Chapter 14: Firms in Competitive Markets

Section 1

What Is a Competitive Market?

A perfectly competitive market is an idealized baseline for how prices and quantities are set. Most real markets are more complicated, but the model captures powerful truths about industries with many rivals selling similar products.

Four Defining Characteristics

The key consequence: every firm is a price taker — too small to influence the market price. It simply observes the price and decides how much to produce.

Revenue of a Competitive Firm

Because the firm takes the price as given, selling an extra unit always brings in exactly P in revenue.

For a competitive firm, P = AR = MR — unique to competitive markets.

Market sets P*; the firm takes it as given and sells any quantity at that price.

Section 2

Profit Maximization

The firm finds the profit-maximizing output through marginal analysis — comparing the revenue from one more unit to its cost.

The MR = MC Rule

At any given output level, ask: "If I produce one more unit, does that help or hurt?"

• If MR > MC: produce more — the extra unit earns more than it costs.
• If MR < MC: produce less — the extra unit costs more than it earns.
• If MR = MC: stop — profit is at its maximum.

Profit is maximized where P = MC (green dot). The green-shaded rectangle is economic profit: (P − ATC) × Q*.

Section 3

The Firm's Short-Run Supply Decision

What if the price is so low the firm loses money? Should it keep producing or shut down? It depends on whether revenue covers variable costs.

The Shutdown Condition

In the short run, fixed costs are sunk — owed whether the firm produces or not. So the only question: does producing cover variable costs?

Three Short-Run Cases

The gold dot marks the shutdown point (min AVC).

The Short-Run Supply Curve

Combine the two rules: produce where P = MC, unless P < min AVC (then shut down).

Min AVC is the shutdown point. At any lower price, no output level can cover even variable costs — every unit produced deepens the loss beyond the fixed costs already owed.

Drag the price slider to see how the firm responds across all three cases.

Section 4

Entry, Exit, and Long-Run Equilibrium

In the long run, firms can enter or exit. This drives competitive markets toward their most remarkable result: zero economic profit.

Entry and Exit Decisions

The Adjustment Process

P > ATC → positive profit → new firms enter → supply increases → price falls back to min ATC. P < ATC → losses → firms exit → supply decreases → price rises back to min ATC.

Entry shifts market supply right, pushing price from P₁ down to P* = min ATC. The firm earns zero economic profit in the long run — the defining feature of perfect competition.

The Long-Run Equilibrium Condition

The firm operates at min ATC — the only price where neither entry nor exit occurs:

Section 5

The Supply Curve in a Competitive Market

Short-Run Market Supply

With a fixed number of firms, the market supply curve is the horizontal sum of all firms' MC curves above AVC — at any price, add up each firm's quantity.

Long-Run Market Supply: Three Industry Types

The long-run supply shape depends on what happens to input prices as the industry grows:

Constant-cost: flat LRS. Increasing-cost: upward LRS. Decreasing-cost: downward LRS.

Why Even LR Upward-Sloping Supply?

If firms earn zero profit, why isn't LR supply always flat? Because of input markets. In oil, the best drilling sites get used first — later entrants face higher costs. The equilibrium price rises not because firms earn excess profit, but because every firm's min ATC is higher.