RMIT Classification: Trusted
Chapter 9
Firms in a Competitive
Market
Copyright © 2021 by W. W. Norton & Company, Inc.
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Previously—1
• Economists break cost into explicit costs and implicit costs and
consider economic profit.
• Marginal cost plays the most crucial role in a firm’s cost structure.
• The MC curve always leads (pulls) the ATC and AVC curves.
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Average Cost Curves and Marginal Cost
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Previously—2
• Economists break cost into explicit costs and implicit costs and
consider economic profit.
• Marginal cost plays the most crucial role in a firm’s cost structure.
• The MC curve always leads the ATC and AVC curves.
• Scale economies determine long-run costs.
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Big Questions
1. How do competitive markets work?
2. How do firms maximize profits?
3. What does the supply curve look like in perfectly competitive
markets?
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Firms in a Competitive Market
• Characteristics of the Competitive Market
• Profit-Maximizing Rule
❖ MR = MC
❖ Profit = (P – ATC) × Q
• Operational Rules (Short-Run)
❖ P < AVC → shut down
❖ AVC < P < ATC → operate (at a loss)
❖ P > ATC → operate (at a profit)
• Sunk Cost
• Long-Run Equilibrium
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Competitive Markets
Competitive Markets
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Are These Markets Really “Perfectly”
Competitive?—1
Example How It Works Reality Check
Stock market Millions of shares of stocks are traded Large institutional investors
daily. Buyers and sellers have access to real- are big enough to be able to
time information. Most of the influence the market price.
traders represent only a small share of the
market, so they have little ability to influence
the market price.
Farmers’ Sellers are able to set up at little or no cost. Many product markets do not
markets There are many buyers and sellers of similar have enough sellers to
products, which causes the market price for achieve a perfectly
similar products to converge toward a single competitive result. With fewer
price. vendors, individual sellers can
often set higher prices.
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Are These Markets Really “Perfectly”
Competitive?—2
Example How It Works Reality Check
Online ticket The resale market for tickets to major events Some ticket companies and
auctions involves many buyers and sellers. The prices fans get special privileges that
for seats in identical sections end up enable them to buy and sell
converging quickly to a narrow range. blocks of tickets before others
can enter the market.
Currency Hundreds of thousands of traders Currency markets are subject
trading around the globe engage in currency to intervention on the part of
buying and selling on any given governments that might wish to
day. Because all traders have very good real- strategically alter the prevailing
time information, currency trades in different price of their currency.
parts of the world converge toward the same
price.
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How Do Firms Maximize Profits?
• How many driveways should Mr. Plow clear to maximize profits?
❖ Want to derive a firm’s profit-maximizing rule.
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Calculating Profits: Price = $10—1
Change in Profit
TR Profit MR MC
Quantity TC MR − MC
P×Q TR − TC Δ TR ÷ Δ Q Δ TC ÷ Δ Q
Δ TR ÷ Δ Q
0 $0 $25 -$25
1 10 34 -245 $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
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Profit-Maximizing Rule—1
• Mr. Plow wants to compare his marginal revenue to his marginal
cost.
• Marginal revenue (MR)
❖ MR =
• Marginal cost (MC)
❖ MC =
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Profit-Maximizing Rule—2
• Marginal profit:
❖ Δ Profit = ____ – ____.
• Profit-maximizing rule:
❖ Profit is maximized by choosing the level of output such that
____ = ____.
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Calculating Profits: Price = $10—2
Change in
TR Profit MR MC Profit
Quantity TC
P×Q TR − TC Δ TR ÷ Δ Q Δ TC ÷ Δ Q 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
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Profit-Maximizing Rule—3
• Profit is maximized by choosing the level of output such that:
❖ MR = MC.
• What should the firm do if MR > MC?
• What should the firm do if MR < MC?
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Deciding How Much to Produce
• Mr. Plow will maximize profits where:
❖ MR = MC.
• Since he is a price taker: P* = MR.
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Profit Maximization
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How to Calculate Profit
• Profit = (price – average total cost) × Q.
𝛑 = 𝐏 − 𝐀𝐓𝐂 𝐱 𝐐
• 𝜋 = $10 − $8.75 𝑥 8 = $10
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Class Activity: Think-Pair-Share
• Suppose you are the owner of a firm producing jelly beans at the
average cost per case in the table below.
• Initially, you produce 200 cases of jelly beans per time period. Then, a
new customer calls and places an order for a case, requiring you to
increase your output to 201 cases. She offers you $350 for the case.
Should you produce it?
CASES AVERAGE COST
200 $200
201 $201
202 $202
203 $203
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The Firm in the Short Run
• Firms can’t always make a profit.
• Shutting down:
❖ When will a firm shut down?
❖ Is shutting down the same as going out of business?
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When to Operate or Shut Down
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Profit and Loss in the Short Run
Condition Outcome
P > ATC The firm makes a profit.
ATC > P > AVC The firm will operate to minimize loss.
AVC > P The firm will temporarily shut down.
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Short-Run Supply Curve
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Long-Run Supply Curve
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Long-Run Shutdown Criteria
Condition Outcome
P > ATC The firm makes a profit.
P < ATC The firm should shut down.
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Sunk Costs
• Sunk costs:
❖ What are sunk costs?
• Sunk-cost fallacy:
❖ What is the sunk-cost fallacy?
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Sunk-Cost Fallacies in Your Life—1
• You are waiting in a long line with your friend at one food court
restaurant while there is no line at another.
❖ Your friend says, “We might as well stay in line. We’ve already
been waiting for 15 minutes.”
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Sunk-Cost Fallacies in Your Life—2
• After one semester of college:
❖ “I’m not getting much from my experience at Tech, but I’ve
already spent time and money for a whole semester here, so I
don’t want to transfer to State.”
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Practice What You Know—1
Steve runs a competitive sandwich shop. Right now, he is
producing output at a level where MR > MC. To increase his
profits, Steve should
A. try to use more capital in his production.
B. try to use more labor in his production.
C. produce less output.
D. produce more output.
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Practice What You Know—2
Suppose a competitive firm is faced with a price in the short run
that is below ATC but above AVC. In the short run, this firm
should
A. shut down.
B. exit the industry.
C. raise the price of the good.
D. produce at the output level where MR = MC.
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Practice What You Know—3
A competitive firm will shut down and produce output level Q =
0 if
A. price < min. ATC.
B. min. AVC < price < min. ATC.
C. price < min. AVC.
D. P = MR.
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Conclusion
• In competitive markets, firms have no control over price.
• Profits and losses act as signals in a perfectly competitive market.
• Competitive markets serve as an ideal benchmark we can
compare other market structures to.
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