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The price taking firm

August 13, 2011

In a perfectly competitive market, the firm is a price-taker, it cannot influence the market price through the quantity it produces. In practice this means the firm is so small in proportion to the overall market that it has no market power, so it can sell any quantity it is able to produce at the market price.

The overall market price is determined by the market supply (provided by all the firms in the market) and the market demand (demanded by all the consumers in the market). The firm can sell any quantity it can produce at the market price, so even though the market is likely to face a downward sloping market demand curve, the individual firm faces a horizontal market demand curve at the market price. Because the firm can sell as much as it can produce at the market price, the marginal revenue for each unit sold is equal to the price, and the average revenue is also equal to the price, as every unit costs the same, so when you divide the total revenue by the number of units sold, you get the price.

The price-taking firm will observe two rules:

Marginal output rule – the firm will produce at an output where the price is equal to the marginal cost of production (MR = MC, and here P = MR so P = MC)

Shutdown rule – the firm will shut down if the average revenue is lower than the average cost at all output levels, so as the price equals average revenue, it will shut down if the price is lower than the average total cost at all levels.

We can look at this in terms of graphs:

This is the market supply and market demand. The equilibrium market price is P1.

This is the firm’s supply and demand graph. The firm’s supply curve is the marginal cost of production, and it faces a horizontal demand curve at the market price of P1. So it produces quantity q1, the point where price equals marginal cost. Here the firm is able to make some profit $\pi$ because at point q1 the average revenue (the price) is greater than the average total cost. This is a short run situation, because when other people see that there are profits to be made in the industry, it will attract the entry of new firms to the market.

The arrival of the new firms expands the market supply to S2, which drives down the equilibrium market price to P2.

At P2, the price has been driven to the level where the firm produces at point q2, where the price is equal to the marginal cost and the average total cost. At this point because the average revenue (price) is equal to the average cost, there is zero profit. So now you reach an equilibrium point. No new firms will enter the industry as there are no profits to be made, firms are just breaking even. But no firms will leave the industry as they are not making losses and are not in the shutdown position. Remember that perfect competition assumes that the firms are identical and face identical cost functions.

So firms in a perfectly competitive market can make profits in the short run, but will make zero profit in the long run.