Firms in Competitive Markets

Microeconomics - Lecture 6
mr.drs. I. (Ibrahim) Jabri
October 20th, 2021
Market Structures

Market concentration

Perfect Monopolistic Oligopoly Monopoly

Competition Competition

2
What is the legal
relevance of studying
these market
structures?
• Ex:
Competition Law
Sector Regulation

3
What is a Competitive Market?

• A perfectly competitive market has the following characteristics:

• There are many buyers and sellers in the market
• The goods offered by the various sellers are largely the
same (homogeneous goods; almost identical producers).
• There is perfect information.
• Firms can freely enter or exit the market.
• Ex.: most agricultural products
What is a Competitive Market?
• As a result of its characteristics, the perfectly competitive market
has the following outcomes:
• The actions of any single buyer or seller in the market have a
insignificant impact on the market price.
• Each buyer and seller takes the market price as given.

• Sellers and buyers are price takers.

But what should be the price in a

competitive market?
Market v Firm’s curve
Market Firm
Price Costs and
Revenue
Supply

P Demand
P

Demand
0
Q Quantity
Quantity

In a perfect competitive market, the price is

taken, the demand of a firm is perfectly elastic
Total and Average Revenue of a Competitive Firm
• Total revenue for a firm is the selling price times the quantity
sold.
TR = (P  Q)
• Average revenue tells us how much revenue a firm receives
for the typical unit sold.
• Average revenue is total revenue divided by the quantity
sold:
AR = TR/Q

• In perfect competition, average revenue equals the price of

the good.
Average Revenue = TR/ Q
Marginal Revenue of a Competitive Firm
• Marginal revenue is the change in total revenue from an
additional unit sold.
MR =TR/ Q
• For competitive firms, marginal revenue equals the price of
the good.
MR = P
• In perfect competition MR = AR = P
Total, Average, and Marginal Revenue for a
Competitive Firm

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Profit Maximization and the Competitive Firm’s
Supply Curve
• The goal of a competitive firm is to maximize profit
(Remember Profit=TR – TC)
• This means that the firm will want to produce the quantity that
maximizes the difference between total revenue and total
cost.
• Profit maximization occurs at the quantity where marginal
revenue equals marginal cost.

Let’s see why…

Profit Maximization: A Numerical Example

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 MR. DARP RULE
Market v Firm’s curve MR=D=AR=P
Market Firm
Price Costs and
Revenue
Supply
MC = Supply
of the Firm

P MR=
P ATC
Demand

Demand
0
Q Quantity
Quantity
 Profit Maximization for a Competitive Firm
Costs
The firm maximizes How can I
and
Revenue profit by producing see the profit
the quantity at which maximization
marginal cost equals MC
marginal revenue. in this
graph?

ATC
P = MR1 = MR2 P = AR = MR

0 QMAX Quantity
Profit as the Area between Price and Average Total
Cost (a) A Firm with Profits
Costs If this firm
and Revenue
decides to
MC ATC produce more
Profit or less than
P Q, the profit
will be
ATC P = AR = MR
negatively
impacted

0 Q Quantity
(profit-maximizing quantity)
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Profit as the Area between Price and Average Total
Cost (b) A Firm with Losses
Costs
and Revenue

MC ATC

ATC

P P = AR = MR

Loss

0 Q Quantity
(loss-minimizing quantity)
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Profit as the Area between Price and Average Total
Cost (c) A Firm with Profit-zero
Costs
and Revenue
Remember:
we are
MC
talking about
ATC economic
profit
ATC P P = AR = MR

0 Q Quantity
(loss-minimizing quantity)
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 Profit Maximization for a Competitive Firm

Costs
and • When MR > MC the
Revenue
MC
firm should increase Q
to increase profit
MC2
• When MR < MC the
ATC
P = MR1 = MR2 P = AR = MR firm should decrease Q
to increase profit
MC1
• When MR = MC profit
is maximized.

0 Q1 QMAX Q2 Quantity
Shutdown and Exit: the decision of the firm
• A shutdown refers to a short-
run decision not to produce
anything during a specific period
of time because of current
market conditions.
• Shutdown is temporary
• An Exit refers to a long-run
decision to leave the market.
• Exit is permanent
The Firm’s Short-Run Decision to Shut Down
• The firm ignores the sunk-costs when deciding whether to shut
down.
• Sunk costs are costs that have already been committed and
cannot be recovered.
• Therefore, the firm considers only the variable costs when deciding
whether to shut down.
• In the short-run, the firm shuts down if the revenue it gets from
producing is less than the variable cost of production.
• Shut down if TR < VC
• Shut down if TR/Q < VC/Q
• Shut down if AR < AVC or P<AVC
The Competitive Firm’s Short Run Supply
Curve 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 AVC
produce in the
short run.

Firm
shuts
down if
P< AVC
0 Quantity

Copyright©2011 South-Western
The Firm’s Long-Run Decision to Exit or Enter a
Market Exit Enter

• Different from the short run, in the • In the long run, a firm will enter
long run the firm will consider the the industry if such an action would
total cost (not only the variable be profitable.
costs) when deciding whether to exit
the market: • Enter if TR > TC

• Exit if TR < TC • Enter if TR/Q > TC/Q

• Exit if TR/Q < TC/Q • Enter if P > ATC

• Exit if P < ATC

The Competitive Firm’s Long-Run Supply
Curve
Costs
Firm’s long-run
supply curve MC = long-run S

Firm
enters if
P > ATC ATC

Firm
exits if
P < ATC

0 Quantity

Copyright©2011 South-Western
Do not forget!
• Short-Run Supply Curve
• The portion of its marginal cost curve that lies
above average variable cost.
• Long-Run Supply Curve
• The marginal cost curve above the minimum
point of its average total cost curve.
The Supply Curve in a Competitive Market
• Remember from Lecture 2: Market supply equals the sum of the
quantities supplied by the individual firms in the market.

• In the short run:

• For any given price, each firm supplies a quantity of output so that
its marginal cost equals price.
• Therefore, the market supply curve reflects the individual firms’
marginal cost curves.
Market Supply with a Fixed Number of Firms
(Short Run)
(a) Individual Firm Supply (b) Market Supply
Price Price

MC Supply

€ 2.00 € 2.00

1.00 1.00

0 100 200 Quantity (firm) 0 100,000 200,000 Quantity (market)

Copyright©2011 South-Western
The Long Run: Market Supply with Free Entry and
Exit
In the long run:
• If firms are making profit in a
certain market, more firms will
enter that market, leading to a
decrease in price, and therefore
a later-stage decrease in profit.
• Firms will enter or exit the
market until profit is driven to
zero.
• In the long run equilibrium
(where firms have no incentive
to enter or exit the market),
price equals the minimum of
Market Supply with Entry and Exit
(Long Run)
(a) Firm’s Zero-Profit Condition (b) Market Supply
Price Price

MC

ATC

P = minimum Supply
ATC

0 Quantity (firm) 0 Quantity (market)

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The Long Run: Market Supply with Entry and Exit
• While there is profit in a certain market, firms will keep entering.
While there is loss in a market, firms will keep exiting.
• At the end of the process of entry and exit, firms that remain must
be making zero economic profit.
• The process of entry and exit ends only when price and average
total cost are driven to equality.
• Long-run equilibrium must have firms operating at their efficient
scale.
An Increase in Demand in the Short Run and
Long Run
(a) Initial Condition
Firm Market
Price Price

MC ATC Short-run supply, S1

A
P1 P1 Long-run
supply

Demand, D1

0 Quantity (firm) 0 Q1 Quantity (market)

Copyright©2011 South-Western
An Increase in Demand in the Short Run and
Long Run
(b) Short-Run Response
Firm Market
Price Price

Profit MC ATC S1
B
P2 P2
A
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Quantity (market)

Copyright©2011 South-Western
An Increase in Demand in the Short Run and
Long Run
(c) Long-Run Response
Firm Market
Price Price

MC S1
ATC B S2
P2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity (firm) 0 Q1 Q2 Q3 Quantity (market)

Because of free entry

and exit, the supply
always adjusts in the
long run…
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Why Do Competitive Firms Stay in Business If They
Make Zero Profit?
• Profit equals total revenue minus total cost
• Total cost includes all the opportunity costs of the
firm (implicit and explicit costs)
• In the zero-profit equilibrium, the firm’s revenue
compensates the owners for the time and money
they expend to keep the business going
Class discussion: Insights from Competition
Law
• Do you think Mergers can be problematic in
a competitive market?
• Do you think companies are able to do
Cartels in a competitive market?
• Are the Competition Authorities/ Regulators
worried about competitive markets?

33
Concepts for the Tutorials!!
• Marginal Cost Function
• Average Total Cost Function
• Condition to Maximize Profit: MR= MC  P=MC
• Short run decision to shut down: TR < VC  P<AVC
• Long run decision to exit: TR<TC  P<ATC
• Short and Long run equilibrium after changes in demand (follow
slides 31-33)

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