MICROECONOMICS
TOPIC 7 – FIRMS IN COMPETITIVE MARKET
AFTER LEARNING TOPIC 7, YOU SHOULD BE ABLE TO:
• Explain why a perfect competitor faces a horizontal demand curve
• Explain how a perfect competitor decides how much to produce
• Use graphs to show the competitive firm’s profit or loss
• Explain why firms may shut down temporarily
• Explain how entry and exit ensure that firms earn zero economic profit in
the long run
• Explain how perfect competition leads to economic efficiency
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SHORT RUN COSTS REVISITED
• Average total cost (ATC):
o Total cost divided by the number of units produced.
o ATC = TC ÷ Q.
• Average variable cost (AVC):
o Total variable cost divided by the number of units produced.
o AVC = TVC ÷ Q.
• Average fixed cost (AFC):
o Total fixed cost divided by the number of units produced.
o AFC = TFC ÷ Q.
• Marginal cost (MC):
o Increase in cost from producing one more unit of output.
o Change in total cost divided by change in output.
o MC = ΔTC ÷ ΔQ.
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REVENUE EXPLAINED
• Total Revenue (TR) = p x q
• Average Revenue (AR) = TR/q = (p x q)/q = p
• Marginal Revenue (MR) = ∆TR/ ∆q
• Marginal revenue is the change in total revenue from an additional unit
sold.
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MARKET STRUCTURES
Four market structure types:
• Competitive market (Perfect competition)
• Monopolistic competition
• Oligopoly
• Monopoly
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• Many buyers and many sellers
• Similar goods (can be close substitutes of each other)
• Firms are price takers.
• Free entry and exit.
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COMPETITIVE MARKETS
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ARE THESE MARKETS REALLY “PERFECTLY” COMPETITIVE?
Example How It Works Reality Check
Stock market Millions of shares of stocks are traded
daily. Buyers and sellers have access to
real-time information. Most of the
traders represent only a small share of
the market, so they have little ability to
influence the market price.
Large institutional
investors are big
enough to be able to
influence the market
price.
Farmers’
markets
Sellers are able to set up at little or no
cost. There are many buyers and sellers
of similar products, which causes the
market price for similar products to
converge toward a single price.
Many product markets
do not have enough
sellers to achieve a
perfectly competitive
result. With fewer
vendors, individual
sellers can often set
higher prices.
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THE COMPETITIVE FIRM IS A PRICE TAKER
Price
$10$10
1,000,000
Price
MARKET FIRM
For a competitive
firm MR = AR
because the firm is
a price taker and
faces a constant
average revenue
or price.
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PROFIT MAXIMISING RULE
• Profit is maximized by choosing the level of output such that MR = MC.
• Marginal revenue (MR)
o MR = ΔTR ÷ ΔQ
• Marginal cost (MC)
o MC = ΔTC ÷ ΔQ
• Marginal profit:
o Δ Profit = MR – MC.
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CALCULATING PROFITS
Price = $ 10
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Quantity
TR
P  Q
TC
Profit
TR – TC
MR
Δ TR ÷ Δ Q
MC
Δ TC ÷ Δ Q
Change in Profit
MR – MC
Δ TR ÷ Δ Q
0 $0 $25 -$25
1 10 34 -24 $10 $9 1
2 20 41 -21 10 7 3
3 30 46 -16 10 5 5
4 40 49 -9 10 3 7
5 50 51 -1 10 2 8
6 60 54 6 10 3 7
7 70 60 10 10 6 4
8 80 70 10 10 10 0
9 90 95 -5 10 25 -15
10 100 145 -45 10 50 -40
COMPETITIVE FIRM IN THE SHORT RUN
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• Profit = (price – average total cost) × Q.
o π = ($10 – $8.75) x 8 = $10.
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CALCULATING SHORT RUN PROFIT
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PROFIT AND LOSS IN THE SHORT RUN
PROFIT MAXIMISATION
• Profit is maximized by choosing the level of output such that:
o MR = MC.
• What should the firm do if MR > MC?
• What should the firm do if MR < MC?
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• Firms cannot
always make a
profit.
• Shutting down:
• A firm will shut
down if it cannot
cover variable
costs.
• Shutting down is
not the same as
going out of
business and
exiting the industry.
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WHEN TO OPERATE OR SHUT DOWN
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SHORT-RUN SUPPLY CURVE
SIGNALS
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• Signals convey information about the profitability of various markets.
• What happens if existing firms are earning positive or negative profits?
• When firms make zero economic profit, the market is in long-run
equilibrium.
LONG RUN – EXIT AND ENTRY
• Decisions about entry and exit in a competitive market depend on the
incentives faced by the owners of existing firms and the entrepreneurs
who could start new firms
• If firms already in the market are profitable then new firms will enter the
market.
• Remember free entry – no barriers to enter
• Entry increases the number of firms, increasing the supply and driving
down prices and profits
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LONG-RUN SUPPLY CURVE
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• Why join an industry if you can’t earn an economic profit in the long run?
• When a firm breaks even, they just cover both their explicit costs and
implicit costs.
• So the firm covers the opportunity costs of their next-best alternative
business venture.
A REMINDER ABOUT ECONOMIC PROFITS
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COMPETITIVE MARKET IN LONG-RUN EQUILIBRIUM
SHORT-RUN ADJUSTMENT TO DEMAND DECREASE
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• If firms in the market are making losses then some existing firms will exit
the market. Exit reduces the number of firms, decreasing the supply and
drive up prices and profits
• At the end of this process of entry and exit, firms that remain in the market
must be making zero economic profit (price equals average total cost
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SHORT-RUN ADJUSTMENT TO DEMAND DECREASE
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LONG-RUN ADJUSTMENT TO DEMAND DECREASE