Chapter (14) Firms in Competitive Markets In this ch.docx

Chapter (14)
Firms in Competitive Markets
In this chapter, we will discuss the general characteristics of a
perfectly competitive
market, and the operations of a perfectly competitive firm.
In any economy, there exists a number of market structures,
these are:
1. Perfectly competitive market.
2. Monopoly
3. Oligopoly
4. Monopolistic competitive market.
In the chapter, we will discuss the perfectly competitive market,
whereas the following 3
chapters will introduce to us the other market structures.
One major difference between perfectly competitive market and
all other markets is that
all these markets (other than the perfectly competitive market)
are considered imperfectly

competitive markets.
What do perfectly and imperfectly competitive markets mean?
We will start first by listing the major characteristics of a
perfectly competitive market.
Characteristics of a perfectly competitive market:
1. Many small sellers that no producer can affect the market
price of the product.
2. Many small consumers that no consumer can affect the
market price of the product.
3. Homogeneous or standard product supplied by all producers.
4. Any firm operating in this market is a price taker, where
firms in this market produce
and sell at the given market price.
5. Barriers to entry to this market are very low and even
nonexistent. Hence firms can
enter and leave the industry freely.
From the above characteristics, we can conclude the following
definition of a perfectly
competitive market:
A perfectly competitive market is a market where any firm has

no control on
determining the price of its product. In other words, it is the
market forces (that is
forces of DD and SS) that determines the price of perfectly
competitive firms’ products,
and the firms operating in this market accept these market
‘prices; hence we call perfectly
competitive firms as price-takers that is taking the price of their
products from the market
and having no control on setting or determining the price of
their products.
When a firm has no control on setting the price of its product,
its DD curve is a
completely horizontal curve.
On the other side, imperfectly competitive market is a market
where the operating firms
have some degree of control on setting the price of their
products. The degree of control
determines the degree of imperfection existing in this market.
Sine an imperfectly
competitive firm controls the price of its product, then its DD
curve is a downward-

sloping curve.
In economics, we identify 3 major imperfectly competitive
markets:
1. Monopoly
2. Oligopoly
3. Monopolistic Competitive Market
Objectives, Important Decisions: and Operations of a Perfectly
Competitive Firm
To understand the operations of a perfectly competitive firm,
we need to recall some
algebraic theorems to understand the below analysis.
1. When we have a horizontal function, its first derivative
should be horizontal and
coinciding with it.
In Microeconomics, the MR function is the first derivative of
the DD curve function.
Since the DD curve of a perfectly competitive firm is a
horizontal curve, then its first
derivative – the MR curve- will also be a horizontal curve
coinciding with the DD
curve.

2. Graphically, the price of any product lies on the DD curve of
the product.
3. TP = TR – TC
If we divide the formula by Q –quantity of production and
sales-, then we get:
TP = TR – TC
Q Q Q
AP = AR – AC
AP is the profit that the seller gets as he sells one unit of the
product.
AR is the revenue that the seller gets as he sells one unit of the
product.
As such AR = P.
AC is the cost of producing one unit of the output.
Hence the formula can be written as such: AP = P -AC
Objective of a perfectly competitive firm:
The objective of any business firm is to maximize profits.
TP = TR – TC
Profits are maximum when MR = MC

MR is the additional or extra revenue earned when the firm sells
one extra unit of the
output.
MC is the additional or extra revenue incurred when the firm
produces 1 extra unit of the
output.
Important Decisions:
Since a perfectly competitive firm is a price taker which implies
that it has no control on
setting, determining or changing the price of its product, then
the only important decision
that a perfectly competitive firm that is responsible to make in
order to achieve its
objective is: HOW MUCH Q SHOULD THE FIRM IN ORDER
TO ACHIEVE
MAXIMUM PROFITS?
That is what is the optimal quantity of production and sales (Q)
to achieve maximum
profits?
Operations of a perfectly competitive firm:

In a perfectly competitive market:
1. Any firm is a price taker (that is it takes the price that it sells
its product at from
the market).
2. Any firm has no control on the price of its product, and that
is why its DD curve
is drawn as completely horizontal curve.
3. Each firm in this market takes the P of its product from the
market and sets on the
DD curve so that the firm will operate according to it.
4. The MR function is the first derivative of DD curve, that is
why it is a horizontal
curve coinciding with the DD curve on the graph.
5. For a perfectly competitive market, P = MR = AR
6. The only decision that a perfectly competitive firm makes is
that, how much Q
(level of output or production and sales) should it produce to
achieve its
maximum-profit objective.
7. Maximum profits are achieved at the point where MR = MC
of the firm. At this
point, the firm decides its level of Q at which its profits are
maximum.
8. Next, if this firm achieves maximum profits at this P and Q,
we need to determine
how much is this maximum profits?

9. We know that, AP = P – AC (AP = Average profits = profits
per unit). If AP are
positive (AP > 0), this means that the firm is achieving positive
economic profits
at this P and Q, and generally, we advice it to continue its
operations at this P
and Q as it is profiting economically.
Situation ONE:
If P > AC
P > AVC then the firm is achieving positive economic
profits, we advice the
firm to continue its operations in the market.
With this level of profits, more new firms will be encouraged to
enter the market,
hence SS (Sellers) increase and DD remains constant in the
market. This is a case of
market surplus, where price tends to decrease to maintain
equilibrium.
Again, each firm operating in this market cannot continue to
operate at the old P, it
has to decrease its price as determined by the new condition in
the market and operate

accordingly to this new less price to achieve its maximum-profit
objective,
Accepting the new less price, the firm has to adjust its Q at the
point of maximum
profits of MR = MC.
Situation TWO:
If P < AC
P > AVC Then the firm is not covering all its cost’
components (P<AC), in
fact the firm is covering all its variable costs (P>AVC) and part
of its fixed costs but
not all of its fixed costs, that is why its P < AC; as such this
firm is achieving
negative economic profits (also called economic loss).
Our advice for this firm, in a perfectly competitive market, the
rule for operations is this:
If the firm covers its variable costs but part or none of its fixed
costs is not covered; we
advice this firm to continue its operations for the meantime
because covering fixed costs

needs a period of time (sometimes years) to be completed,
however, what is important is
covering variable costs.
So our advice for this firm, that although it is incurring
economic loss (negative
economic profits), we advice it to continue its operations in the
meantime as long it is
covering its variable costs of production.
Situation THREE:
P < AC
P = AVC at its minimum point (called the shut-down point).
Then this firm, very similar to situation two, is incurring
negative economic profits
where it is not covering all its costs of production. This firm is
only just covering its
variable costs (P = AVC at its minimum point) but none of its
fixed costs ( P <AC).
We say to this firm, as we said in situation two, that although
you are incurring
negative economic profits but as you are covering your variable
costs, we advice you

to continue your operations in the market, but BE CAREFUL:
you are operating at
the verge of shutting down and exiting from the market. You are
operating at the
critical Shutdown point, if price decreases any further, you
should shut down and exit
from the market immediately.
Situation FOUR:
P < AC
& P < AVC then this firm is incurring negative economic
profits and the firm is
not covering any of its costs of production. We, immediately,
advice this firm to shut
down and exit from the market.
Situation FIVE:
Finally this exit and entry of firms continues to happen until a
state of long-run
equilibrium is attained where at this point:
P = AC at its minimum point (cost-efficient point or break-
even point)
& P>AVC

At this point, the firm is covering all its costs (P = AC at its
minimum point) but
economic profits are ZERO – called normal profits- (AP= P –
AC = 0).
When firms operate at this point, it is said that the market is
maintained in a state of long-
run equilibrium where no more firms will either enter or exit
from the market because the
reason of positive profits no longer exists to attract new firms
to enter the market. But
what about the existing firms operating in the market? They are
in the best position of
producing and selling in the market, and this is what is meant
by long-run equilibrium to
operating firms.
To conclude:
So in the short-run, it is the forces of competition that tend to
push firms into this market
towards zero-profit long-run state.
The firms that are profitable attract new firms to enter the

market thereby driving down
prices and reducing profits.
By contrast, those firms which are suffering losses tend to quit
or exit from the market.
The long-run equilibrium is one with no pure positive economic
profits but only ZERO
Economic Profits or in other words NORMAL PROFITS.
Ass#4
ECON 2301Fall 2014-15
**This assignment is either an individual or a group assignment
of 2-3 students. You may choose to submit it as individual or
group of 2-3 students.
****The due date to submit the assignment is Sunday, Dec 28,
2014
All graphs must be hand drawn not done by computers.
Homework answers can either be handwritten clearly with blue
or black ink or typed. PENCILS are not corrected at all.
Answer the following questions and problems:
I. In a perfectly competitive firm, given the following data
about firm (A):

PA = $ 26
TFC = $880,000
MC = $26
AC = $30
Q = 100,000 units
a. Given this data, can we say that this firm is achieving its
maximum total profits objective at this given P and Q? If yes or
no, explain how did you conclude your answer? If no, what are
the appropriate P and Q to say that this firm is achieving its
maximum total profits?
b. IF Firm (A) is achieving its maximum profit level, what is
the profit position of this firm –that is calculate this maximum
total profits-, and what economic advice would you give this
firm?
c. Draw corresponding graph of the above operating situation of
Firm (A) above?
II. Firm (X) is one of many small firms that produce Cotton in
Egypt. This season, due to good weather, Cotton- production
was tremendous and huge. This huge production has resulted in
decreasing the market price of 1 ton of cotton from $2500 to
$2300.
At this new price, Firm (X) operates with the following data for
this season:
TC = $720,000, TFC = $180,000, Q (quantity of production &
sales) = 120 tons of cotton.
Assume that the firm’s objective is to maximize its total profits,
and given the above data, answer the following questions:

a. What is the market structure of Firm (X), identify (Name)
this market and explain your reasoning showing why and based
on what characteristics you selected this market structure?
(provide at least 2 reasons or characteristics why did you name
this market for Firm(X))
b. Calculate Total Maximum Economic Profits of firm (X)?
c. What advice would you give this firm as to its position and
operations in the market, explain your answer?
d. Given all the above information, draw the graph that
represents the above situation of firm (X)?
III. In a monopoly, given the following data about a monopolist,
firm (X):
P x = $80
MR = $68
Q= 240,000 units
TFC = $ 2,160,000
AC = $72
MC = $68
a) Given this data, can we say that this firm is achieving its
maximum total profit objective at this P and Q? If Yes or No,
please explain and prove your answer using the above numbers?
b) If firm (X) is achieving its maximum profit level, what is the
profit position (that is calculate Total Profits) of this firm, and
then what economic advice would you give this monopolist?

Draw the operating situation of this monopoly.
c) If this firm (X) turned to become a perfectly competitive firm
where P changes to become $78, as an economic consultant,
with all the other above data and numbers remain unchanged
(same), what would be your economic advice to this perfectly
competitive firm. Explain and verify your answer using
calculations.
Draw the above operating situation of Firm(X) as a perfectly
competitive firm.
Good Luck

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