Lecture 9 · Week 11 · Besanko & Braeutigam ch. 9 · about 50 min

Perfectly Competitive Markets

The benchmark market structure: why a price-taking firm sets P = MC, the shutdown rule, the short-run supply curve, producer surplus, and why free entry drives long-run economic profit to exactly zero.

By the end you can

Apply the P = MC profit-maximising rule for a price-taking firm
Apply the shutdown rule and explain the difference between shutting down and exiting
Derive the short-run firm supply curve from the MC curve
Explain why long-run competitive equilibrium drives economic profit to zero

The price-taking firm

In a perfectly competitive market (recall the Week 2 checklist: many small firms, homogeneous product, free entry/exit, full information), a single firm is too small to affect the market price. It is a price taker: marginal revenue equals price at every output level.

Price-taking firm's marginal revenueFormula sheet →

MR = P

$MR$: marginal revenue
$P$: the market price, taken as given by an individual competitive firm

Use it when the firm is one of many small sellers of an identical product — the defining feature that collapses marginal revenue down to just the market price.

Profit maximisation: P = MC

Applying the general marginal decision rule from Week 2 ( $MB=MC$ ) to a price-taking firm gives a very clean output rule.

Profit-maximising output ruleKey ruleFormula sheet →

\text{Produce where } P = MC(Q), \text{ provided } P \geq \min AVC

Use it when you need the profit-maximising output for a competitive firm at a given market price.

The shutdown rule

In the short run, fixed cost must be paid regardless of the output decision — including producing zero. This changes the relevant comparison for whether to operate at all.

Shutdown ruleKey ruleFormula sheet →

\text{Operate if } P \geq \min AVC \qquad \text{Shut down if } P \lt \min AVC

Use it when the market price is so low that the firm is considering producing nothing at all, in the short run.

The short-run supply curve

Since a price-taking firm always sets $Q$ where $P = MC(Q)$ , provided $P$ clears the shutdown bar, the firm’s short-run supply curve is exactly its MC curve, for the portion at or above minimum AVC — and zero below that.

Short-run firm supply curveKey resultFormula sheet →

Q^s(P) = \begin{cases} MC^{-1}(P) & P \geq \min AVC \\ 0 & P \lt \min AVC \end{cases}

Use it when you need to state or sketch a competitive firm's short-run supply curve directly from its cost structure.

The market short-run supply curve is simply the horizontal sum of every individual firm’s supply curve.

Producer surplus

Producer surplusKey formulaFormula sheet →

PS = TR - VC = \int_0^{Q^*}\big[P - MC(q)\big]\,dq

$PS$: producer surplus, the firm's short-run reward above and beyond variable cost

Use it when you need the area between the market price and the MC curve, up to the profit-maximising quantity — the producer-side twin of consumer surplus.

Long-run equilibrium: zero economic profit

In the long run, free entry and exit is the decisive force. If firms earn positive economic profit, new firms enter, market supply shifts right, and price falls until profit reaches zero; if firms lose money, some exit, supply shifts left, and price rises back up. The process stops only where price equals the minimum of long-run average total cost.

Long-run competitive equilibrium conditionKey conditionFormula sheet →

P = \min LRATC \quad\Longrightarrow\quad \text{economic profit} = 0

Use it when you need to find the long-run equilibrium price in a perfectly competitive industry, or explain why competitive firms earn zero economic profit in the long run.

Exam practice

Summary and review

Price-taking firm: $MR = P$ ; profit-maximising output where $P = MC$ .
Shutdown rule: operate if $P \geq \min AVC$ ; shut down if $P \lt \min AVC$ . Fixed cost is irrelevant to this decision (it is sunk).
Shutdown (temporary, short run) differs from exit (permanent, long run).
Short-run firm supply curve = the MC curve at or above min AVC; zero below it.
Producer surplus $PS = TR - VC = \text{profit} + FC$ .
Long-run equilibrium: free entry/exit drives $P = \min LRATC$ , so economic profit is exactly zero.