ECN104 – Chapter 14 Notes
Chapter 14 Notes
o What is a perfectly competitive market?
o What is marginal revenue? How is it related to total and average
o How does a competitive firm determine the quantity that maximizes
o When might a competitive firm shut down in the short run? Exit the
market in the long run?
o What does the market supply curve look like in the short run? In the
• Introduction: A Scenario
o Three years after graduation, you run your own business
o You must decide how much to produce, what price to charge, how
many workers to hire, etc.
o What factors should affect these decisions?
Your costs (studied in preceding chapter)
How much competition you face
o We begin by studying the behaviour of firms in perfectly competitive
• Characteristics of Perfect Competition
o 1. Many buyers and many sellers
o 2. The goods offered for sale are largely the same.
o 3. Firms can freely enter or exit the market.
o Because of 1 and 2, each buyer and seller is a price taker – takes the
price as given
• The Revenue of a Competitive Firm
o Total Revenue (TR) = Profit x Output (P x Q)
o Average Revenue (AR) = Total Revenue (TR) / Output (Quantity) = P
o Marginal Revenue (MR) (Change in TR from selling one more unit) =
(Change in Total Revenue) / (Change in Output)
• MR = P for a Competitive Firm
o A competitive firm can keep increasing its output without affecting the
o So, each one-unit increase in Output causes revenue to rise by P
(Profit), E.g., MR = P
o MR = P is only true for firms in competitive markets.
• Profit Maximization
o What Output maximizes the firm’s profit?
o To find the answer, “think at the margin.”
If you increase Output by one unit, revenue rises by MR, cost
rises by MC
o If MR > MC, then increase Output to raise profit
o If MR < MC, then reduce Output to raise profit • Shutdown vs. Exit
o Shutdown: A short-run decision not to produce anything because of
o Exit: A long-run decision to leave the market
o A key difference:
If shutdown in short run, must still pay FC
If exit in long run, zero costs
• A Firm’s Short-run Decision to Shut Down
o Cost of shutting down: revenue loss = TR
o Benefit of shutting down: cost savings = VC (firm must still pay FC)
o So, shut down if TR < VC
o Divide both sides by Output: TR/Q < VC/Q
o So, firm’s decision rule is:
Shut down if P < AVC
• A Competitive Firm’s Short-Run Supply Curve
o The firm’s Short-Run supply curve is the portion of its MC curve above
o If P > AVC, then firm produces Q where P = MC
o If P < AVC, then firm shuts down (produces Q = 0)
• The Irrelevance of Sunk Costs
o Sunk Cost: a cost that has already been committed and cannot be
o Sunk Costs should be irrelevant to decisions; you must pay them
regardless of your choice
o FC is a sunk cost: The firm must pay its fixed costs whether it produces
or shuts down
o So, FC should not matter in the decision to shut down.
• A Firm’s Long-Run Decision to Exit
o Cost of exiting the market: revenue loss = TR
o Benefit of exiting the market: cost savings = TC
o So, firm exits if TR < TC
o Divide both sides by Q to write the firm’s decision rule as: Exit if P <
• A New Firm’s Decision to Enter Market
o In the long run, a new firm will enter the market if it is profitable to do
so: if TR > TC
o Divide by sides by Q to express the firm’s entry decision as: Enter if P
• The Competitive Firm’s Supply Curve o The firm’s long-run supply curve i