Microeconomics Department of Economics

Bonga University
Perfectly Competitive Markets
• 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?
Chapter 4 Part I 1
 Basic assumptions
1. Many buyers and many sellers.
2. Product Homogeneity
– When the products of all of the firms in a market are perfectly
substitutable with one another—that is, when they are homogeneous—no
firm can raise the price of its product above the price of other firms
without losing most or all of its business.
– The goods offered for sale are largely the same.
3. Price Taking : b/c 1 and 2 assumption
– Because each individual firm sells a sufficiently small proportion of total
market output, its decisions have no impact on market price. Firm that has
no influence over market price and thus takes the price as given is price
taker
4. free entry (or exit)
– Condition under which there are no special costs that make it difficult for a
firm to enter (or exit) an industry.
– “Firms can freely enter or exit the market” means there are no barriers or
impediments to entry or exit. E.g., the government does not restrict the
number of firms in the market.
Chapter 4 Part I 2
 When Is a Market Highly Competitive?
• Because firms can implicitly or explicitly collude in
setting prices, the presence of many firms is not
sufficient for an industry to approximate perfect
competition.
• Conversely, the presence of only a few firms in a
market does not rule out competitive behavior.

Chapter 4 Part I 3
 Do firms maximize profits?
• The assumption of profit maximization is frequently used in
microeconomics because it predicts business behavior reasonably
accurately and avoids unnecessary analytical complications.
• For smaller firms managed by their owners, profit is likely to
dominate almost all decisions.
• In larger firms, however, managers who make day-to-day decisions
usually have little contact with the owners (i.e. the stockholders).
• In any case, firms that do not come close to maximizing profit are not
likely to survive.
• Firms that do survive in competitive industries make long-run profit
maximization one of their highest priorities.
• Managers in firms may be concerned with other objectives
– Revenue maximization
– Revenue growth
– Dividend maximization

Chapter 4 Part I 4
 • Demand curve for a
Profit Maximization Competitive Firm
Price
Because each firm in a
competitive industry sells 50
only a small fraction of
the entire industry D=AR=MR=P
output, how much output 40
the firm decides to sell
will have no effect on the 30
market price of the
product.
20
Because it is a price taker,
the demand curve d
facing an individual 10
competitive firm is given
by a horizontal line. 0 1 2 3 4 5 6 7 8 9 10 11
Output
Chapter 4 Part I 5
•
Short Run Profit Maximization
What Q maximizes the firm’s profit?
• To find the answer, “Think at the margin.”
– If increase Q by one unit, revenue rises by MR, cost rises by MC.
• Maximize economic profit
– Quantity at which total revenue exceeds total cost by the greatest
amount
• Profit = MR– MC
– If MR > MC, then increase or expand Q to raise profit.
– If MR < MC, then reduce or stop Q to raise profit.
• Profit = TR – TC
– If TR > TC: economic profit
– If TC > TR: economic loss
– Increase production as long as each additional unit adds more to TR
than TC
Profit Maximization by a Competitive Firm

MC(q) =Chapter
MR =4 Part
P I 6
 Short-run profit maximization for a perfectly competitive firm
(a) Total revenue minus total cost In panel (a), the total revenue curve for a
Total cost Total revenue perfectly competitive firm is a straight line with a
(=$5 × q) slope of 5, the market price. Total cost increases
$60 with output, first at a decreasing rate and then at
Total dollars

Maximum economic
48 an increasing rate. Economic profit is maximized
profit = $12
where total revenue exceeds total cost by the
greatest amount, which occurs at 12 bushels of
15 wheat per day.

Bushels of wheat per day

0 5 7 10 12 15
(b) Marginal cost equals marginal revenue In panel (b), marginal revenue is a
Marginal cost horizontal line at the market price of $5.
Dollars per bushel

e Average total cost Economic profit is maximized at 12

$5 bushels of wheat per day, where marginal
Profit d = Marginal revenue
4 revenue equals marginal cost (point e).
a = Average revenue
That profit equals 12 bushels multiplied
by the amount by which the market price
of $5 exceeds the average total cost of $4.
Bushels of wheat per day Economic profit is identified by the
0 5 7 10 12 15 shaded rectangle.
Chapter 4 Part I 7
 Choosing Output In The Short Run
• The demand curve facing an individual firm in a
competitive market is both its average revenue curve
and its marginal revenue curve.
• Along this demand curve, marginal revenue, average
revenue, and price are all equal.
• Profit Maximization by a Competitive Firm
– MC(q) = MR = P
• Marginal revenue equals marginal cost at a point at
which the marginal cost curve is rising.
• Output Rule: If a firm is producing any output, it should
produce at the level at which marginal revenue equals
marginal cost.
Chapter 4 Part I 8
 A Firm’s Short-Run Decision
• Decision to Shut Down :
A short-run decision not to produce anything because
of market conditions.
• if TR>TC: economic profit
– Produce if TR>VC (P>AVC)
• Revenue covers variable costs and a portion of fixed cost
• Loss < fixed cost
– Shut down (short run) if TR<VC (P<AVC)
• Loss = FC
• If firm shuts down temporarily,
– revenue falls by TR and costs fall by VC
Chapter 4 Part I 9
 Short-Run Loss Minimization for a Perfectly Competitive Firm
Because total cost always
(a) Total revenue minus total cost exceeds total revenue in panel
Total cost Total revenue (a), the firm suffers a loss no
(=$3 × q) matter how much is produced.
Total dollars

The loss is minimized where

$40
30 Minimum economic output is 10 bushels per day.
loss = $10 Panel (b) shows that marginal
15 revenue equals marginal cost at
point e. The loss is equal to
Bushels of wheat per day output of 10 multiplied by the
0 5 10 15
(b) Marginal cost equals marginal revenue difference between average total
Marginal cost cost ($4) and price ($3). Because
Average total cost
Dollars per bushel

price exceeds average variable

$4.00 Average variable cost cost ($2.50), the firm is better off
Loss e continuing to produce in the
3.00
2.50 d = Marginal revenue short run, since revenue covers
= Average revenue
some fixed cost.

Bushels of wheat per day

0 5 10 15
Chapter 4 Part I 10
 In the short run, the firm chooses its output so that marginal cost MC is
equal to price as long as the firm covers its average variable cost.

The short-run supply curve is given by

the crosshatched portion of the marginal
cost curve.

If P > AVC, then firm

produces Q where P
= MC.

If P < AVC, then firm

shuts down (produces
Q = 0).
Chapter 4 Part I 11
 The Irrelevance of Sunk Costs

• Sunk cost: a cost that has already been committed

and cannot be recovered
• Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
• FC is a sunk cost: The firm must pay its fixed costs
whether it produces or shuts down.
• So, FC should not matter in the decision to shut
down.

Chapter 4 Part I 12
 Summary of a perfectly competitive firm’s short-run output decisions

Marginal cost Firm’s short run S curve

At price p1, the firm produces
5 d5 nothing because p1 is less than the
p5
Average total cost firm’s average variable cost. At
4 price p2, the firm is indifferent
Dollars per unit

p4 d4
Average variable cost between shutting down or
3 producing q2 units of output,
p3 d3
because in either case, the firm
2 suffers a loss equal to its fixed cost.
p2 d2
p1 1 At p3, it produces q3 units and
d1
Shutdown suffers a loss that is less than its
point fixed cost.
0
q1 q2 q3 q4 q5 Quantity per period
At p4, the firm produces q4 and just breaks even, earning a normal profit, because p4 equals
average total cost. Finally, at p5, the firm produces q5 and earns an economic profit. The firm’s
short-run supply curve is that portion of its marginal cost curve at or rising above the minimum
point of average variable cost (point 2). Chapter 4 Part I 13
Aggregating individual supply curves of perfectly competitive firms to form
the market supply curve

(a) Firm A (b) Firm B (c) Firm C (d) Industry, or market, supply
sA sB sC
Price per unit

sA + s B + s C = S

p’ p’ p’ p’

p p p p

0 10 20 0 10 20 0 10 20 0 30 60
Quantity per period Quantity per period Quantity per period
At price p, each firm supplies 10 units of output & market supplies 30 units. In general, the market
supply curve in panel (d) is the horizontal sum of the individual firm supply curves sA, sB, and sC.
Chapter 4 Part I 14
 Class work
Identifying a firm’s profit
A competitive firm
• Determine Costs, P
this firm’s MC
total profit.
P = $10 MR
• Identify the area ATC
on the graph that
$6
represents
the firm’s profit.

Q
50

Chapter 4 Part I 15
15
 Answers
A competitive firm
Costs, P
profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q =
$4 x 50 Q
= $200 50

Chapter 4 Part I 16
16
 Identifying a firm’s loss
A competitive firm
• Determine Costs, P
this firm’s MC
total loss.
• Identify the area ATC
on the graph that
represents $5
the firm’s loss. P = $3 MR

Q
30

Chapter 4 Part I 17
17
 Answers
A competitive firm
Costs, P
MC
Total loss
= (ATC – P) x Q =
$2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30

Chapter 4 Part I 18
18
 Homework
• Suppose the same firm’s cost function is C(q) =4𝑞 2 + 16.
a) Find variable cost, fixed cost, average cost, average variable
cost, average fixed cost and Marginal cost .
b) Find the output that minimizes average cost.
c) At what range of prices will the firm earn a negative profit?
d) At what range of prices will the firm earn a positive profit?

Chapter 4 Part I 19