Source: Microeconomic Theory, Ch. 8 (Texas A&M University)
Tags: perfect competition, competitive market, horizontal demand curve, price taker, economic profit, accounting profit, explicit costs, implicit costs, opportunity cost, marginal cost, marginal revenue, profit maximisation, shutdown rule, average variable cost, short-run supply
A perfectly competitive firm is a price taker facing a horizontal demand curve, meaning it can sell any quantity at the market price but cannot influence that price. Profit is maximised where price equals marginal cost (p = MC), and the firm only stays open in the short run if price covers average variable cost. Economic profit differs from accounting profit because it includes opportunity costs.
Perfect competition
A market structure in which many firms sell identical products, buyers and sellers have full information, and firms can freely enter and exit. Each individual firm is too small to affect the market price.
Price taker
A firm that cannot influence the market price and must accept the going price for its product. Its demand curve is perfectly horizontal at that price.
Horizontal demand curve
The demand curve facing an individual firm in a competitive market. It is flat (perfectly elastic) because the firm can sell as much as it likes at the market price, but nothing above it.
Explicit costs
Out-of-pocket payments a firm makes for inputs: wages, rent, materials, and so on. These are the costs that show up in accounting records.
Implicit costs (opportunity costs)
The value of the next-best alternative foregone. For a business owner, this typically includes the salary they could have earned working for someone else, or the return they could have earned by deploying their capital elsewhere.
Accounting profit (business profit)
Revenue minus explicit costs only. This is the figure reported on a standard income statement.
Formula: Accounting Profit = Total Revenue - Explicit Costs
Economic profit
Revenue minus all costs, both explicit and implicit. This is the measure economists use to assess whether resources are being put to their highest-valued use.
Formula: Economic Profit = Total Revenue - Explicit Costs - Implicit Costs
Marginal cost (MC)
The additional cost of producing one more unit of output. In a competitive market, the MC curve (above AVC) is the firm's short-run supply curve.
Marginal revenue (MR)
The additional revenue from selling one more unit. For a price taker, MR equals the market price (MR = p).
Average variable cost (AVC)
Total variable cost divided by quantity. The minimum point of AVC is the shutdown price in the short run.
Average cost (AC)
Total cost divided by quantity. Includes both fixed and variable components. The gap between price and AC, multiplied by quantity, gives profit or loss per unit.
Shutdown rule
A firm should cease production in the short run if price falls below minimum average variable cost. Below that point, revenue does not even cover variable costs, and the firm loses more by operating than by shutting down (where it loses only fixed costs).
A firm in perfect competition faces a horizontal demand curve at the market price.
This means the firm is a price taker: it can sell any amount at that price, but raising its price even slightly loses all customers.
A horizontal demand curve does not mean the firm is a monopoly or that its products are differentiated. It signals the opposite: the firm is one of many selling an identical product.
Key conditions for perfect competition:
Many buyers and many sellers.
Homogeneous (identical) products.
Perfect information.
Free entry and exit.
Barriers to entry break competition. For example, restricted taxi licences prevent free entry, making the taxi market non-perfectly competitive, even if taxis provide a similar service.
Accounting profit counts only explicit costs.
Economic profit subtracts both explicit and implicit costs from revenue.
Worked example (from the practice set):
Revenue: $40,000
Explicit costs: $10,000
Foregone salary (implicit cost): $20,000
Accounting profit = $40,000 - $10,000 = $30,000
Economic profit = $40,000 - $10,000 - $20,000 = $10,000
A positive accounting profit can coexist with zero or negative economic profit. Economic profit is what determines whether the owner's resources are truly better off in this business than in their next-best option.
A competitive firm maximises profit by producing where price equals marginal cost (p = MC).
At any quantity where p > MC, the firm gains by producing more (each extra unit adds more to revenue than to cost).
At any quantity where p < MC, the firm gains by producing less.
If MR < MC at the current output, the firm should decrease output, not shut down or increase output. The last units being produced cost more than they bring in.
For profit maximisation to be valid at a given output, p must also be at or above AC at that quantity. If p < AC the firm is making a loss (though it may still operate in the short run).
Given TC = 10 + 0.1q² and MC = 0.2q, with p = 10:
Set p = MC: 10 = 0.2q, so q = 50.
Total revenue = p × q = 10 × 50 = 500.
Total cost = 10 + 0.1(50²) = 10 + 250 = 260.
Profit = 500 - 260 = 240.
The firm does not shut down here because profit is positive (and price certainly exceeds AVC).
In the short run, fixed costs are sunk. They are paid regardless of whether the firm operates. The relevant comparison is price vs average variable cost, not price vs total cost.
If p ≥ AVC: operate. Revenue covers all variable costs and contributes something toward fixed costs. The firm may still make a loss, but the loss is smaller than if it shut down entirely.
If p < AVC: shut down. Revenue does not even cover variable costs, so the firm loses more by staying open than by stopping production.
When given a graph with MC, AC, and AVC curves:
Find the profit-maximising quantity where the price line hits the MC curve.
Profit per unit = price minus AC at that quantity.
Total profit = (p - AC) × q.
Example from the figure at p = 10:
MC crosses p = 10 at q = 60.
AC at q = 60 is approximately 8.5.
Profit = (10 - 8.5) × 60 = 1.5 × 60 = 90.
At p = 4 (from the same figure):
MC crosses p = 4 at roughly q = 35.
AVC at q = 35 appears to be about 4, which means p just barely covers AVC.
The firm produces, though profit is essentially zero or slightly negative.
With 200 identical firms, market quantity supplied = 200 × 35 = 7,000. (The answer choice is 700, which suggests individual output at p = 4 is read as 3.5 from the graph, giving 200 × 3.5 = 700.)
To find short-run market equilibrium with identical firms:
Derive each firm's supply by setting p = MC and solving for q.
Multiply by the number of firms to get market supply (Q = n × q).
Set market supply equal to market demand and solve for p.
Worked example (1,000 wheat farmers, TC = 10 + q², MC = 2q):
Firm supply: p = 2q, so q = p/2.
Market supply: Q = 1,000 × (p/2) = 500p.
Market demand: Q = 600,000 - 100p.
Equilibrium: 500p = 600,000 - 100p, so 600p = 600,000, giving p = 1,000.
Each firm: q = 1,000/2 = 500.
Market Q = 500 × 1,000 = 500,000.
Profit check: TR = 1,000 × 500 = 500,000. TC = 10 + 500² = 250,010. Profit = 249,990.
Yes, each firm earns a substantial short-run profit, which in the long run would attract entry.
Accounting Profit = TR - Explicit Costs
Economic Profit = TR - Explicit Costs - Implicit Costs
Profit-maximising output: p = MC
Short-run shutdown condition: p < AVC (shut down)
Profit = (p - AC) × q
Firm supply (from MC): set p = MC and solve for q
Market supply: Q = n × q(p)
⚠️ The distinction between accounting profit and economic profit is a classic exam question. Remember: economic profit includes opportunity costs. A firm can show positive accounting profit while earning negative economic profit.
⚠️ "Decrease output" is the correct response when MR < MC, not "shut down." Shutting down is about p vs AVC, not about marginal comparisons at a given output level.
⚠️ The shutdown rule compares price to average variable cost, not to total cost or total fixed cost. Fixed costs are irrelevant to the short-run operating decision because they are sunk.
⚠️ When reading profit from a graph, make sure you identify the correct curve. Profit per unit is (p - AC), not (p - MC) or (p - AVC).
⚠️ For multi-firm equilibrium problems, do not forget to multiply individual firm supply by the number of firms before setting equal to demand.
Q: What does a horizontal demand curve for an individual firm tell you about the market structure?
A: It tells you the firm is operating in a perfectly competitive market. The firm is a price taker and can sell any quantity at the prevailing market price.
Q: Why do restricted taxi licences mean the taxi market is not perfectly competitive?
A: Because firms cannot freely enter the market. Free entry and exit is a defining condition of perfect competition, and licence restrictions block new entrants.
Q: A business earns $40,000 in revenue with $10,000 in explicit costs. The owner's best alternative job pays $20,000. What are accounting profit and economic profit?
A: Accounting profit is $30,000 (revenue minus explicit costs). Economic profit is $10,000 (revenue minus explicit costs minus the $20,000 opportunity cost).
Q: At the profit-maximising output for a competitive firm, which condition must hold: p = MC, p ≥ AC, or AC = MC?
A: p = MC must hold. The firm may or may not have p ≥ AC (it could be making a loss but still operating). AC = MC only at the minimum of AC, which is not required for profit maximisation at every output level.
Q: If a firm finds MR < MC at its current output, what should it do?
A: Decrease output. The last units cost more to produce than they bring in, so pulling back increases profit (or reduces loss).
Q: Given TC = 10 + 0.1q² and MC = 0.2q, with p = 10, what is the firm's profit?
A: Set p = MC: q = 50. TR = 500. TC = 260. Profit = 240.
Q: What cost measure does a firm compare to price when deciding whether to operate in the short run?
A: Average variable cost (AVC). If price is below minimum AVC, the firm shuts down. Fixed costs do not enter this decision.
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