CHAPTER
12
Firms in Perfectly Competitive
Markets
Chapter Outline and
Learning Objectives
12.1 Perfectly Competitive Markets
12.2 How a Firm Maximizes Profit in a
Perfectly Competitive Market
12.3 Illustrating Profit or Loss on the
Cost Curve Graph
12.4 Deciding Whether to Produce or to
Shut Down in the Short Run
12.5 The Entry and Exit of Firms in the
Long Run
12.6 Perfect Competition and Efficiency
Pure
Competition
Monopolistic Competition
Oligopoly
Monopoly
Number
of Firms
Pure
Competition
Monopolistic
Competition
Many small
Many small
Oligopoly
Monopoly
A few large
one
Considers action or reaction of other firms
Product type
Homogeneous Differentiated
Diff or
Homog
one
Need to stress differences?
Barriers to
Entry
none
none
large
large
Long run profits possible?
Price
Taker/Maker
taker
taker/seeker
maker
maker
Ability to influence market price?
Non-price
Competition
no
yes
yes
As important as price?
yes
• Entrepreneurs are continually introducing new
products or new ways of selling products,
which—when successful—enable them to earn
economic profits in the short run.
• But in the long run, competition among firms
forces prices to the level where they just
cover the costs of production.
Perfect Competition in Farmers’ Markets
• Demand for organically grown food increased
at a rate of 20 percent per year,
Prices rose
More farmers have begun participating in
farmers’ markets.
• Supply increased,
• Prices dropped
• Profits from farmers’ markets is no longer
higher than what they earn selling to
supermarkets.
Perfectly competitive market:
1. many buyers and sellers,
2. all firms selling identical products,
3. no barriers to new firms entering the market.
4. Price takers. Firms are unable to affect the
market price.
A good crop from one wheat farmer, or if one wheat
farmer stops growing wheat altogether, the market
supply curve for wheat will not shift by enough to
change the equilibrium price by even 1 cent.
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Perfect Competition (many small firms)
•
•
•
•
•
Market supply & demand determine price.
The firm’s demand will be perfectly elastic.
Firms can sell as much as they want at P
Above P, they lose business
Below P they lose revenue.
Firm
Price
Price
Firms must
take the
market price
P
Market
demand
Market
Market
supply
Firm’s
demand
Output
P
Output
Profit = Total revenue - total cost.
Average revenue (AR)
- TR / Quantity sold = Price
Marginal revenue (MR) The change in total revenue
from selling one more unit of a product, also = Price
AR = MR = Price = Demand
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Farmer Parker’s Revenue from
Wheat Farming
Number of
Bushels
(Q)
Market Price
(per bushel)
(P)
0
1
2
3
4
5
6
$4
4
4
4
4
4
4
Total
Revenue
(TR)
$0
4
8
12
16
20
24
Average
Revenue
(AR)
—
$4
4
4
4
4
4
AR = MR = Price
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Marginal
Revenue
(MR)
—
$4
4
4
4
4
4
Determining the Profit-Maximizing
Level of Output
Quantity
(bushels)
(Q)
Total
Revenue
(TR)
Total
Cost
(TC)
0
1
2
3
4
5
6
7
8
9
10
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
$2.00
5.00
7.00
8.50
10.50
13.00
16.50
21.50
28.50
38.00
50.50
Profit
(TR−TC)
−$2.00
−1.00
1.00
3.50
5.50
7.00
7.50
6.50
3.50
−2.00
−10.50
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
—
$4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
—
$3.00
2.00
1.50
2.00
2.50
3.50
5.00
7.00
9.50
12.50
Maximum Profit, or MR = MC
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Maximum Profit
Profit is maximized
where the vertical
distance between
total revenue and
total cost is the
largest.
This happens at an
output of 6 bushels.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
MR = MC
MR = $4 per bushel.
Profit is maximized by producing
up to the point where the marginal
revenue of the last bushel
produced is equal to its
marginal cost, or MR = MC.
The closest Farmer Parker can
come is to produce 6 bushels
of wheat.
Once marginal cost is
greater than marginal revenue
profits begin to decline.
.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
Conclusions:
1. The profit-maximizing level of output:
a. where TR – TC is the greatest.
b. where MR = MC.
2. In a perfectly competitive industry, P = MR.
So, we can restate the MR = MC condition as P = MC.
© 2013 Pearson Education, Inc. Publishing as Prentice Hall
Showing a Profit on the Graph
A firm maximizes
profit where MR = MC.
Price - average total
cost = profit per unit
of output.
Total profit is equal to
P – ATC time quantity
of output.
The green-shaded
rectangle, which has a
height equal to (P −
ATC) and a width equal
to Q.
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Determining Profit-Maximizing
Price and Quantity
a. Suppose the current equilibrium price in the
Output
per Day
basketball market is $12.50.
To maximize profit, how many basketballs will Andy 0
produce?
1
What price will he charge?
2
And how much profit (or loss) will he make?
3
Draw a graph to illustrate your answer.
4
Label clearly Andy’s demand, ATC, AVC, MC, and
5
MR curves;
6
the price he is charging;
7
the quantity he is producing;
8
and the area representing his profit (or loss).
9
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Total
Cost
$10.00
20.50
24.50
28.50
34.00
43.00
55.50
72.00
93.00
119.00
Determining Profit-Maximizing Price and Quantity
Step 1: Calculate Andy’s marginal cost, average total cost, and average variable cost.
Andy will produce the level of output where marginal revenue is equal to marginal cost.
We can calculate costs from the information given in the table to draw the required graph.
Average total cost (ATC) equals total cost (TC) divided by the level of output (Q).
Average variable cost (AVC) equals variable cost (VC) divided by output (Q).
To calculate variable cost, recall that total cost equals variable cost plus fixed cost.
When output equals zero, total cost equals fixed cost. In this case, fixed cost equals $10.00.
Output
per Day
(Q)
Total
Cost
(TC)
Fixed
Cost
(FC)
Variable
Cost
(VC)
Average
Total Cost
(ATC)
Average
Variable
Cost (AVC)
Marginal
Cost
(MC)
0
$10.00
$10.00
$0.00
—
—
—
1
20.50
10.00
10.50
$20.50
$10.50
$10.50
2
24.50
10.00
14.50
12.25
7.25
4.00
3
28.00
10.00
18.00
9.33
6.00
3.50
4
34.00
10.00
24.00
8.50
6.00
6.00
5
43.00
10.00
33.00
8.60
6.60
9.00
6
55.50
10.00
45.50
9.25
7.58
12.50
7
72.00
10.00
62.00
10.29
8.86
16.50
8
93.00
10.00
83.00
11.63
10.38
21.00
9
119.00
10.00
109.00
13.22
12.11
26.00
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or
Calculate Andy’s marginal cost, and average total cost
Andy will produce the level of output where MR = MC
Average total cost (ATC) equals total cost (TC) divided by output (Q).
Step 1:
Output per
Day (Q)
Total Cost
(TC)
Average Total
Cost (ATC)
0
$10.00
1
20.50
$20.50
$10.50
$12.50
2
24.50
12.25
4.00
12.50
3
28.00
9.33
3.50
12.50
4
34.00
8.50
6.00
12.50
5
43.00
8.60
9.00
12.50
6
55.50
9.25
12.50
12.50
7
72.00
10.29
16.50
12.50
8
93.00
11.63
21.00
12.50
9
119.00
13.22
26.00
12.50
—
Marginal
Cost (MC)
Marginal
Revenue (MR)
—
Step 2: MR = MC when Andy produces 6 basketballs per day.
Profits per unit = MR – ATC at 6 units. (12.50 – 9.25 = 3.25). His total Profits equal per
unit profits times output )3.25 x 6 = 19.50 or TR – TC = 6 x 12.50 – 55.50 = $75.00 −
$55.50 = $19.50.
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Graphing Profits
MR = MC when Andy produces 6 basketballs per day.
Andy’s profits are equal to his marginal revenue minus his average total
costs times his output. ($12.50 – 9.25) x 6 = $19.50.
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Suppose the equilibrium price of basketballs falls
to $6.00.
Now how many basketballs will Andy produce?
What price will he charge?
And how much profit (or loss) will he make?
Draw a graph to illustrate this situation,
using the instructions in part (a).
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Output
per Day
Total
Cost
0
$10.00
1
20.50
2
24.50
3
28.50
4
34.00
5
43.00
6
55.50
7
72.00
8
93.00
9
119.00
Andy will still produce the level of output where MR = MC, but MR = 6
Output per
Day (Q)
Total Cost
(TC)
Average Total
Cost (ATC)
0
$10.00
1
20.50
$20.50
$10.50
$6.00
2
24.50
12.25
4.00
6.00
3
28.00
9.33
3.50
6.00
4
34.00
8.50
6.00
6.00
5
43.00
8.60
9.00
6.00
6
55.50
9.25
12.50
6.00
7
72.00
10.29
16.50
6.00
8
93.00
11.63
21.00
6.00
9
119.00
13.22
26.00
6.00
—
Marginal
Cost (MC)
Marginal
Revenue (MR)
—
Now MR = MC when Andy produces 4 basketballs per day.
Profits per unit = MR – ATC at 4 units. (6 – 8.50 = -2.50). His total losses equal per
unit losses times output )-2.50 x 4 = -10.00 or TR – TC = 4 x 6.00 – 34.00 = $24.00 −
$34.00 = -$10.00.
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Graphing Losses
MR = MC when Andy produces 4 basketballs per day.
Andy’s losses are equal to his marginal revenue minus his average total
costs times his output. ($6.00 – 8.50) x 4 = -$10.00.
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Remember That Firms Maximize Their Total
Profit, Not Their Profit per Unit
Only when the firm has expanded production to Q2 will it have
produced every unit for which marginal revenue is greater than
marginal cost.
At that point, it will have maximized profit.
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Equilibrium
Price
Operating at Minimum ATC
ATC
MC
$6
$5
$4
$3
Price = Demand = MR
$2
$1
0
10
20
30
40
50
60
Quantity
Short Run Profits
Earn economic profit
MR (P) > ATC
Normal Profit
MR (P) = ATC
Short Run Losses
Firm
Price
MC
P3
MR
Firm covers AVC, but not AFC:
MR (P) < ATC, but MR > AVC
Shut Down
Firm can’t cover AVC, minimize losses by
shutting down
MR (P) < AVC
ATC
AVC
Output
Case 1: Prices rise
Profits?
Entry or Exit?
Supply
An Increase in Market Demand
• Consider the market for toothpicks. A new candy that
sticks to teeth causes the market demand for toothpicks
to increase from D1 to D2 … market price increases to P2 …
shifting the firm’s demand curve upward. At the higher
price, firms expand output to q2 and earn short-run profits.
• Economic profits will draw competitors into the industry,
shifting the market supply curve from S1 to S2.
Firm
Price
Price
S1
MC ATC
S2
P2
d2
P2
P1
d1
P1
q1 q2
Output
Market
D1 D2
Q1 Q2
Output
The Adjustment
• After the increase in market supply, a new equilibrium is
established at the original market price P1 and a larger rate
of output (Q3).
• As the market price returns to P1, the demand curve
facing the firm returns to its original level.
• In the long-run, economic profits are driven down to
zero.
Firm
Price
Price
S1
MC ATC
P2
d2
P1
d1
q1 q2
Output
Market
S2
P2
Slr
P1
D1 D2
Q1 Q2 Q3
Output
Price
$6
1. Price goes up
2. Firms enter, Supply increases
3. Price goes down
ATC
MC
$5
$4
SR Profits
$3
$2
$1
0
Price = Demand = MR
4. No LR Profits
10
20
30
40
50
60
Quantity
Case 2: Prices fall
Profits?
Entry or Exit?
Supply
A Decrease in Demand
• If, instead, something causes market demand for toothpicks
the market price falls to P2
to decrease from D1 to D2 …
shifting the firm’s demand curve downward, leading to a
reduction in output to q2. The firm is now making losses.
• Short-run losses cause some competitors to exit the market,
and others to reduce the scale of their operation, shifting the
market supply curve from S1 to S2.
Firm
Price
Price
S2 S1
Market
MC ATC
P1
d1
P1
P2
d2
P2
q2
q1
Output
D2
Q2 Q1
D1
Output
The Adjustment:
• After the decrease in market supply, a new equilibrium is
established at the original market price P1 and a smaller
rate of output Q3.
• As the market price returns to P1, the demand curve facing
the firm returns to its original level.
• In the long-run, economic profit returns to zero.
• Note the long-run market supply curve is flat Slr.
Firm
Price
Price
S2 S1
Market
MC ATC
P1
d1
P1
P2
d2
P2
q2
q1
Output
Slr
D2
Q3 Q2 Q1
D1
Output
Price
$6
1. Price goes down
2. Firms leave, Supply decreases
3. Price goes up
ATC
MC
$5
$4
P = D = MR
$3
$2
$1
0
SR Losses
4. No LR Losses
10
20
30
40
50
60
Quantity
The Supply Curve
• The marginal cost curve (MC) is the firm’s supply curve.
• Below MC = AVC, the firm will shut down
Output = 0 below P1,,
• At P2 MR = MC at q2.
• At P3 MR = MC at q3.
Price
Firm
MC is the firm’s
Supply Curve
MC
ATC
P3
AVC
P2
P1
q1 q2 q3
Output
Short Run Profits
Cause firms to enter the market
Supply shifts out and price drops
Short Run Losses
Cause firms to leave the market
Supply shifts in and price rises
Long-run Equilibrium
• The two conditions necessary for long-run equilibrium in
a price-taker market are depicted here.
• The quantity supplied and the quantity demanded must be
equal in the market, as shown below at P1 with output Q1.
• At the price established in the market, firms in the
industry earn zero economic profit
Firm
Price
Price
Ssr
Market
MC ATC
P1
d1
q1
Output
P1
D
Q1
Output
An increase in Market
Demand will lead to higher
per-unit costs of production
for all firms.
The long-run market supply curve in a
increasing-cost industry is upward-sloping.
1. Productive Efficiency
a. The situation in which a good or service is produced
at the lowest possible cost.
b. The forces of competition will
drive the market price to the
minimum average cost of the
typical firm.
c. Therefore, in the long run,
only the consumer benefits
from cost reductions.
Firm
Price
MC ATC
P1
MR
q1
Output
2. Allocative Efficiency
a. Goods and services are produced up to the point
where the last unit provides a marginal benefit to
consumers equal to the marginal cost of producing it.
b. Perfectly competitive firms produce up to the point
where the price of the good equals the marginal cost
of producing the last Price
Firm
unit.
MC ATC
MR = MC
P1
MR
q1
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Output
In perfectly competitive markets, firms
a. can sell all of their output at the market price.
b. produce differentiated products.
c. can influence the market price by altering their output level.
d. are large relative to the total market.
When we say that a firm is a price taker, we are indicating that the
a. firm takes the price established in the market then tries to increase
that price through advertising.
b. firm can change output levels without having any significant effect on
price.
c. demand curve faced by the firm is perfectly inelastic.
d. firm will have to take a lower price if it wants to increase the number
of units that it sells.
In perfectly competitive markets, individual firms have no control over
price. Therefore, the firm’s marginal revenue curve is
a. a downward-sloping curve.
b. indeterminate.
c. constant at the market price of the product.
d. precisely the same as the firm’s total revenue curve.
If marginal revenue exceeds marginal cost, a perfectly competitive firm
should
output
a. expand output.
b.
reduce output.
c. lower its price.
d.
do both a and c.
When firms in a perfectly competitive market are temporarily able to
charge prices that exceed their production costs,
a. the firms will earn long-run economic profit.
b. additional firms will be attracted into the market until price falls to the
level of per-unit production cost.
c. the firms will earn short-run economic profits that will be offset by
long-run economic losses.
d. the existing firms must be colluding or rigging the market, otherwise,
they would be unable to charge such high prices.
Suppose a restaurant that is highly profitable during the summer
months is unable to cover its total cost during the winter months. If it
wants to maximize profits, the restaurant should
a. shut down during the winter, even if it is able to cover its variable
costs during that period.
b. continue operating during the winter months if it is able to cover its
variable costs.
c. go a out of business immediately; losses should never be tolerated.
d. lower its prices during the summer months.
This graph illustrates a firm
a. capable of earning economic profit.
b. that is only able to break even when
it maximizes profit.
c. taking economic losses.
d. that should shut down immediately
This graph depicts the cost curves of a
firm in a perfectly competitive industry.
At what output would the firm’s perunit cost be at a minimum?
a.
100
c.
150
b.
125
d.
an output > 150
For the above graph, if the market price is $30, what is the firm’s
profit-maximizing output and maximum profit.
a.
output, 125; economic profit, zero
b.
output, 125; economic profit, between $1,000 and $1,250
c.
output, 150; economic profit, $1,500
d.
output, 150; economic profit, between $1,250 and $1,500