Competitive Markets

B 2 B Marketing
WHAT IS A COMPETITIVE
MARKET?
In a perfectly competitive market
There are many buyers
There are many sellers
Firms can freely enter or exit the market, in the
long run.
In the short run, the number of firms is
assumed fixed (constant).
All sellers sell the same product.
WHAT IS A COMPETITIVE
MARKET?
As a result:
The actions of any single buyer or seller
have a negligible impact on the market
price.
That is, the market price is unaffected by the
amount bought by a buyer or the amount sold
by a seller
Therefore, every buyer and every seller
takes the market price as given.
Everybody is a price taker
Price takers
A firm in a perfectly competitive market cannot stay
in business if its price is higher than what the other
firms are charging
No firm would be able to raise the market price by
reducing production and attempting to create a
shortage.
Conversely, there is no danger that a firm would
drive the market price down by producing too
much.
Therefore, no firm would want to charge a price
lower than what the others are charging.
In short, each firm takes the prevailing market price
as a givenlike the weatherand charges that
price.
Average Revenue of a Competitive Firm
Average revenue is the revenue per unit sold
P = AR.
This is simply because all units sold are sold at the
same price.
Average Revenue =
Total revenue
Quantity
Price Quantity
Quantity
Price

Marginal Revenue of a Competitive Firm

Marginal Revenue is the increase ()
in total revenue when an additional
unit is sold.
MR = TR / Q
The Revenue of a Competitive Firm
In perfect competition, marginal
revenue equals price: P = MR.
We saw earlier that P = AR
Therefore, for all firms in perfect
competition, P = AR = MR
Demand curves for the firm and the market (industry)
Jones and Peters, a firm
Quantity (firm) 0
Price
Market
Quantity (market)
Price
0
Demand, P = AR
P
The market demand curve is
negatively sloped, as usual. That
is, the market price, which is the
lowest prevailing price, is
inversely related to the quantity
demanded.
The market price is P. No matter
what amount Jones and Peters
produces, the market price will not
change. Therefore, J&P will be
able to sell any feasible output if it
charges the price P.
Demand, P = AR = MR
Supply: short run and long run
The analysis of supply in perfect
competition depends on whether it is the
short run or the long run.
Short run and long run:
assumptions
The quantity of a resource used by a
firm may be fixed in the short run but
not in the long run.
Example: If a firm currently has three custom-
made machines and if it takes six months to get
new machines, then the firm is stuck with its
three machines for the next six months.
All fixed costs are sunk costs in the
short run but not in the long run
The number of firms in an industry is
fixed in the short run but not in the
long run
Shut Down and Exit
Before a firm decides how much to
supply, it must decide whether or not
to stay in business
A shutdown refers to a short-run
decision to stop production
temporarily, perhaps because of poor
market conditions.
Exit refers to a long-run decision to
end production permanently.
The Firms Short-Run Decision to Shut
Down
A firm will shut down (temporarily) if its
variable costs exceed its total revenue, no
matter what quantity it produces
Its fixed costs do not matter!
This is because
Fixed costs are sunk costs in the short run
sunk costs are defined as costs that will have to be
paid even if the firm shuts down.
Therefore, FC cannot affect a firms decision on
whether to stay open or shut down
Sunk Costs
Sunk costs will have to be paid even
when a firm is in a temporary
shutdown.
Examples:
If the firm signs a long-term contract with its
landlord, the rent will have to be paid even
when the firm is temporarily shut down.
Some maintenance costs will have to be
incurred even when the firm is shut down.
The firm may be under contract to provide
customer service to past customers even after
it shuts down.
A Firms Shut Down Decision
Quantity
AVC
0
$
The firm shuts down
because P <Minimum AVC
The firm stays open
because P >Minimum AVC
Minimum AVC Minimum AVC
P
H

P
L

Figure 1 Profit Maximization for a Competitive Firm
Quantity 0
Costs
and
Revenue
MC
ATC
AVC
MC
1
Q
1
MC
2
Q
2
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
Q
MAX
P = MR
1
= MR
2
P = AR = MR
Therefore, P = AR =
MR = MC is the
fingerprint of perfect
competition
We have seen before
that, as firms are price
takers in perfect
competition, P = AR =
MR.
We have also seen
that, profit
maximization implies
MR = MC.
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRMS SUPPLY
CURVE
Profit maximization occurs at the
quantity where marginal revenue
equals marginal cost.
This is a crucial principle in understanding
the behavior of firms
PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRMS SUPPLY
CURVE
When MR > MC increase Q
When MR < MC decrease Q
When MR = MC Profit is
maximized; stick
with this Q.
Recall: The Supply Curve
Quantity 0
Price
Supply
P
1
Q
1
P
2
Q
2
Figure 2 Marginal Cost as the Competitive Firms
Supply Curve
Quantity 0
Price
MC
ATC
AVC
P
1
Q
1
P
2
Q
2
This section of the
firms MC curve is
also the firms supply
curve.
Figure 3 The Competitive Firms Short Run Supply
Curve
MC
Quantity
ATC
AVC
0
Costs
Firm
shuts
down if
P < AVC
Firm s short-run
supply curve
If P > AVC, firm will
continue to produce
in the short run.
If P > ATC, the firm
will continue to
produce at a profit.
What can shift the supply
curve to the right?
The Short Run: Market Supply with a
Fixed Number of Firms
The market supply curve is the
horizontal sum of the individual firms
short run supply curves.
Figure 6 Market Supply with a Fixed Number of Firms
(a) Individual Firm Supply
Quantity (firm) 0
Price
MC
1.00
100
$2.00
200
(b) Market Supply (# of firms fixed)
Quantity (market) 0
Price
Supply
1.00
100,000
$2.00
200,000
Q: What is the number of firms?
Short-Run Equilibrium: back where we began!
(a) Individual Firm Supply
Quantity (firm) 0
Price
MC
1.00
100
$2.00
200
(b) Market Supply (# of firms fixed)
Quantity (market) 0
Price
Supply
1.00
100,000
$2.00
200,000
Demand
L
Demand
H
THE LONG RUN
Price = Minimum ATC; profit = zero; demand has no
effect on price, and no effect on the quantity produced
by a firm; demand does affect the quantity produced by
the industry, and the number of firms in the industry
The Firms Long-Run Decision to Exit or
Enter a Market
In the long run, the firm exits if it sees
that its total revenue would be less
than its total cost no matter what
quantity (Q) it might produce
That is, a firm exits if
TR < TC, no matter what Q is.
TR/Q < TC/Q , no matter what Q is.
P < ATC , no matter what Q is.
The Firms Long-Run Decision to Exit or
Enter a Market
A new firm will enter the industry if it
can expect to be profitable.
That is, a new firm will enter if
TR > TC for some value of Q
TR/Q > TC/Q for some value of Q
P > ATC for some value of Q

Entry and Exit of Firms in the Long-Run
Quantity
ATC
0
$
Minimum ATC Minimum ATC
Existing firms will exit
because P <Minimum ATC
The number of firms will
stabilize when P =Minimum
ATC. This is the long run price!
New firms will enter
because P >Minimum ATC
P
H

P
L

This is the efficient scale output.
This is each firms long-run
equilibrium output!
Figure 4 The Competitive Firms Long-Run Supply
Curve
MC = long-run S
Firm
exits if
P < ATC
Quantity
ATC
0
Costs
Firm s long-run
supply curve
Firm
enters if
P > ATC
ATC
THE SUPPLY CURVE IN A
COMPETITIVE MARKET
A Firms Short-Run
Supply Curve
The portion of its (short run)
marginal cost curve that lies
above the (short run)
average variable cost curve.
A Firms Long-Run Supply
Curve
The portion of its (long run)
marginal cost curve that lies
above the (long run)
average total cost curve.
MC
ATC
AVC
Long-Run Equilibrium
ATC
Price Price
Quantity
(industry)
Quantity
(firm)
6,000 200
(efficient
scale)
$1.50
$1.50
P = Minimum ATC =
Market
Demand
P = AR = MR = MC = ATC is the
fingerprint of perfect competition in
the long run.

A Firms Profit
Profit equals total revenue minus total
costs.
Profit = TR TC
Profit/Q = TR/Q TC/Q
Profit = (TR/Q TC/Q) Q
Profit = (P ATC) Q
Figure 5 Profit as the Area between Price and Average
Total Cost
(a) A Firm with Profits
Quantity 0
Price
P = AR = MR
ATC MC
P
ATC
Q
(profit-maximizing quantity)
Profit
Figure 5 Profit as the Area between Price and Average
Total Cost
(b) A Firm with Losses
Quantity 0
Price
ATC MC
(loss-minimizing quantity)
P = AR = MR P
ATC
Q
Loss
The Long Run: Market Supply with Entry
and Exit
Firms will enter or exit the market until
profit is driven to zero.
Price equals the minimum of average
total cost.
The long-run market supply curve is a
horizontal line at this price.
Figure 7 Market Supply with Entry and Exit
(a) Firm s Zero-Profit Condition
Quantity (firm) 0
Price
(b) Market Supply (# of firms variable)
Quantity (market)
Price
0
P = minimum
ATC
Supply
MC
ATC
Why Do Competitive Firms Stay in
Business If They Make Zero Profit?
Profit = TR TC
Total cost = explicit cost + implicit
cost.
Profit = 0 implies TR = explicit cost +
implicit cost
In the zero-profit equilibrium, the firm
earns enough revenue to compensate
the owners for the time and money
they spend to keep the business
going.
So, dont feel sorry for the owners!
Recap: Economic and Accountants
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
How an Accountant
Views a Firm
Revenue
Economic
profit
Implicit
costs
Explicit
costs
Explicit
costs
Accounting
profit
Application
We will now work through what
happens when the demand for a
product increases.
Short Run and Long Run Effects of a
Shift in Demand: an application
An increase in demand raises price and quantity
(for each firm and the industry) in the short run.
Firms earn positive profits
because price now exceeds average total cost.
New firms enter
Market supply increases (shifts right)
Price decreases; gradually returns to minimum
ATC
Profits decrease; gradually return to zero
So, the long-run effect of an increase in demand
is as follows: the price is unchanged, each firms
output is unchanged, the number of firms
increases, industry output increases.
Figure 8 An Increase in Demand in the Short Run and
Long Run
Firm
(a) Initial zero-profit long-run equilibrium
Quantity (firm) 0
Price
Market
Quantity (market)
Price
0
D Demand,
1
S Short-run supply,
1
P
1
ATC
Long-run
supply
P
1
1 Q
A
MC
q
1
Figure 8 An Increase in Demand in the Short Run and
Long Run
Market
Firm
(b) Short-Run Response to an increase in demand
Quantity (firm) 0
Price
MC
ATC
Profit
P 1
Quantity (market)
Long-run
supply
Price
0
D
1
D
2
P 1
S 1
P
2
Q
1
A
Q 2
P
2
B
q
1
q
2
Figure 8 An Increase in Demand in the Short Run and
Long Run
P 1
Firm
Quantity (firm) 0
Price
MC
ATC
Market
Quantity (market)
Price
0
P 1
P
2
Q
1
Q 2
Long-run
supply
B
D 1
D 2
S 1
A
S
2
Q 3
C
(c) Long-Run Response to positive short-run profits: new firms enter,
pushing the short-run market supply to the right.
An increase in demand leads to an increase in price in the short run. But this
price increase will not last. New firms will enter and push the price back to P
1
,
the minimum ATC. Each firms output will return to q
1
. The only long-run effect of
demand will be to increase the number of firms.
q
1
Summary
Because a competitive firm is a price
taker, its revenue is proportional to the
amount of output it produces.
The price of the good equals both the
firms average revenue and its
marginal revenue.
Summary
To maximize profit, a firm chooses the
quantity of output such that marginal
revenue equals marginal cost.
This is also the quantity at which price
equals marginal cost.
Therefore, the firms marginal cost
curve is its supply curve.
Summary
In the short run, when a firm cannot
recover its fixed costs, the firm will
choose to shut down temporarily if the
price of the good is less than average
variable cost.
In the long run, when the firm can
recover both fixed and variable costs,
it will choose to exit if the price is less
than average total cost.
Summary
In a market with free entry and exit,
profits are driven to zero in the long
run and all firms produce at the
efficient scale.
Changes in demand have different
effects over different time horizons.
In the long run, the number of firms
adjusts to drive the market back to the
zero-profit equilibrium.