The Theory of the Competitive Firm

Elasticity of Supply

Determination of Market Price

Long Run Equilibrium


How the Firm Determines How Much to Produce

In the real world, business decisions may be influenced by many different kinds of considerations. The owners and managers of firms may have a variety of goals and objectives, especially over longer periods of time. They may conceivably be motivated by a desire to become well respected in the community, or to serve some other higher purpose such as promoting their home country's national objectives, or they may simply want their organisation to become as large and powerful as possible. But the basic economic theory of business behaviour, as indicated earlier, is based on a very different premise: that firms exist to earn profits and that the goal of their managers will be to maximise those profits (or minimise their losses)... period.

This simplifying assumption about business motivation is no doubt extreme, but it is nevertheless plausible under certain circumstances -- for example, when the time period under consideration is short. At any particular point in time a firm is faced with the necessity of choosing its best level of output using its existing plant and other capital facilities. 

Another rather extreme assumption made to simplify the elementary analysis of how firm's behave is that the firm is unable to affect the price of its product. Confining the analysis of a firm’s behaviour to the short run and to a business environment in which the firm can only adapt to the existing market price severely limits the scope for anything other than narrowly defined profit-maximising or loss-minimising behaviour. As we will see, this second assumption can be relaxed, but for now we will limit our discussion to the behaviour of an individual firm operating in an environment so competitive that the firm cannot influence the price of its output. Our objective will be to see how such a firm determines how much it should produce in the short run if its objective is to maximise its profits or minimise its losses.

The profit-maximising (or loss-minimising) rule for a firm under these conditions is simple and intuitively appealing. Output should be set at the level where the difference between total revenue (quantity produced times the price per unit) and the total cost of producing that output is the greatest.

The same idea may be expressed using marginal rather than total values: the firm should produce that level of output at which its marginal revenue is equal to its marginal cost. In less technical language this is saying that in deciding whether to increase output by one more unit or not, the firm should produce that additional unit if, by doing so, it can increase its revenues by more than its costs. If it would cost more to produce an additional unit than that unit can be sold for, it would be a mistake to produce it.

It is important to emphasize that this whole body theory is highly abstract. A competitive firm produces so small a part of the total amount of this product supplied to the market that its output decisions have no impact on the market whatever. Because of this, firms operating under such circumstances (often called perfect competition) have no influence over the price of their product. They are called "price takers" because the price established in the market as a whole is the price they will get for their output — whether they produce one unit or a million. Notice that this means that the firm’s marginal revenue is constant over the whole range of its possible and that, consequently, marginal revenue, average revenue and price are all the same amount. This assumption that price does not change with output is characteristic of a truly competitive firm as represented in standard neo-classical theory.

If the firm gets the same price for each unit it produces, the increase in its revenues resulting from producing an additional unit of output is always the same. In other words the marginal revenue is always the same. Furthermore, if the marginal revenue is always the same, the average of all these increments to revenue must always be the same. (If new students joining a class all have marks the same as the class average, that average is neither raised nor lowered.) Thus, average revenue and marginal revenue for a competitive firm always have the same value. Because average revenue and price are the same by definition, it follows that a firm operating under conditions of perfect competition faces a constant price whatever its level of output.

Recall now how the relationship between price and quantity is summarized in the concept of demand. If the firm can sell all it can produce at the going market price, it will be faced with a perfectly elastic demand for its product. This going market price would be determined in the market for the product, where market demand would interact with the supply of it arising from the production decisions of all the firms, such as the "representative one" we are considering. Remember that under conditions of competition none of these firms’ output is significant in influencing this market price. If the term "industry" is used to refer to all the firms producing the same product, this amounts to saying that the price is the same for all the firms in the industry.

Under these circumstances, all the individual firm can do is adapt to the market price by adjusting its output level so as to maximise its earnings or minimise its losses. Which it will be depends on the particular relationship between its revenues and costs.

What effect would a change in the market price have on the output decision of a representative firm in the industry? Whatever the price becomes, the firm responds by applying the same decision-making rule used before. It chooses levels of output such that marginal cost equals marginal revenue. (And, as before, marginal revenue, price and average revenue are all the same for a competitive firm, equating marginal cost and marginal revenue also implies equating marginal cost and average revenue, or price.) Not surprisingly, the higher the price the larger the amount the firm will choose to produce.

It is not necessary for the firm to be covering all its costs for it to operate at its best possible output level. In the short run a firm may continue to operate even if it has a loss at this best possible output. Whether there are profits or losses or the firm just breaks even depends on its overall cost structure — how high or low its average variable and average total costs are relative to the prevailing market price for its product. 

So long as the firm is able to cover its average variable costs when it sets output so as to equate marginal cost and marginal revenue it will probably be willing to stay in operation, at least in the short run, even if it cannot cover its total costs. Such a situation may be acceptable to the firm in the short run because the alternative is to shut down and fail to cover any of its costs.

In such a situation the firm is minimising its losses by operating at the best possible output level as indicated. If price is a bit higher the firm may be covering its average variable costs and some of its fixed costs as well. And at a still higher price the firm may cover all its costs. If price went even higher, the firm would be earning profits (recall that this means it is earning revenues in excess of all its costs including a "normal" return on its investment). At the opposite extreme, if price fell below an amount at which the firm could cover its average variable costs at its best level of output, the firm would shut down and produce nothing.

This means that the part of the firm's marginal cost curve that lies above its intersection with the average variable cost curve is the firm's supply curve. If the market price for the product falls within this range of the firm's marginal costs, it will produce at a level of output where its marginal cost equals its marginal revenue.

The next step in the analysis is to combine the outputs of the individual firms in the industry to obtain the market supply of the product. Just as in the treatment of consumer behaviour, where the demands of individual consumers were aggregated to determine the total quantities consumers would be willing to buy over a range of prices, the amounts individual firms would be willing to produce at particular prices can be summed to determine the total they will collectively bring to the market.

Remember that each firm chooses to produce at the point where its marginal cost equals the price and that this is also true for the industry as a whole. This is an important and perhaps rather surprising result. It is asserting that under conditions of competition, the price the consumer pays for a good is equal to what it cost producers to produce the last (marginal) unit which they found it to be worth producing. Under competition, price equals marginal cost.

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Elasticity of Supply

Now that the concept of market supply has been developed it may be noted that the notion of elasticity introduced in the theory of demand can also be applied to supply. Just as elasticity of demand measures the responsiveness of quantity demanded to changes in price or other influences, elasticity of supply measures the responsiveness of quantity supplied to changes in price or other forces that may bear upon it. The important difference is that the relationship between price and quantity supplied is normally positive, whereas that of demand is (nearly always) negative.

As with the elasticity of demand, there are two important special cases of elasticity of supply. A completely inelastic supply means that the quantity of the good supplied is the same whatever the price. This would be the case with something which cannot, for some reason, be increased in supply. The other extreme is a perfectly elastic supply — which implies that producers of a good can supply any quantity of it which could possibly be wanted at some particular price. These two extreme cases will be useful later on, especially in our study of how factor incomes are determined, but otherwise elasticity of supply will not be important for the purposes of this course.

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Determination of Market Price

Once market demand and market supply have been determined, market price is established automatically. Because the relationships between price and quantity demanded and price and quantity supplied are opposite (higher price, smaller quantity demanded; higher price, larger quantity supplied and vice versa) there will be some price at which the quantity demanded and the quantity supplied are the same. At this price sellers and buyers are satisfied. There will be no surplus of the good nor will there be any shortage of it — the market will "clear". At any higher price than this, more units of the product will be offered for sale than consumers want to buy at such a price. In a competitive market you would expect such a situation to result in some producers cutting their price to attract sales and the price would tend to fall. At any lower price the quantity demanded will be greater than the quantity offered for sale. In this case, competition among consumers to obtain the desired goods will tend to force the price up. The price at which the quantity demanded (at that price, remember) equals the quantity supplied (again, at that price remember) is called an "equilibrium price" because it will tend to persist until something happens to change the underlying supply or demand conditions in the conditions -- which would be shown by a shift in either the demand or the supply curves, or both of them.

Prices in freely competitive markets will always move toward such an equilibrium position and they will tend to remain there unless the underlying conditions of demand or supply are altered, as, for example, when there is a change in consumer preferences or something happens to change producers’ costs.

As we saw earlier, the equilibrium price established in the product market will be the price to which individual firms must adjust their output. There is no reason to expect that the prevailing market price will guarantee particular firms enough revenues to cover all their costs of production. As we have seen, in the short run firms may be willing to operate at a loss (so long as they can cover their average variable costs) rather than close down altogether. But in the long run firms can be expected to leave an industry if they cannot make a normal return. Alternatively, if the market price is high enough for firms to make profits over and above such a normal return, new firms may be attracted to the industry. Thus, if firms can leave or enter the industry, total output will be affected not only by the short term profit-maximising/loss-minimising adjustments of output by individual firms, but also by changes in the number of firms in the industry.

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Long Run Equilibrium for the Industry and Its Firms

The movement of firms into and out of a particular industry is governed by their cost situation (some firms may have a family of cost curves much higher or lower than others) and the level of the price established in the market for their output. A conjunction of low price and high costs will drive firms out of business. High prices relative to costs will keep them in and the profits they earn will attract more competitors. What will be the effect of such entry and exit? The total amount of the product offered for sale will increase if firms enter the industry and decrease if they leave. Consequently, profits will lead to increased competition and falling prices, losses will reduce the number of firms and lead to a reduction in total output. Such shifts in supply will come to rest only when the typical firm in the industry is neither earning profits nor sustaining losses. 

The perfectly competitive equilibrium which has just been developed is not only a rather elegant theoretical edifice, but it has powerful implications with respect to the (theoretical) efficiency of an economy. Given the nature of the economic problem as outlined at the beginning of the course, it is obviously desirable to have all scarce economic resources put to their best possible use. If all producers are motivated to minimise their costs of production in their quest for profits, they will attempt to produce goods and services using as few costly inputs (labour, raw materials and capital) as possible. If only those firms which can adjust to market prices established through the free interaction of buyers and sellers by minimising their costs can survive in an industry, inefficient firms will be eliminated. And if markets are perfectly competitive it follows that these market prices will be equal to the costs of production. 

In a perfectly competitive market system all the waste and inefficiency associated with badly managed economies, such as that of the late Soviet Union, would be eliminated. All resources would be used to produce what people want as indicated by their willingness to pay for them. No resources would be wasted producing goods and services people did not want. All goods and services that consumers did want would be produced at minimum cost. The prices of goods would be equal to the value of the resources used to produce them, nothing more nor less. The material well-being of society would be maximised. For these reasons, perfect competition can be taken as a standard against which other kinds of economic organisation can be compared. Unfortunately, it is a condition seldom encountered in the real world. 

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