Chapter 14

Firms in
Competitive
Markets

©
© 2002
2002 by
by Nelson,
Nelson, aa division
division of
of Thomson
Thomson Canada
Canada Limited
Limited
In this chapter you will…
•• Learn
Learn what
what characteristics
characteristics make
make aa market
market
competitive.
competitive.
•• Examine
Examine how
how competitive
competitive firms
firms decide
decide
how
how much
much output
output to
to produce.
produce.
•• Examine
Examine how
how competitive
competitive firms
firms decide
decide
when
when to
to shut
shut down
down production
production temporarily.
temporarily.
•• Examine
Examine how
how competitive
competitive firms
firms decide
decide
whether
whether to
to exit
exit or
or entry
entry the
the market.
market.
•• See
See how
how firm
firm behaviour
behaviour determines
determines aa
market’s
market’s short-run
short-run and
and long-run
long-run supply
supply
curves.
curves.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 2
 WHAT IS A COMPETITIVE
MARKET
•• AA perfectly
perfectly competitive
competitive market
market hashas
the
the following
following characteristics:
characteristics:
––There
There are
are many
many buyers
buyers and and sellers
sellers
in
in the
the market.
market.
––The
The goods
goods offered
offered byby the
the various
various
sellers
sellers are
are largely
largely the
the same.
same.
––Firms
Firms can
can freely
freely enter
enter or or exit
exit the
the
market.
market.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 3
 WHAT IS A COMPETITIVE
MARKET
•• As
As aa result
result ofof its
its characteristics,
characteristics, the
the
perfectly
perfectly competitive
competitive market
market has
has the
the
following
following outcomes:
outcomes:
––The
The actions
actions of of any
any single
single buyer
buyer oror
seller
seller in
in the
the market
market have
have aa
negligible
negligible impact
impact on on the
the market
market
price.
price.
––Each
Each buyer
buyer and and seller
seller takes
takes the
the
market
market price
price as as given.
given.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 4
 WHAT IS A COMPETITIVE
MARKET
•• A
A competitive
competitive market
market has
has many
many
buyers
buyers andand sellers
sellers trading
trading identical
identical
products
products so so that
that each
each buyer
buyer and
and
seller
seller is
is aa price
price taker.
taker.
––Buyers
Buyers and and sellers
sellers must
must accept
accept the
the
price
price determined
determined by by the
the market.
market.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 5
 The Revenue of a Competitive
Firm
•• Total
Total revenue
revenue for
for aa firm
firm is
is the
the selling
selling
price
price times
times the
the quantity
quantity sold.
sold.
TR (P  Q)
TR == (P Q)
•• Total
Total revenue
revenue is
is proportional
proportional to to the
the
amount
amount ofof output.
output.
•• Average
Average revenue
revenue tells
tells us
us how
how much
much
revenue
revenue aa firm
firm receives
receives forfor the
the typical
typical unit
unit
sold.
sold.
•• Average
Average revenue
revenue is is total
total revenue
revenue divided
divided
by
by the
the quantity
quantity sold.
sold.
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 6
 The Revenue of a Competitive
Firm
•• In
In perfect
perfect competition,
competition, average
average revenue
revenue
equals
equals the
the price
price of
of the
the good.
good.

Total revenue
Average Revenue =
Quantity

Price × Quantity
=
Quantity

= Price
Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 7
 The Revenue of a Competitive
Firm
•• Marginal
Marginal revenue
revenue isis the
the change
change in in
total
total revenue
revenue from
from an
an additional
additional unit
unit
sold.
sold.
•• For
For competitive
competitive firms,
firms, marginal
marginal
revenue
revenue equals
equals the
the price
price of
of the
the good.
good.

MR =TR/ Q

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 8
Table 14-1: Total, Average, and Marginal
Revenue for a Competitive Firm

Quantity Total Average Marginal

(in litres) Price Revenue Revenue Revenue
(Q) (P) (TR = P x Q) (AR = TR/ Q) (MR = ∆TR/∆Q)

1 $6 $6 $6
$6
2 6 12 6
6
3 6 18 6
6
4 6 24 6
6
5 6 30 6
6
6 6 36 6
6
7 6 42 6
6
8 6 48 6

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 9
 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE

•• The
The goal
goal of
of aa competitive
competitive firmfirm is
is to
to
maximize
maximize profit,
profit, which
which equals
equals total
total
revenue
revenue minus
minus total
total cost.
cost.
•• This
This means
means that
that the
the firm
firm will
will want
want toto
produce
produce thethe quantity
quantity that
that maximizes
maximizes
the
the difference
difference between
between total
total revenue
revenue
and
and total
total cost.
cost.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 10
 Table 14-2: Profit Maximization: A Numerical
Example

Quantity Total Marginal Marginal Change

(in litres) Revenue Total Cost Profit Revenue Cost in Profit
(MC =
(Q) (TR) (TC) (TR - TC) (MR = ∆TR/∆Q) (MR - MC)
∆TC/∆Q)

0 $0 $3 -$3
$6 $2 $4
1 6 5 1
6 3 3
2 12 8 4
6 4 2
3 18 12 6
6 5 1
4 24 17 7
6 6 0
5 30 23 7
6 7 -1
6 36 30 6
6 8 -2
7 42 38 4
6 9 -3
8 48 47 1

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 11
 PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRM’S SUPPLY CURVE

•• Profit
Profit maximization
maximization occurs
occurs at at the
the
quantity
quantity where
where marginal
marginal revenue
revenue
equals
equals marginal
marginal cost.
cost.
•• When
When MRMR >> MC
MC  increase
increase Q Q
•• When
When MRMR << MC
MC  decrease
decrease Q Q
•• When
When MRMR == MC
MC  Profit
Profit is
is maximized
maximized..

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 12
 Figure 14-1: Profit Maximization for a
Competitive Firm
The firm maximizes
Costs profit by producing
and the quantity at which
Revenue
marginal cost equals
marginal revenue.

MC
MC2

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

MC1

0 Q1 Q MAX Q2
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 13
Figure 14-2: Marginal Cost and the Firm’s
Supply Curve
Price
This section of the
firm’s MC curve is
also the firm’s supply
curve.
MC
P2

ATC
P1
AVC

0 Q1 Q2 Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 14
 A Firm’s Short-Run Decisions

•• AA shutdown
shutdown refers
refers toto aa short-run
short-run
decision
decision not
not to
to produce
produce anything
anything
during
during aa specific
specific period
period of
of time
time
because
because ofof current
current market
market
conditions.
conditions.
•• Exit
Exit refers
refers to
to aa long-run
long-run decision
decision to
to
leave
leave the
the market.
market.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 15
 A Firm’s Short-Run Decisions

•• The
The firm
firm considers
considers its
its sunk
sunk costs
costs
when
when deciding
deciding to
to exit,
exit, but
but ignores
ignores
them
them when
when deciding
deciding whether
whether toto shut
shut
down.
down.
––Sunk
Sunk costs
costs are
are costs
costs that
that have
have
already
already been
been committed
committed and and
cannot
cannot bebe recovered.
recovered.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 16
 A Firm’s Short-Run Decisions

•• The
The firm
firm shuts
shuts down
down ifif the
the revenue
revenue itit
gets
gets from
from producing
producing is is less
less than
than the
the
variable
variable cost
cost of
of production.
production.
––Shut
Shut down
down ifif TR
TR << VC
VC
––Shut
Shut down
down ifif TR/Q
TR/Q << VC/Q
VC/Q
––Shut
Shut down
down ifif PP << AVC
AVC

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 17
 Figure 14-3: The Competitive Firm’s Short-
Run Supply Curve
Price

Firm’s short-run
supply curve
MC

If ATC < P the

firm will
produce at a
profit. ATC

If AVC < P < AVC

ATC, firm will
produce in
the S-R but at
a loss.

Firm shuts
down if P <
AVC

0
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 18
 A Firm’s Short-Run Decisions

•• The
The portion
portion of
of the
the marginal-cost
marginal-cost curve
curve that
that
lies
lies above
above average
average variable
variable cost
cost is
is the
the
competitive
competitive firm’s
firm’s short-run
short-run supply
supply curve.
curve.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 19
 A Firm’s Long-Run Decision to
Enter or Exit
•• In
Inthe
thelong
longrun,run,the
thefirm
firmexits
exitsififthe
therevenue
revenueitit
would
wouldget get from
fromproducing
producingisisless
lessthan
thanits
itstotal
total
cost.
cost.
–– Exit
Exitifif TR
TR<< TC
TC
–– Exit
Exitifif TR/Q
TR/Q <<TC/Q
TC/Q
–– Exit
Exitifif PP<<ATC
ATC
•• AAfirm
firm will
willenter
enter the
theindustry
industryifif such
suchananaction
action
would
wouldbe beprofitable.
profitable.
–– Enter
Enterifif TR
TR>> TC
TC
–– Enter
Enterifif TR/Q
TR/Q >>TC/Q
TC/Q
–– Enter
Enterifif PP>>ATC
ATC

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 20
 Figure 14-4: The Competitive Firm’s Long-
Run Supply Curve
Price

Firm’slong-run
supply curve
MC

ATC

AVC
Firm shuts
down if P <
ATC

0
Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 21
 THE SUPPLY CURVE IN
COMPETITIVE MARKETS
•• Short-Run
Short-Run Supply
Supply Curve
Curve
––The
The portion
portion ofof its
its marginal
marginal cost
cost
curve
curve that
that lies
lies above
above average
average
variable
variable cost.
cost.
•• Long-Run
Long-Run Supply
Supply CurveCurve
––The
The marginal
marginal cost
cost curve
curve above
above the
the
minimum
minimum point
point of of its
its average
average total
total
cost
cost curve.
curve.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 22
 Figure 14-5: 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
P

ATC ATC

P = AR = MR P

Loss P = AR = MR

0 Q 0
Q
Quantity Quantity

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 23
 THE SUPPLY CURVE IN
COMPETITIVE MARKETS
•• Market
Market supply
supply equals
equals the
the sum
sum ofof the
the
quantities
quantities supplied
supplied by
by the
the individual
individual
firms
firms in
in the
the market.
market.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 24
The Short Run: Market Supply with
a Fixed Number of Firms
•• For
For any
any given
given price,
price, each
each firm
firm
supplies
supplies aa quantity
quantity of
of output
output so
so that
that
its
its marginal
marginal cost
cost equals
equals price.
price.
•• The
The market
market supply
supply curve
curve reflects
reflects the
the
individual
individual firms’
firms’ marginal
marginal cost
cost
curves.
curves.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 25
 Figure 14-6: Market Supply with a Fixed
Number of Firms
(a) Individual Firm Supply (b) Market Supply
Price Price

MC MC

$2.00 $2.00

$1.00 $1.00

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

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 26
The Long Run: Market Supply with
Entry and Exit

•• Firms
Firms will
will enter
enter or
or exit
exit the
the
market
market until
until profit
profit is
is driven
driven toto
zero.
zero.
•• In
In the
the long
long run,
run, price
price equals
equals the
the
minimum
minimum of of average
average total
total cost.
cost.
•• The
The long-run
long-run market
market supply
supply
curve
curve isis horizontal
horizontal at at this
this price.
price.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 27
 Figure 14-7: Market Supply with Entry and
Exit
(a) Firm’s Zero-Profit Condition (b) Market Supply
Price Price

MC
ATC

P=
minimum Supply
ATC

0 0
Quantity (firm) Quantity (market)

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 28
The Long Run: Market Supply with
Entry and Exit
•• At
At the
the end
end ofof the
the process
process of of entry
entry and
and exit,
exit,
firms
firms that
that remain
remain mustmust bebe making
making zero
zero
economic
economic profit.
profit.
•• The
The process
process of of entry
entry and
and exit
exit ends
ends only
only
when
when price
price and
and average
average total
total cost
cost are
are
driven
driven toto equality.
equality.
•• Long-run
Long-run equilibrium
equilibrium mustmust have
have firms
firms
operating
operating at at their
their efficient
efficient scale.
scale.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 29
 Why Stay in Business if You Make
Zero Profit?
•• Profit
Profit equals
equals total
total revenue
revenue minus
minus
total
total cost.
cost.
•• Total
Total cost
cost includes
includes allall the
the
opportunity
opportunity costscosts of
of the
the firm.
firm.
•• In
In the
the zero-profit
zero-profit equilibrium,
equilibrium, thethe
firm’s
firm’s revenue
revenue compensates
compensates the the
owners
owners for for the
the time
time and
and money
money they
they
expend
expend to to keep
keep thethe business
business going.
going.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 30
 Why Stay in Business if You Make
Zero Profit?
•• An
An increase
increase in
in demand
demand raises
raises price
price
and
and quantity
quantity in
in the
the short
short run.
run.
•• Firms
Firms earn
earn profits
profits because
because price
price now
now
exceeds
exceeds average
average total
total cost.
cost.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 31
 Figure 14-8: An Increase in Demand in the
Short Run and the Long Run.
(a) Initial Condition
Price Price
Firm Market

MC
Short-run Supply, D1
ATC

A
P1 P P1 Long-run
Supply

Demand, D1

0 0
Quantity (firm) Q1 Quantity (market)

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 32
 Figure 14-8: An Increase in Demand in the
Short Run and the Long Run.
(b) Short-Run Response
Price Price
Firm Market

MC
Short-run Supply, S1
Profit ATC
B
P2 P2
A
P1 P1 Long-run
Supply

D2
D1

0 0
Quantity (firm) Q1 Q 2 Quantity (market)

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 33
 Figure 14-8: An Increase in Demand in the
Short Run and the Long Run.
(c) Long-Run Response
Price Price
Firm Market

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

D2
D1

0 0
Quantity (firm) Q1 Q 2 Q3 Quantity (market)

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 34
 Why the Long Run Supply Curve
Might Slope Upward
•• Some
Some resources
resources used
used in in production
production may may
be
be available
available only
only in
in limited
limited quantities.
quantities.
•• Firms
Firms may may have
have different
different costs
costs
•• Marginal
Marginal Firm Firm
–– The
The marginal
marginal firm
firm is is the
the firm
firm that
that would
would
exit
exit the
the market
market ifif the
the price
price were
were any
any
lower.
lower.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 35
Summary
•• Because
Because aa competitive
competitive firm firm is
is aa price
price
taker,
taker, its
its revenue
revenue is is proportional
proportional to to the
the
amount
amount of of output
output itit produces.
produces.
•• The
The price
price of of the
the good
good equals
equals both
both the
the
firm’s
firm’s average
average revenue
revenue and and its
its marginal
marginal
revenue.
revenue.
•• To
To maximize
maximize profit,
profit, aa firm
firm chooses
chooses the the
quantity
quantity of of output
output such
such that that marginal
marginal
revenue
revenue equals
equals marginal
marginal cost. cost.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 36
Summary
•• This
This is is also
also thethe quantity
quantity atat which
which price
price
equals
equals marginal
marginal cost.cost.
•• Therefore,
Therefore, the the firm’s
firm’s marginal
marginal costcost curve
curve
is
is its
its supply
supply curve.
curve.
•• In
In the
the short
short run,
run, when
when aa firm
firm cannot
cannot
recover
recover its its fixed
fixed costs,
costs, the
the firm
firm will
will
choose
choose to to shut
shut down
down temporarily
temporarily ifif the
the
price
price of of the
the good
good isis less
less than
than average
average
variable
variable cost.cost.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 37
Summary
•• In
In the
the long
long run,
run, when
when the the firm
firm can
can recover
recover
both
both fixed
fixed and
and variable
variable costs,
costs, itit will
will
choose
choose to to exit
exit ifif the
the price
price is is less
less than
than
average
average total
total cost.
cost.
•• In
In aa market
market with
with free
free entry
entry and
and exit,
exit, profits
profits
are
are driven
driven to
to zero
zero in in the
the long
long runrun and
and all
all
firms
firms produce
produce at at thethe efficient
efficient scale.
scale.
•• Changes
Changes in in demand
demand have have different
different effects
effects
over
over different
different time
time horizons.
horizons.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 38
Summary
•• In
In the
the long
long run,
run, the
the number
number of
of firms
firms
adjusts
adjusts to to drive
drive the
the market
market back
back to to the
the
zero-profit
zero-profit equilibrium.
equilibrium.

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 39
The End

Mankiw et al. Principles of Microeconomics, 2nd Canadian Edition Chapter 14: Page 40