Exploring how firms in perfectly competitive markets make profit-maximizing decisions when they cannot change their plant size or exit the industry.
In perfect competition, individual firms face a perfectly elastic (horizontal) demand curve at the market price. This is because:
Products are identical – Consumers have no reason to pay more for one firm's product over another.
Perfect information – Buyers know all prices and can easily switch to the cheapest seller.
Firms are small – Each firm's output is negligible compared to total market supply.
Key Insight: If a firm raises its price even slightly above market price, it loses ALL customers. If it lowers price, it gains no new customers (can already sell all output at market price).
The firm can sell any quantity at the market price P*, but nothing above it.
Understanding why these three values are always equal in perfect competition.
The market-determined price at which all transactions occur.
Set by market supply and demand. The firm has no control over this price.
Total revenue divided by quantity sold.
AR = TR / Q = (P × Q) / Q = P
Since each unit sells at price P, average revenue equals P.
Additional revenue from selling one more unit.
MR = ΔTR / ΔQ = P
Each additional unit sold adds exactly P to total revenue.
| Quantity (Q) | Price (P) | Total Revenue (TR = P × Q) | Average Revenue (AR = TR/Q) | Marginal Revenue (MR = ΔTR) |
|---|---|---|---|---|
| 1 | $10 | $10 | $10 | $10 |
| 2 | $10 | $20 | $10 | $10 |
| 3 | $10 | $30 | $10 | $10 |
| 4 | $10 | $40 | $10 | $10 |
Notice how P, AR, and MR are all equal to $10 regardless of quantity produced.
The golden rule of profit maximization: produce where marginal revenue equals marginal cost.
The MR = MC rule tells us the profit-maximizing quantity, not whether the firm earns a profit. The firm could still have:
Critical price levels that determine whether a firm should continue operating or shut down.
P = ATCmin
The breakeven point occurs where price equals the minimum average total cost. At this point:
Above breakeven: P > ATC → Economic profit
Below breakeven: P < ATC → Economic loss
P = AVCmin
The shutdown point occurs where price equals the minimum average variable cost. At this point:
Above shutdown: P > AVC → Continue operating (loss
< fixed costs)
Below shutdown: P < AVC → Shut down (loss would
exceed fixed costs)
P > ATC
Produce: Earn economic profit
AVC < P < ATC
Produce: Loss is less than fixed costs
P < AVC
Shut down: Loss exceeds fixed costs
The firm's short-run supply curve is the portion of the marginal cost curve that lies above the average variable cost curve.
Below the AVC minimum, the firm shuts down and produces zero. Above this point, the firm produces where P = MC, making MC the supply curve.
For any given price, find where P intersects MC (above AVC). The horizontal distance to the y-axis shows quantity supplied.
The market supply curve is the horizontal sum of all individual firms' supply curves. Add up quantities supplied by all firms at each price level.
Understanding how to calculate and interpret profits in the short run.
TR = P × Q
Total revenue is calculated by multiplying the market price by the quantity sold. Since perfectly competitive firms are price takers, P is constant for all units sold.
TC = ATC × Q
Total cost includes all explicit and implicit costs of production. It can be calculated by multiplying average total cost by quantity produced.
π = TR - TC = (P - ATC) × Q
Economic profit (π) is the difference between total revenue and total cost. It can also be calculated as the difference between price and average total cost, multiplied by quantity. This represents profit above and beyond what could be earned in the next best alternative (normal profit).
Verify Profit-Maximizing Output
Since P = MR = MC = $50, the firm is producing at the profit-maximizing quantity.
Calculate Total Revenue
TR = P × Q = $50 × 100 = $5,000
Calculate Total Cost
TC = ATC × Q = $45 × 100 = $4,500
Calculate Economic Profit
π = TR - TC = $5,000 - $4,500 = $500
Or: π = (P - ATC) × Q = ($50 - $45) × 100 = $5 × 100 = $500
This firm is earning an economic profit of $500 in the short run. Since P > ATC, the firm should continue operating. However, this profit will attract new firms to enter the industry in the long run (if there are no barriers to entry), eventually driving economic profit to zero.
Price takers be like:
"What price should I charge?"
The market: "Here's your price. Take it or leave it."
Farmer: "Guess I'll take it then." 🤷
The shutdown decision:
"Should I keep operating at a loss?"
If P > AVC: "Pain is temporary, glory is forever!"
If P < AVC: "I'm out!" 🏃♂️💨
Remember: MR = MC is the golden rule!
Now explore what happens when firms can enter or exit the industry in the long run.