Firms in Competitive Markets

Economics
PRINCIPLES OF

N. Gregory Mankiw

Chapter 14
In this chapter,
look for the answers to these questions:
▪ What is a perfectly competitive market?
▪ What is marginal revenue? How is it related to total
and average revenue?
▪ How does a competitive firm determine the quantity
that maximizes profits?
▪ When might a competitive firm shut down in the
short run? Exit the market in the long run?
▪ What does the market supply curve look like in the
short run? In the long run?
1
 Introduction: A Scenario
▪ Three years after graduating, you run your own
business.
▪ You must decide how much to produce, what price
to charge, how many workers to hire, etc.
▪ What factors should affect these decisions?
▪ Your costs (studied in preceding chapter)
▪ How much competition you face
▪ We begin by studying the behavior of firms in
perfectly competitive markets.

FIRMS IN COMPETITIVE MARKETS 2

 Characteristics of Perfect Competition

1. Many buyers and many sellers.

2. The goods offered for sale are largely the

_____.
3. Firms can freely enter or _____ the market.
▪ Because of 1 & 2, each buyer and seller is a
“price taker” – takes the price as given.
o The actions of any single buyer or seller has
a negligible impact on the market price.
o What's the "opposite" of this assumption?
FIRMS IN COMPETITIVE MARKETS 3
 Objective of a Competitive Firm
▪ Firms want to maximize _____.

o _____ = Total Revenue – Total Cost

▪ → What is the firm's revenue and what are

its costs?

▪ → How do revenue and costs – together --

inform the supply decisions of firms?

FIRMS IN COMPETITIVE MARKETS 4

 The Revenue of a Competitive Firm
▪ Total revenue (TR) TR = P x Q

TR
▪ Average revenue (AR) AR = =P
Q
▪ Marginal revenue (MR):
∆TR
The change in TR from MR =
∆Q
selling one more unit.

FIRMS IN COMPETITIVE MARKETS 5

ACTIVE LEARNING 1
Calculating TR, AR, MR
Fill in the empty spaces of the table.

Q P TR AR MR

0 $10 n/a

1 $10 $10

2 $10

3 $10

4 $10 $40
$10
5 $10 $50
6
ACTIVE LEARNING 1 Notice that
Answers MR = ___
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n/a

1 $10 $10

2 $10 $20 $10

3 $10

4 $10 $40
$10
5 $10 $50 $10
7
 MR = P for a Competitive Firm
▪ A competitive firm (i.e., a firm operating in a
competitive marketplace) can keep increasing its
output _____ affecting the market price.
▪ So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
o Since P is _____ for a competitive firm.
MR = P is only true for
firms in competitive markets.

FIRMS IN COMPETITIVE MARKETS 8

 Profit Maximization
▪ What Q maximizes the firm’s profit?
▪ To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by ___,
cost rises by ___.
▪ → Compare MR to MC to determine optimal
output, Q.
▪ If MR > MC, then increase Q to raise profit.
▪ If MR < MC, then reduce Q to raise profit.
FIRMS IN COMPETITIVE MARKETS 9
 Profit Maximization
(continued from earlier exercise)

At any Q Q TR TC Profit MR MC
 Profit =
where MR > MR – MC
MC, increasing 0 $0 $5 –$5
$10 $4 $6
Q _____ profit. 1 10 9 1
10 6 4
At any Q 2 20 15 5
10 8 2
where MR < 3 30 23 7
MC, reducing 10 10 0
4 40 33 7
Q _____ profit. 10 12 –2
5 50 45 5

FIRMS IN COMPETITIVE MARKETS 10

 MC and the Firm’s Supply Decision
At the profit-maximizing Q, ___ = ___
At Qa, MC < MR. Costs
So, _____ Q
MC
to raise profit.
At Qb, MC > MR.
So, _____ Q
to raise profit. P1 MR
At Q1, MC = MR.
Changing Q
would lower profit. Q
Q a Q1 Q b

FIRMS IN COMPETITIVE MARKETS 11

 MC and the Firm’s Supply Decision
The MC curve _____
the firm’s Q at any Costs
price.
MC
Hence, the MC
P2 MR2
curve is the firm’s
_____ curve. Why?
P1 MR
Ex: If price rises to
P2, then the profit-
maximizing quantity Q
rises to Q2. Q1 Q2

FIRMS IN COMPETITIVE MARKETS 12

 Shutdown vs. Exit
▪ What if firm decides to not produce anything at
all?
▪ Shutdown:
A short-run (SR) decision not to produce
anything because of market conditions.
▪ Exit:
A long-run (LR) decision to _____ the market.
▪ A key difference between shutdown and exit:
▪ If shutdown in SR, must still pay fixed costs,
FC.
▪ Not true in LR.
FIRMS IN COMPETITIVE MARKETS 13
A Firm’s Short-run Decision to Shut Down
▪ When deciding whether to shut down, firm
compares _____ vs. _____.
▪ Cost of shutting down: revenue loss = TR
▪ Benefit of shutting down: cost savings = ____
(firm must still pay ___).
▪ So, shut down if TR < ___
▪ Let's divide both sides by Q: TR/Q < VC/Q
▪ So, firm’s shut down decision rule is:
Shut down if P < ___
FIRMS IN COMPETITIVE MARKETS 14
 A Competitive Firm’s Short Run Supply
The firm’s short Curve
run supply curve
is the portion of Costs
its MC curve
MC
_____ AVC.
If P > AVC, then
firm produces at ATC
Q where P =
AVC
MC.
If P < ___, then
firm shuts down
(produces Q = 0). Q

FIRMS IN COMPETITIVE MARKETS 15

 The Irrelevance of Sunk Costs
▪ Sunk cost: a cost that has already been
committed and _____ be recovered.
▪ Sunk costs should be _____ to decisions;
you must pay them regardless of your choice.
▪ FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
▪ → So, FC should not matter in the decision to
shut down.
▪ Other sunk cost examples?
▪ Sunk cost fallacy?
FIRMS IN COMPETITIVE MARKETS 16
 Example - Near-empty Restaurants &
Off-season Miniature Golf
▪ Restaurant must decide if to stay open for lunch.
▪ Restaurant should consider its two costs.
▪ Fixed costs: not relevant; they are sunk
costs in short run.
▪ Examples of fixed costs?
▪ Variable costs, VC: relevant
▪ Shut down if ______________.
▪ Stay open if _____________.
▪ Examples of variable costs?
Staying open can be profitable,
even with many tables empty.

17
 A Firm’s Long-Run Decision to Exit
▪ Compare the costs vs. benefits to make decision.
▪ Cost of exiting the market: revenue loss = TR
▪ Benefit of exiting the market: cost savings = TC
▪ So, firm exits if TR < ___
▪ Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ___

FIRMS IN COMPETITIVE MARKETS 18

A New Firm’s Decision to Enter Market
▪ In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
▪ Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ____

FIRMS IN COMPETITIVE MARKETS 19

 Examples of Business Closures 2025

FIRMS IN COMPETITIVE MARKETS 20

The Competitive Firm’s Long-Run Supply
Curve
The firm’s
Costs
long-run supply
curve is the MC
portion of
its MC curve ATC
_____ the long-
run ATC.

FIRMS IN COMPETITIVE MARKETS 21

ACTIVE LEARNING 2
Identifying a firm’s profit
A competitive firm
Determine
this firm’s Costs, P
total profit if MC
produce 50
P = $10 MR
units.
ATC
Identify the
$6
area on the
graph that
represents
the firm’s Q
profit. 50
22
ACTIVE LEARNING 2
Identifying a firm’s profit
Start off with the relationship that
Profit = TR – TC
Hint, divide and multiply by Q

23
ACTIVE LEARNING 2
Answers
A competitive firm
Costs, P
Profit per unit MC
= _____
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= _____ x Q =
$4 x 50 Q
= $200 50
24
ACTIVE LEARNING 3
Identifying a firm’s loss
Determine A competitive firm
this firm’s Costs, P
total loss, MC
assuming AVC
< $3 and
produce 30 ATC
units.
$5
Identify the
P = $3 MR
area on the
graph that
Q
represents 30
the firm’s loss. 25
ACTIVE LEARNING 3
Answers
A competitive firm
Costs, P
Profit MC
= (P – ATC) x Q
= _______
ATC
= _______
→ Firm is _____ $5
money. loss loss per unit = $2
P = $3 MR

Q
30
26
ACTIVE LEARNING 2
Identifying a firm’s profit
Question
When P = $3, ATC = $5, and AVC <$3, this firm
should.
A. Exit in the short-run.
B. Exit in the long-run.
C. Exit in the short- and long-run.
D. No change in production.

27
 Summary: Profit-Maximizing Rules
for a Competitive Firm
1) Find Q at which P = MC.
2) ______, shut down immediately and remain out
of business.
3) If __________, operate in the short run but exit
in the long run.
4) If ATC<P, stay in business.

FIRMS IN COMPETITIVE MARKETS 28

 Market Supply: Assumptions
1) All existing firms and potential entrants have
_____ costs.
2) Each firm’s costs do not change as other firms
enter or exit the market.
3) Assume the number of firms in the market is
▪ _____ in the short run
(due to fixed costs)
▪ Variable/can change in the _____ run
(due to free entry and exit).

FIRMS IN COMPETITIVE MARKETS 29

The Short-Run Market Supply Curve
▪ As long as P ≥ ____, each firm will produce its
profit-maximizing quantity, where MR = MC.
▪ Also recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.
▪ Thus, the quantity of output supplied to the
market is the sum of quantities supplied by each
firm.

FIRMS IN COMPETITIVE MARKETS 30

 The Short-Run Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

FIRMS IN COMPETITIVE MARKETS 31
 Entry & Exit in the Long Run
▪ In the LR, the number of firms can change due to
entry & exit.
▪ Why might new firms enter or exit?
▪ If existing firms are earning positive economic profit,
▪ → New firms enter, short-run market supply shifts
_____.
▪ → P falls, reducing profits and slowing entry.
▪ If existing firms incur losses,
▪ → Some existing firms exit, short-run market supply
shifts _____.
▪ P rises, reducing remaining firms’ losses.
32
FIRMS IN COMPETITIVE MARKETS
 The Zero-Profit Condition
▪ Long-run equilibrium:
In the LR, the process of entry or exit is complete
– remaining firms earn _____ economic profit.
▪ _____ economic profit occurs when P = ATC.
▪ Remember, profit = (P-ATC) x Q
▪ If P>ATC, profit>0 and new firms enter.
▪ If P<ATC, profit<0 and firms exit.
▪ Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
FIRMS IN COMPETITIVE MARKETS 33
 The Zero-Profit Condition
▪ Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn ______ economic profit.
▪ Recall that MC intersects ATC at minimum ATC.
▪ Hence, in the long run, P = minimum ATC.
▪ →Firms are operating at their _______ scale.
▪ *Ch 13 – the level of production with the lowest ATC is
the firm’s efficient scale.

FIRMS IN COMPETITIVE MARKETS 34

 Revisit Example 2: ATC and MC
1. When MC < $200 ATC
ATC, MC
$175
ATC is falling.
$150
2. When MC > $125

Costs
ATC,
$100
ATC is rising.
$75
3. The MC curve $50
crosses the
$25
ATC curve at
$0
the ATC curve’s
0 1 2 3 4 5 6 7
_____.
Q
THE COSTS OF PRODUCTION 35
Why Do Firms Stay in Business if Profit = 0?
▪ Recall, economic profit is revenue minus all costs
– including _____ costs, like the opportunity cost
of an owner’s time and money.
▪ In the zero-profit equilibrium,
▪ Firms earn enough revenue to cover these
costs.
▪ Accounting profit is positive (>0).

FIRMS IN COMPETITIVE MARKETS 36

 The Long-Run Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
FIRMS IN COMPETITIVE MARKETS 37
 SR & LR Effects of an Increase in Demand

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
FIRMS IN COMPETITIVE MARKETS 38
 Why the Long-Run Supply Curve Might Slope
Upward
▪ The LR market supply curve is _____ if
1) All firms have ______ costs, and
2) Costs do not ______ as other firms enter or
exit the market.
▪ If either of these assumptions is not true,
then long-run supply curve slopes upward.

FIRMS IN COMPETITIVE MARKETS 39

 1) Firms Have Different Costs
▪ For any given price, P, those with lower costs are
more likely to enter the market than those w/higher
costs.
▪ As P rises, firms with lower costs enter the
market before those with higher costs.
▪ To increase quantity supplied (via firm _____),
need to increase P to make it _______ for higher-
cost firms to enter market.
▪ Hence, LR market supply curve slopes upward.
▪ →As quantity supplied increases, so must P.

FIRMS IN COMPETITIVE MARKETS 40

 1) Firms Have Different Costs
▪ Note - Some firms may earn positive profit in the
long-run when costs differ.
▪ Why? At price = P,
▪ For the ______ firm (firms that enter when price
= P), P = _____ ATC and profit = 0.
▪ But, for firms w/lower costs (not marginal firm at
P), they are earning profit>0 because P now
reflects the min ATC of marginal firm, not the
min ATC of lower cost firm.

FIRMS IN COMPETITIVE MARKETS 41

 2) Costs Rise as Firms Enter the Market
▪ In some industries, the supply of a key input is
______.
▪ e.g., amount of land suitable for farming is fixed.
▪ The entry of new firms increases demand for this
input, causing input’s price to rise.
▪ This increases all firms’ costs.
▪ Hence, an increase in P is required to ______ the
market quantity supplied, so the supply curve is
upward-sloping.

FIRMS IN COMPETITIVE MARKETS 42

 Conclusion: The Efficiency of a Competitive
Market
▪ Profit-maximization: MC = MR
▪ Perfect competition: P = MR
▪ So, in the competitive eq’m: P = MC
▪ Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
▪ So, the competitive equilibrium is efficient,
maximizes total surplus.
▪ In the next chapter, we cover monopoly,
pricing/production decisions, deadweight loss,
regulation.
FIRMS IN COMPETITIVE MARKETS 43
 Question
1. A perfectly competitive firm
▪ A. Chooses its price to maximize profits.
▪ B. Sets its price to undercut other firms selling
similar products.
▪ C. Takes its price as given by the market
condition.
▪ D. Is a price maker.
▪ E. Picts the price that yields the largest market
share.

FIRMS IN COMPETITIVE MARKETS 44

 Question
2. A competitive firm’s short-run supply curve is its
___ cost curve above its ____ cost curve.
▪ A. average-total; marginal
▪ B. average-variable; marginal
▪ C. marginal; average-total
▪ D. marginal; average-variable

FIRMS IN COMPETITIVE MARKETS 45

 Question
3. If a profit-maximizing, competitive firm is producing
a quantity at which marginal cost is between average
variable cost and average total cost, it will
▪ A. Keep producing in the short run but exit the
market in the long run.
▪ B. Shut down in the short run but return to
production in the long run.
▪ C. Shut down in the short run and exit the market in
the long run.
▪ D. Keep producing both in the short run and in the
long run.
FIRMS IN COMPETITIVE MARKETS 47
 Question
4. In the short-run equilibrium of a competitive
market with identical firms, if new firms are getting
ready to enter, what are the relationships among
price P, marginal cost MC, and average total cost
ATC.
▪ A. P>MC and P>ATC.
▪ B. P>MC and P=ATC.
▪ C. P=MC and P>ATC.
▪ D. P=MC and P = ATC.

FIRMS IN COMPETITIVE MARKETS 48

 Question
5. When a perfectly competitive firm increases the
quantity it produces and sells by 10 percent, its
marginal revenue ___ and its total revenue
increases by ____.
▪ A. Falls; less than 10 percent.
▪ B. Falls; exactly 10 percent.
▪ C. Stays the same; less than 10 percent.
▪ D. Stays the same; exactly 10 percent.

FIRMS IN COMPETITIVE MARKETS 49

 Question
6. In the long-run equilibrium of a competitive
market with identical firms, what are the
relationships among price P, marginal cost MC, and
average total cost ATC?
▪ A. P>MC and P>ATC.
▪ B. P>MC and P = ATC.
▪ C. P = MC and P>ATC.
▪ D. P = MC and P = ATC.

FIRMS IN COMPETITIVE MARKETS 50