Chapter 14 Summary

Chapter 14 expanded on the concepts relating to firms' costs introduced in Chapter 13 by applying them to the decisions firms face in perfectly competitive markets. An important feature of competitive markets is that firms in them are price takers (that is, their production decisions have no impact on the market price). Additionally, perfect competition implies free entry into and exit from the market. Because these firms are price takers, their marginal revenue (or the revenue they get from producing an additional unit of output) is equal to the market price. These firms maximize their profit when the marginal revenue is equal to the marginal cost. In essence, this works because the marginal cost curve is the firm's supply curve. If the firm's revenue in the short run is less than its variable costs, the firm will shut down (i.e. temporarily stop producing), treating its fixed costs as sunk costs (as they cannot be changed in the short run). In the long run, a firm will exit the market if its average total costs are greater than its revenue. When marginal cost is above average total cost when marginal cost is equal to marginal revenue, the firm makes an economic profit. However, this will incentivize other firms to enter the market, thereby increasing supply and reducing the price. Eventually, a competitive market equilibrium will arise with each firm operating at its efficient scale.