Chapter 14: Firms in Competitive Markets

Chapter 14 starts off with the definition of competitive markets, where there are so many buyers and sellers trading an identical product that everyone is a price taker. We are introduced to average revenue and marginal revenue, which end up being the price of the good in a competitive market. A relationship between marginal revenue and marginal cost come into play here, where is revenue is greater than cost, production should be increased. At the profit maximizing level of output, revenue and cost are exactly equal. Since the firm’s marginal cost curve determines the quantity supplied, it ends up looking like the supply curve.

There are two ways that a firm could leave the market: a short-run shutdown (decision to abstain from activity due to current economic conditions) and exit (a long term decision to leave the market). Since fixed costs cannot be avoided in the short run, firms that shut down would have to pay off the fixed costs. Although, since fixed costs can be changed in the long run, firms can decide to not pay both variable and fixed costs. The fixed costs that cannot be avoided are referred to as sunk costs (in the short run) and this happens when the revenue from a firm’s outputs is less than the cost.The short-run supply curve is the part of the marginal cost curve that lies above average variable cost.

In the long run, firms would decide to leave the market depending on whether or not the revenue from its outputs overweigh the costs. The firm’s long-run supply curve is the portion of the marginal cost curve that lies above ATC. Firms would attempt to maximize profit and minimize losses, which occurs by producing the quantity where price is equal to marginal cost.

In the short run, firms have a nearly identical curve to the supply curve. However, this case is different in the long run. In the long run, firms end up making zero economic profit due to entry and exit. Entry would drive up production and lower price, whereas exit does the opposite. Although they make zero economic profit, that takes into account implicit costs too, so producers actually end up getting a profit. Marginal firms come into play here, where they are the firms that would leave the market if costs increased or prices decreases. Also, since firms can leave and join the market more easily in the long run, the long run supply curve is more elastic than the short run supply curve.