Comppetitive

1. FIRMIN COMPETITIVE MARKETS
If your local gas stationraisedthe price itcharges forgasoline by20 percent,itwouldsee alarge dropin
the amountof gasoline itsold.Itscustomerswouldquicklyswitchtobuyingtheirgasolineatothergas
stations. Bycontrast,if yourlocal watercompanyraisedthe price of waterby 20 percent,itwouldsee
onlya small decrease inthe amountof waterit sold.People mightwatertheirlawnslessoftenandbuy
more water-efficientshowerheads,buttheywouldbe hard-pressedtoreduce waterconsumption
greatlyandwouldbe unlikelytofindanothersupplier.The difference betweenthe gasolinemarketand
the watermarketis obvious:There are manyfirmspumpinggasoline,butthere isonlyone firmpumping
water.Asyou mightexpect,thisdifference inmarketstructure shapesthe pricingandproduction
decisionsof the firmsthatoperate inthese markets.
In thischapterwe examine the behaviorof competitivefirms,suchasyourlocal gas station.You may
recall that a marketiscompetitive if eachbuyerandsellerissmall comparedtothe size of the market
and,therefore,haslittle abilitytoinfluence marketprices.Bycontrast,if a firmcan influence the market
price of the goodit sells,itissaidtohave market power.Inthe three chaptersthatfollow thisone,we
examine the behaviorof firmswithmarketpower,suchasyourlocal watercompany.
Our analysisof competitive firmsinthischapterwillshedlightonthe decisionsthatlie behindthe
supplycurve ina competitive market.Notsurprisingly,we willfindthatamarketsupplycurve istightly
linkedtofirms’costsof production.(Indeed,thisgeneral insightshouldbe familiartoyoufromour
analysisinChapter7.) But among a firm’svariouscosts—fixed, variable,average,andmarginal—which
onesare mostrelevantforitsdecisionaboutthe quantitytosupply?We will seethatall these measures
of costplay importantandinterrelatedroles
WHAT IS A COMPETITIVEMARKET?
Our goal in thischapteristo examine how firmsmake productiondecisionsincompetitive markets.Asa
backgroundforthis analysis,we beginbyconsideringwhatacompetitive marketis.
THE MEANINGOF COMPETITION
Althoughwe have alreadydiscussedthe meaningof competitioninChapter4,let’sreviewthe lesson
briefly.A competitivemarket,sometimescalledaperfectlycompetitivemarket,hastwocharacteristics:
1. There are manybuyersandmany sellersinthe market.
2. The goods offeredbythe varioussellersare largelythe same.
As a resultof these conditions,the actionsof anysingle buyerorsellerinthe markethave anegligible
impacton the marketprice.Each buyerand sellertakesthe marketprice asgiven.
An example isthe marketformilk.Nosinglebuyerof milkcaninfluence the price of milkbecauseeach
buyerpurchasesa small amountrelative tothe size of the market.Similarly,eachsellerof milkhas
limitedcontrol overthe price because manyothersellersare offeringmilkthatisessentiallyidentical.
Because eachsellercansell all he wantsat the goingprice,he has little reasontocharge less,andif he

2. chargesmore,buyerswill goelsewhere.Buyersandsellersincompetitive marketsmustacceptthe price
the marketdeterminesand,therefore,are saidtobe price takers.
In additiontothe foregoingtwoconditionsforcompetition,thereisathirdconditionsometimes
thoughtto characterize perfectlycompetitivemarkets:
1. Firmscan freelyenterorexitthe market.
If,for instance,anyone candecide tostarta dairy farm, and if any existingdairyfarmercandecide
to leave the dairybusiness,thenthe dairyindustrywouldsatisfythiscondition.Itshouldbe noted
that much of the analysisof competitivefirmsdoesnotrelyonthe assumptionof free entryandexit
because thisconditionisnotnecessaryforfirmstobe price takers.But as we will see laterinthis
chapter,entryand exitare oftenpowerfulforcesshapingthe long-runoutcome incompetitive
markets
THE REVENUE OF A COMPETITIVE FIRM
A firmina competitive market,like mostotherfirmsinthe economy,triestomaximizeprofit,which
equalstotal revenue minustotal cost.To see how itdoesthis,we firstconsiderthe revenueof a
competitivefirm.Tokeepmattersconcrete,let’sconsideraspecificfirm:the SmithFamilyDairyFarm.
A firmina competitive market,like mostotherfirmsinthe economy,triestomaximizeprofit,which
equalstotal revenue minustotal cost.To see how itdoesthis,we firstconsiderthe revenueof a
competitivefirm.Tokeepmattersconcrete,let’sconsideraspecificfirm:the SmithFamilyDairyFarm.
Because the SmithFarm issmall comparedtothe worldmarketformilk,ittakesthe price as givenby
marketconditions.Thismeans,inparticular,thatthe price of milkdoesnotdependonthe quantityof
outputthat the SmithFarm producesandsells.If the Smithsdouble the amountof milktheyproduce,
the price of milkremainsthe same,andtheirtotal revenue doubles.Asaresult,total revenue is
proportional tothe amountof output.
Table 14-1 showsthe revenue forthe SmithFamilyDairyFarm.The firsttwocolumnsshow the amount
of outputthe farmproducesand the price at whichit sellsitsoutput.The thirdcolumnisthe farm’s
total revenue.The table assumesthatthe price of milkis$6 a gallon,sototal revenue issimply$6times
the numberof gallons.
Justas the conceptsof average andmarginal were useful inthe precedingchapterwhenanalyzingcosts,
theyare alsouseful whenanalyzingrevenue.Tosee whatthese conceptstell us,considerthese two
questions:
1. How muchrevenue doesthe farmreceive forthe typical gallonof milk?
2. How muchadditional revenue doesthe farmreceiveif itincreasesproductionof milkby1
gallon?
The last twocolumnsinTable 14-1 answerthese questions.The fourthcolumninthe table shows
average revenue,whichistotal revenue (fromthe thirdcolumn) dividedbythe amountof output(from
the firstcolumn).Average revenue tellsushow muchrevenue afirmreceivesforthe typical unitsold.In
Table 14-1, youcan see that average revenue equals$6,the price of a gallonof milk.Thisillustratesa

3. general lessonthatappliesnotonlytocompetitivefirmsbuttootherfirmsas well.Total revenue isthe
price timesthe quantity(P Q),and average revenue istotal revenue (P Q) dividedbythe quantity(Q).
Therefore,forall firms,average revenueequalsthe price of the good.The fifthcolumnshowsmarginal
revenue,whichisthe change intotal revenue fromthe sale of eachadditionalunitof output.InTable
14-1, marginal revenue equals$6,the price of a gallonof milk.Thisresultillustratesalessonthatapplies
onlyto competitivefirms.Total revenue isP Q,and P isfixedfora competitivefirm.Therefore,whenQ
risesby 1 unit,total revenue risesbyPdollars.Forcompetitive firms,marginal revenueequalsthe price
of the good.