Identify the
area on the ATC
graph that
$5
represents
the firm’s loss. P = $3 MR

Q
30

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Profit as the Area between Price and Average Total Cost

(a) A Firm with Profits

Price

MC ATC
Profit

ATC P = AR = MR

0 Q Quantity
(profit-maximizing quantity) 31
Copyright © 2004 South-Western
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)
Copyright © 2004 South-Western
 SUMMARY
● For a firm in a perfectly competitive market,
price = marginal revenue = average revenue.
● If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC.
● If P < AVC, a firm will shut down in the short run.
● If P < ATC, a firm will exit in the long run.
● In the short run, entry is not possible, and an
increase in demand increases firmsfirms’’ profits.
● With free entry and exit, profits = 0 in the long
run, and P = minimum ATC
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