Perfect Competition

This is Unit Seven of Principles of Microeconomics, part one of two: the firm that takes its price as given, how it chooses its quantity, when it operates at a loss, and how entry drives profit to zero. Carry one idea. A price taker chooses only its quantity, and it chooses it where marginal cost rises to the price. Everything else in this part is read off that one choice. By the end you will be able to describe the price taker and say why its demand is flat and marginal revenue equals price. To find the profit-maximizing quantity by totals and at the margin. To read profit, break-even or loss at that quantity. To apply the shutdown test and locate the two points. And to derive supply, sum it to the market, and trace entry to zero profit.

Four entries on the price taker: what it is, the four conditions, its flat demand curve, and marginal revenue.

The firm that takes its price.

MIC 0601 The Price Taker

A perfectly competitive firm is a price taker: it can sell any amount at the market price and nothing above it, so it never sets a price at all. A price taker still chooses one thing, its quantity, and that choice is the whole of this unit.

What makes a market work this way.

MIC 0602 Four Conditions of Perfect Competition

Perfect competition needs many firms selling identical products, many buyers, full information on both sides, and free entry and exit. No real market meets all four, and the model is a benchmark whose predictions hold where markets come near it.

The demand curve one firm sees.

MIC 0603 The Firm's Demand Curve Is Flat

The market demand curve slopes down, but the demand curve facing one small firm is horizontal at the market price, perfectly elastic. Two diagrams, two curves, capital D for the market and small d for the firm.

What one more unit brings in.

MIC 0604 Marginal Revenue Equals Price

Marginal revenue is the extra revenue from one more unit sold. For a price taker it equals the price, every unit, because selling more never lowers the price; each flat sells for the same thirty dollars whether first or eighth. Price, marginal revenue and the firm's demand curve are one horizontal line here.

Five entries on choosing the quantity: profit by totals, the marginal rule, and which crossing counts.

Profit by totals.

MIC 0605 Total Revenue Against Total Cost

Profit is total revenue minus total cost, and one way to find the best quantity is to compute both at every output and pick the largest gap. The largest gap is the best the firm can do, and it may still be a loss.

The totals in a table.

MIC 0606 Profit by Totals from a Table

Add a revenue column, price times quantity, and a profit column, revenue minus cost; the best quantity is the row with the largest profit, or the smallest loss. The strawberry farm at thirty dollars a flat has revenue of zero to two forty in steps of thirty for zero to eight flats, against its cost table, so profit runs minus sixty, minus fifty, minus thirty-two, minus twelve, six, twenty, thirty, thirty-six, thirty-eight: eight flats, thirty-eight dollars. Read the profit column, never the revenue column, and a loss in every row means find the smallest loss.

The same answer at the margin.

MIC 0607 The Marginal Rule: MR = MC

Produce every unit whose marginal revenue is at least its marginal cost and no unit beyond; for a price taker, produce until marginal cost rises to the price. The rule finds the quantity, not the profit, which is read afterward against average cost.

The rule on a cost table.

MIC 0608 Profit-Maximizing Quantity from a Cost Table

Take every unit whose marginal cost is at or below the price and stop at the first that exceeds it; the last row taken is the quantity. The farm's marginal costs are twenty, twelve, ten, twelve, sixteen, twenty, twenty-four and twenty-eight for flats one to eight. At twenty-two dollars, flats one through six cost no more than twenty-two and the seventh costs twenty-four, so the farm grows six: revenue one thirty-two against cost one fifty, a loss of eighteen that beats the sixty of growing nothing. Do not stop at the cheapest unit, and do not treat a loss as proof the quantity is wrong.

Which crossing counts.

MIC 0609 Which Crossing Counts

A U-shaped marginal cost curve can cross a price twice, once falling and once rising, and only the rising crossing is the profit-maximizing quantity. A falling crossing is where losses are largest.

Three entries on profit: reading it against average total cost, the three cases, and the break-even point.

Reading profit at the chosen quantity.

MIC 0610 Reading Profit Against Average Total Cost

At the chosen quantity, compare price with average total cost: above means profit, equal means zero economic profit, below means a loss, and profit is the gap times the quantity, a rectangle from the price down to average cost. Measure the gap at the chosen quantity, not at the bottom of average cost; the two rarely coincide.

The three cases with numbers.

MIC 0611 Profit, Break-Even or Loss

For each price, find the quantity by the marginal rule, compute average total cost there, and compare. At thirty dollars the farm grows eight flats, average total cost is about twenty-five twenty-five, and profit is thirty-eight dollars. At twenty-five it grows seven, average total cost is about twenty-four eighty-six, and profit is a dollar, as near break-even as whole flats allow. At twenty-two it grows six, average total cost is twenty-five, and the loss is eighteen. Quantity first, average second; and a small positive number at the break-even price is rounding, not real profit.

The price where profit is zero.

MIC 0612 The Break-Even Point

The break-even point is the lowest point of average total cost, where marginal cost crosses it, and at that price the firm earns zero economic profit, a normal profit: for the farm, about twenty-five dollars at seven flats. Break-even is not where revenue first covers cost on the totals table; it is the price at which the best quantity earns zero.

Six entries on loss and shutdown: operating at a loss, the rule, the test, the point, the three zones, and locating both points.

Prices below break-even.

MIC 0613 Operating at a Loss

Below the break-even price the firm loses at every quantity. It still chooses where marginal cost meets price, the smallest loss, and compares that loss with shutting down. Fixed cost is owed either way in the short run; the question is whether producing loses less.

The rule that decides.

MIC 0614 The Shutdown Rule

A firm shuts down in the short run when price is below average variable cost. Above it, revenue covers variable cost and some fixed cost, so producing loses less; below it, every unit adds to the loss. The test is average variable cost, not average total cost; below total cost a firm can still be right to operate.

Applying the test.

MIC 0615 The Shutdown Test

Find the marginal-rule quantity and the average variable cost there; at or above it, operate, below it, shut down. At twenty-two dollars the farm's rule gives six flats and average variable cost is fifteen; twenty-two exceeds fifteen, so it operates, losing eighteen rather than sixty. At twelve dollars the rule gives four flats and average variable cost is thirteen fifty; twelve is below, so it shuts down, losing sixty rather than sixty-six. Do not compare price with average total cost for this decision, and shutting down does not erase the fixed cost.

The point on the curve.

MIC 0616 The Shutdown Point

The shutdown point is the lowest point of average variable cost, where marginal cost crosses it, and any price below it makes shutting down the better choice: for the farm, thirteen fifty at four flats. The shutdown point sits below and to the left of the break-even point, because average variable cost bottoms out first.

The three regions this creates.

MIC 0617 Three Zones of the Marginal Cost Curve

Above the break-even point, prices bring profit. Between break-even and shutdown, prices bring a loss the firm accepts while operating. Below the shutdown point, the firm produces nothing: thirty dollars, twenty-two dollars and twelve dollars for the farm. The zones are read off one curve, marginal cost, at the two prices where it crosses the two averages.

Locating both points on a table.

MIC 0618 Locating Break-Even and Shutdown on a Table

Compute average variable cost and average total cost at each output. The shutdown point is the output where average variable cost is lowest, and its minimum is the shutdown price; the break-even point is the output where average total cost is lowest, and its minimum is the break-even price. The farm's average variable cost is lowest at four flats, thirteen fifty; its average total cost is lowest at seven flats, about twenty-four eighty-six. The two minima are at different outputs, and with whole-unit rows the crossing is bracketed, so read the minimum row, not an exact equality.

Three entries on supply: the firm's curve, the market's as a sum of marginal costs, and what shifts it.

The curve this all builds.

MIC 0619 The Firm's Short-Run Supply Curve

The firm's short-run supply curve is its marginal cost curve above the shutdown point: at each price above minimum average variable cost it supplies where marginal cost equals price, and below, zero. Trace marginal cost upward from the shutdown point and you have drawn supply. Below that point supply jumps to zero rather than following marginal cost down.

Adding firms up.

MIC 0620 Market Supply Is the Sum of Marginal Costs

Market supply adds every firm's supply curve horizontally: at each price, the sum of the quantities their marginal cost curves give. Market supply is a sum of marginal costs, which is why supply measures marginal cost and why price equals marginal cost at a competitive equilibrium.

What moves the curve.

MIC 0621 Cost Shifters Are Supply Shifters

Anything that shifts a firm's marginal cost curve shifts its supply curve by the same amount: input prices, technology, taxes. Unit two's supply shifters are marginal cost shifters. A change in fixed cost shifts average total cost, not marginal cost, so it moves no short-run supply curve.

Five entries on the long run: shutting down against exiting, entry and exit, profit to zero, equilibrium, and a demand increase traced.

What shutting down is not.

MIC 0622 Shutting Down Is Not Exiting

Shutting down is a short-run choice to produce zero while still paying fixed costs, reversible when price recovers. Exiting is a long-run choice to leave the industry and shed the fixed costs too. A firm can shut down and never exit, or exit without ever shutting down.

The long-run choice.

MIC 0623 Entry and Exit

In the long run, economic profit draws new firms into an industry and economic loss drives firms out. Free entry and exit is what makes the long run different from the short. Economic profit, not accounting profit, is the signal: a firm earning only a normal profit attracts nobody.

How entry ends.

MIC 0624 How Entry Drives Profit to Zero

No single firm moves the price, but many entering shift market supply right and price falls. Entry continues until price reaches minimum average total cost and profit is gone; exit reverses it. The firm's output falls as price falls while industry output rises, since there are more firms.

Where it settles.

MIC 0625 Long-Run Equilibrium: P = MC = Minimum ATC

In long-run equilibrium, price equals marginal cost and equals minimum average total cost: the price sits at the bottom of every firm's average cost curve, every firm earns zero economic profit, a normal profit, and nobody has reason to enter or leave. Zero economic profit is not failure; owners are paid exactly what their resources would earn elsewhere.

A demand increase traced through.

MIC 0626 Tracing a Demand Increase to the Long Run

Demand shifts right, so the price rises; each firm moves up its marginal cost curve, produces more, and earns a profit. Profit attracts entry, market supply shifts right, and the price falls until it is back at minimum average total cost. In the new long-run equilibrium each firm is back at its original output, but there are more firms and industry output is higher. The strawberry market clears at twenty-five dollars with a thousand farms growing seven flats; a health report lifts the price to thirty-two, each farm grows eight flats and earns about fifty-four dollars; new farms enter, the price slides back to twenty-five, and each farm returns to seven flats and zero profit. The profit was a signal, not a state.

Look at what you can now do. You can describe a price taker as a firm with a flat demand curve at the market price, where marginal revenue equals price and the only choice is quantity. You can find that quantity by the largest gap between the totals or by producing until marginal cost rises through the price. You can read profit, break-even or loss as the gap between price and average total cost at that quantity. You can apply the shutdown test against average variable cost, and locate the shutdown point and the break-even point at two different outputs. And you can draw the firm's supply curve as marginal cost above shutdown, sum it to the market, and follow a profit through entry back to zero. Part two covers a demand decrease, cost changes, long-run supply, and what competition achieves.