Week 10 · Chapter

Chapter 10 — Perfect Competition

Principles of Microeconomics Free sample edition

The module's primary reading · ~40–50 minutes · Objective 6 (analyze perfect competition and monopoly with the profit-maximizing rules (P = MC for a price taker; MR = MC for a monopolist), the shutdown rule, long-run entry and exit, and the deadweight loss of market power), building on Objective 5 (describe a firm's short-run production and costs — total, marginal, and average product; diminishing marginal returns; and fixed, variable, total, average, and marginal cost — and distinguish accounting profit from economic profit) · Read it first this week; the lecture, the slide deck, the tutorial, the quiz, and the Model Workshop all build on it.

In plain language

This week the chair workshop from last week meets a market price it cannot change. You will learn what makes a market perfectly competitive (many sellers offering the same product, so no one seller can move the price) and why each firm in it is a price taker (a seller that takes the going price as given). You will use one rule to decide how many chairs to make, read the day's profit or loss as a rectangle on a graph, and find the shutdown price (the price below which closing for the day loses less than staying open). Last, you will see why new firms entering a profitable market, and losing firms leaving, push profit toward zero over time, and why zero profit in this sense does not mean the owner earns nothing.

Why you already care about this

Walk through a farmers' market on a busy morning. A dozen stalls sell brown eggs that look exactly alike. If one seller asks more than the rest, shoppers take two steps to the next table and buy there. If one seller asks less, the others do not have to follow, because each one can sell everything it brought at the going price. No single stall sets the price of eggs. The market does.

Now go back to the chair workshop from Week 9. It sells plain wooden chairs into a market full of workshops making the same chair. The owner cannot raise the price, so the owner has only two choices left: how many chairs to make each day, and whether to open the doors at all. On a good day the answers seem easy. On a bad day, when the price has fallen and every chair sells at a loss, the right answer surprises most people: the workshop often stays open anyway.

By the end of this chapter you will be able to:

list the traits of a perfectly competitive market and explain why each firm is a price taker;
show that a price taker's marginal revenue equals the market price;
choose a price taker's output with the rule P = MC on the rising part of marginal cost;
compute profit or loss at a given price and read it as a rectangle;
find the break-even price and the shutdown price from a cost table and decide whether a firm should operate;
explain how entry and exit push the long-run price to the lowest average total cost and economic profit to zero.

Carry this sentence with you: marginal cost says how many; average cost says whether.

Where we are

Already covered: Week 4 built the market supply curve and the equilibrium price. Week 8 taught the margin: do one more unit while its extra benefit is at least its extra cost. Week 9 built the chair workshop's cost table and split profit into accounting and economic profit.
This week: the perfectly competitive market and the price-taking firm; marginal revenue; the output rule P = MC; profit and loss at a given price; the break-even and shutdown prices; and long-run entry and exit.
How they connect: a market price from the supply-and-demand model meets the cost table from Week 9, and Week 8's marginal rule decides how many chairs to make.
Where we're going next: Week 11 turns to a seller with no close rivals, whose marginal revenue is no longer the price, so the rule from this week has to be read a new way.

Week 9 is the chapter this one leans on most. Recall its chair workshop: a fixed cost of 60 dollars a day for rent and tools, and a total cost of 60, 90, 110, 126, 148, 180, and 228 dollars for 0 to 6 chairs. Recall too that marginal cost is what one more chair adds, while an average cost is a whole bill shared over all the chairs. This week those two kinds of number get two different jobs.

1. Name the traits: what makes a market perfectly competitive

Think about what gives a seller power over its price. A seller with a famous brand, or the only shop in town, can raise its price and keep some buyers. An egg seller at a crowded market cannot. What takes that power away is a set of traits economists bundle into one model.

Perfect competition is a market with many buyers and many sellers, an identical product, buyers and sellers who know the going price, and free entry and exit, so that no single firm can move the price.
A price taker is a firm too small to affect the market price, which can sell as much as it wants at that price and nothing at a higher one, so it takes the price as given.
Free entry and exit is the condition that new firms can start selling in a market, and existing firms can leave it, without legal or cost barriers standing in the way.

Each trait does a job. Many sellers means each one is a small slice of the market. An identical product means buyers have no reason to pay one seller more than another. Known prices mean a seller who asks more is found out at once. Free entry and exit matter later in this chapter, in Section 8, where they decide what happens to profit over time.

An honesty note about the model: few real markets meet every trait exactly. Markets for farm goods such as eggs, wheat, and tomatoes come close, and so do markets for other standardized products. The model is a benchmark, a clean case that makes the logic of the firm's choices easy to see. In this chapter the chair workshop sells into a market we treat as perfectly competitive, so every chair it makes sells at the market price.

Misconception check. Students often think a competitive firm chooses its price, the way a coffee shop picks the number on its menu. The cure: in this model the market price comes from market demand and market supply, the Week 4 model. If the workshop asked even a little more than the going price, buyers would buy the same chair from the next workshop, and it would sell nothing. The firm chooses its quantity, never its price.

2. See why price equals marginal revenue

Picture the workshop on a day when the market price of a chair is 40 dollars. The first chair it sells brings in 40 dollars. So does the second, and so does the sixth. Selling one more chair never forces the price down, because the workshop is too small to move the market.

Marginal revenue is the change in total revenue from selling one more unit of output. For a price taker every unit sells at the market price, so marginal revenue equals the price.

Write P for the market price, Q for chairs per day, TR for total revenue, and MR for marginal revenue. Total revenue is the price times the quantity: TR = P × Q. Recall from Week 5 that total revenue is the money a seller takes in from its sales.

Worked example — total and marginal revenue at 40 dollars a chair. Multiply the price by each quantity, then subtract each total from the next.

Total revenue. 40 × 0 = 0, 40 × 1 = 40, 40 × 2 = 80, 40 × 3 = 120, 40 × 4 = 160, 40 × 5 = 200, and 40 × 6 = 240 dollars.
Marginal revenue. 40 − 0 = 40, 80 − 40 = 40, 120 − 80 = 40, and so on for every chair.

In words: every chair adds exactly 40 dollars to the workshop's revenue, so MR = P = 40 dollars. However many chairs the workshop makes, the next one brings in the same 40 dollars.

Picture this on a graph with chairs along the horizontal axis and dollars per chair up the vertical axis. The demand the workshop faces is a flat horizontal line at 40 dollars. It is flat because the workshop can sell any number of chairs at 40 and none at all above it. The market demand curve from Week 3 still slopes down; only the single firm's slice of it looks flat.

Misconception check. Students often think a flat demand line means buyers do not care about price. They care a great deal. The line is flat because buyers care so much that a seller who asks more than 40 dollars loses every sale. The cure: a flat line for one firm is a sign of intense competition, not of buyers who ignore price.

3. Apply the output rule: MR = MC, which reads P = MC

The workshop now knows what each chair brings in. Week 9 told it what each chair adds to cost. Week 8 gave the rule that joins them: do one more unit while what it adds to benefit is at least what it adds to cost. For a firm, the benefit of one more chair is its marginal revenue.

The profit-maximizing rule is that a firm earns the most profit by producing the quantity where marginal revenue equals marginal cost (MR = MC), making every unit that adds at least as much to revenue as to cost.
The P = MC rule is the profit-maximizing rule as it reads for a price taker: because marginal revenue equals the price, the firm produces where price equals marginal cost, on the rising part of the marginal-cost curve.

Write MC for marginal cost, in dollars per chair. Every profit-maximizing firm uses MR = MC. Only a price taker can swap MR for P, because only for a price taker are they the same number.

Worked example — how many chairs at 40 dollars. Compare each chair's marginal cost with the price of 40 dollars.

The marginal costs. From Week 9, the six chairs add 30, 20, 16, 22, 32, and 48 dollars.
Chairs 1 to 5. Each adds no more than 40 dollars of cost, so each adds to profit or at least does not cut it.
The 6th chair. Its marginal cost of 48 dollars is more than 40, so making it would add 48 dollars of cost for 40 dollars of revenue.

In words: the workshop makes 5 chairs. The 5th chair's marginal cost of 32 dollars is below the price, and the 6th chair's 48 is above it, so the workshop stops at 5.

Check the choice by computing profit, which is total revenue minus total cost, at the quantities around it.

At 4 chairs. 160 − 148 = 12 dollars.
At 5 chairs. 200 − 180 = 20 dollars.
At 6 chairs. 240 − 228 = 12 dollars.

In words: 5 chairs earns 20 dollars, more than the 12 dollars at either 4 or 6. The rule found the best quantity without trying every row.

Why "the rising part"? Marginal cost first falls, from 30 to 20 to 16 dollars, and then rises. At a low price the falling part can cross the price too, but stopping there would mean skipping later chairs that cost less than the price. The firm's choice is always where marginal cost is climbing through the price.

In practice (your tools). In Google Sheets, type the chairs 0 to 6 in cells A2 to A8 and the total costs 60 to 228 in cells B2 to B8. Put the price, 40, in cell J1. In cell C2 type =$J$1*A2 for total revenue and drag it down to C8. In cell D2 type =C2-B2 for profit and drag it down to D8. The largest number in column D, 20, sits beside 5 chairs. Change J1 to 50 and watch the best row move to 6 chairs.

Misconception check. Students often think the firm should make chairs until price equals average total cost. Profit equals the price minus average total cost, times the quantity, so stopping where they are equal makes profit zero by design. The cure: compare price with marginal cost, the cost of the next chair, to decide how many; average total cost tells you how big the profit is, not where to stop.

4. Read profit as a rectangle

Profit is revenue minus cost, and Section 3 computed it that way. There is a second way to compute it that also gives you a picture.

Write ATC for average total cost and TC for total cost. Since total revenue is P × Q and total cost is ATC × Q, profit is (P − ATC) × Q: the profit on each chair times the number of chairs. In this chapter's model, profit means economic profit, for a reason Section 9 explains.

Worked example — profit at 40 and at 50 dollars. Find the output at each price, then multiply the margin per chair by the number of chairs.

At 40 dollars. The workshop makes 5 chairs, where ATC is 36 dollars. Profit is (40 − 36) × 5 = 20 dollars, the same as 200 − 180.
At 50 dollars. The 6th chair's marginal cost of 48 is no more than 50, so the workshop makes 6 chairs, where ATC is 38 dollars.
Profit at 50 dollars. 300 − 228 = 72 dollars, and (50 − 38) × 6 = 72 dollars.

In words: at 40 dollars each of the 5 chairs earns 4 dollars above its average cost, for 20 dollars in all. At 50 dollars each of the 6 chairs earns 12 dollars above its average cost, for 72 dollars. A higher price raises profit twice, by widening the margin on each chair and by making one more chair worth building.

Picture the graph again. Draw the flat price line at 40 dollars and the U-shaped average-total-cost curve below it, which bottoms out at 36 dollars at 5 chairs. Go across to 5 chairs. The profit is a rectangle: its height runs from the ATC curve at 36 up to the price line at 40, and its width runs from zero to 5 chairs. Its area, 4 × 5 = 20, is the day's profit. When the price is below the average-total-cost curve, the same rectangle sits below the price line instead of above it, and its area is a loss.

Misconception check. Students often compute profit as price times quantity, calling 200 dollars the workshop's profit at 40 dollars. That is total revenue. The cure: profit always subtracts cost, either as 200 − 180 or as the margin per chair, (40 − 36), times 5 chairs.

5. Find the break-even price

Suppose the market price falls to 36 dollars. The workshop still sells every chair it makes, but the margin on each one is thinner.

The break-even price is the price equal to the lowest point of a firm's average total cost, at which revenue exactly covers every cost and economic profit is zero.

Worked example — the workshop at 36 dollars. Apply the output rule, then compare revenue with cost.

Output. The 5th chair's marginal cost of 32 is no more than 36, and the 6th chair's 48 is more, so the workshop makes 5 chairs.
Revenue. 36 × 5 = 180 dollars.
Profit. 180 − 180 = 0 dollars.

In words: at 36 dollars the workshop covers every cost and has nothing left over. That price is no accident. It is the lowest point of the workshop's average total cost, which Week 9 found at 36 dollars for 5 chairs. On the graph, the flat price line at 36 touches the bottom of the U-shaped average-total-cost curve, so the profit rectangle has no height at all.

Misconception check. Students often think break-even means the owner made nothing that day. Here the cost table counts the owner's own time as a cost, so at break-even the owner is paid for that time; Section 9 comes back to this. The cure: break-even means zero economic profit, which is a normal return, not an empty pocket.

6. Accept a loss: when staying open beats closing

Now the price drops to 30 dollars, below the lowest average total cost. Every rule so far says to make chairs while marginal cost is at most the price. Following it gives the workshop a loss. Should it close instead?

Worked example — the workshop at 30 dollars. Apply the output rule, then compare staying open with closing.

Output. The 4th chair's marginal cost of 22 is no more than 30, and the 5th chair's 32 is more, so the workshop makes 4 chairs.
Revenue. 30 × 4 = 120 dollars.
Profit. 120 − 148 = −28 dollars, a loss of 28.
If it closes. The rent and tools still cost 60 dollars a day, whether or not any chair is made, so closing loses 60 dollars.
Why operating is better. Revenue of 120 covers the 88 dollars of variable cost and leaves 120 − 88 = 32 dollars toward the rent, so the loss shrinks from 60 to 60 − 32 = 28 dollars.

In words: the workshop loses money either way, but it loses 28 dollars by staying open and 60 by closing. Staying open is the better of two bad choices. Each chair it sells pays for its own wood and labor and puts something toward the rent that is due anyway.

This is Week 8's sunk-cost idea at work. The 60 dollars of rent cannot be avoided today by closing the doors, so it should not drive today's decision. What matters is whether revenue covers the costs the workshop can avoid, the variable costs.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of a business near you that stays open on slow days, such as a restaurant on a quiet weeknight or a shop in the off-season. In two sentences, say which of its costs it pays even when closed and why staying open might still make sense.
(b) Think of a time you kept going with something that was costing you, such as a gym membership or a job with long travel, because some of the cost was already paid. In two sentences, say which part was avoidable and which part was not.

Misconception check. Students often think a firm should shut down whenever it takes a loss. At 30 dollars the workshop loses money, yet closing would lose more. The cure: compare the loss from operating with the loss from closing, which is the fixed cost. Operate whenever the loss is the smaller of the two.

7. State the shutdown rule

Section 6 compared two losses. A simpler test gives the same answer every time, using one number from the cost table.

The shutdown rule is the short-run rule that a firm keeps operating while the price covers average variable cost, even at a loss, and shuts down when the price falls below the minimum of average variable cost, losing only its fixed cost.
The shutdown price is the price equal to the lowest point of a firm's average variable cost; below it, operating loses more than closing does.

Write AVC for average variable cost. Week 9 found the workshop's lowest AVC at 22 dollars, at 3 and 4 chairs. So the workshop's shutdown price is 22 dollars.

Worked example — the workshop at 20 dollars. Compare the price with the lowest average variable cost first.

The test. 20 dollars is below the lowest AVC of 22, so the price cannot cover the variable cost of any batch of chairs.
If it closes. It loses its fixed cost of 60 dollars.
If it made 4 chairs anyway. Revenue is 20 × 4 = 80 dollars, and 80 − 148 = −68 dollars, a loss of 68.

In words: at 20 dollars every chair costs more in wood and labor than it sells for, so each one deepens the loss. The workshop closes for the day and loses only its 60 dollars of fixed cost.

Put the two thresholds side by side. Between 22 and 36 dollars the workshop operates at a loss. At 36 dollars and above it breaks even or earns a profit. Below 22 dollars it shuts down. So the workshop's marginal-cost curve, from the shutdown price of 22 dollars upward, tells you how many chairs it offers at each price.

Dataset M: the chair workshop's output, revenue, total cost, and profit at five market prices, in dollars per day (illustrative)
Price	Chairs made	Revenue	Total cost	Profit	Decision
50	6	300	228	72	operate, profit
40	5	200	180	20	operate, profit
36	5	180	180	0	operate, break even
30	4	120	148	−28	operate, smaller loss than closing
20	0	0	60	−60	shut down, below the lowest AVC of 22

A caveat about the short run: shutting down is a decision about today, not a decision to leave the industry. The workshop that closes for a day at 20 dollars still pays its rent and can reopen when the price recovers. Leaving the market for good is a long-run choice, the subject of the next section.

Misconception check. Students often use average total cost for the shutdown test, closing at any price below 36 dollars. That would have closed the workshop at 30 dollars and cost it 60 dollars instead of 28. The cure: the shutdown test uses average variable cost, because fixed cost is paid either way in the short run.

8. Follow the long run: entry and exit

So far the market price arrived from outside and stayed put. Over a longer stretch it does not stay put, because firms come and go. This is where free entry and exit, the fourth trait from Section 1, does its work.

Worked example — what happens after a profitable stretch. Start at a market price of 40 dollars, where the workshop earns an economic profit of 20 dollars a day.

The signal. Positive economic profit means workshops here earn more than their owners could earn elsewhere.
Entry. New workshops start making the same chair, which nothing in a competitive market stops them from doing.
The market. The market supply curve shifts right, and the market price falls.
Where it stops. Entry continues while there is economic profit to earn, so it stops when the price reaches the lowest average total cost, 36 dollars, and economic profit is zero.

Worked example — what happens after a losing stretch. Start at a market price of 30 dollars, where the workshop loses 28 dollars a day.

The signal. Losses mean owners could do better elsewhere.
Exit. When their leases run out, some workshops leave the market.
The market. The market supply curve shifts left, and the market price rises.
Where it stops. Exit continues while firms take losses, so it stops when the price is back at 36 dollars, where economic profit is zero.

Long-run competitive equilibrium is the resting point of a perfectly competitive market after entry and exit have finished: the price equals the minimum of average total cost and each firm earns zero economic profit.

In words: in a perfectly competitive market, profits invite rivals and losses drive firms out, and both forces push the price to the same place, the bottom of average total cost. For this workshop that is 36 dollars a chair. Notice the order of the logic: name the curve that moved (market supply), the direction (right after profit, left after losses), and where the price lands (36 dollars in the long run). This model does not pin how many chairs the whole market sells after the shift, only where the price settles.

Picture two graphs side by side. On the right, the market: a downward-sloping demand curve and an upward-sloping supply curve. After entry the supply curve slides right and their crossing moves down to a lower price. On the left, one workshop: its flat price line drops with the market price until it rests on the bottom of the U-shaped average-total-cost curve, where the profit rectangle disappears.

Pause and reflect — choose one. Pick either prompt; they count the same.

(a) Think of a product that became popular and then seemed to be sold everywhere, such as a style of drink or a kind of food stand. In two sentences, describe how new sellers arriving might have changed the price and the profit of the first sellers.
(b) Think of a kind of small business that has become rarer where you live. In two sentences, describe how sellers leaving a market could help the ones who stay.

Misconception check. Students often think entry shifts market demand, since more firms seem to mean more chairs bought. Entry adds sellers, not buyers. The cure: entry shifts market supply to the right, which lowers the price; exit shifts market supply to the left, which raises it. Market demand does not move.

9. Read zero economic profit correctly

Long-run competition leaves each workshop with zero economic profit. That sounds bleak, as if the owners work for nothing. It is not what the model says, and Week 9 already gave you the tools to see why.

The workshop's cost table counts every cost, explicit and implicit. Its 60 dollars of fixed cost and its variable costs include a return on the owner's own time and money, the earnings those resources could make in their next-best use. That is an assumption of this classroom model, and it is why profit in this chapter is economic profit. Week 9's definitions still hold: accounting profit subtracts only explicit costs, and economic profit subtracts implicit costs too.

Worked example — reading break-even two ways. At 36 dollars the workshop makes 5 chairs, and revenue of 180 dollars meets total cost of 180 dollars.

Economic profit. 180 − 180 = 0 dollars.
What the total cost includes. The owner's implicit cost, the pay for the owner's own time and the return on the owner's savings.
Accounting profit. The books leave out that implicit cost, so the accounting profit is positive.

In words: zero economic profit means the owner's time and money earn exactly what they could earn in their next-best use, no more and no less. The owner is doing as well here as anywhere else, which is exactly why no one rushes in and no one rushes out.

Last, notice the different jobs of marginal and average cost in this week's decisions.

How many chairs? Marginal cost against the price: make each chair whose MC is at most P, on the rising part.
Open today or close? The price against the lowest average variable cost, 22 dollars.
Profit or loss? The price against average total cost at the chosen output, with the lowest ATC, 36 dollars, as the break-even line.

Misconception check. Students often read zero economic profit as "the owner earns nothing." The cure: economic profit subtracts the owner's forgone earnings, so zero economic profit means the owner earns a normal return, the same as the next-best job and investment would pay. A positive accounting profit sits behind it.

10. Check the classic wrong turns

Most mistakes this week are not deep confusions. They are the wrong cost curve for the question, or a rule borrowed from the wrong kind of market. A short routine catches them.

Step one: who sets the price? In perfect competition the market does; the firm chooses only its quantity.
Step two: how many? Find the last unit whose marginal cost is at most the price, on the rising part of MC.
Step three: profit or loss? Compute total revenue minus total cost, or (P − ATC) × Q.
Step four: open or closed? Compare the price with the lowest AVC, never with the lowest ATC.
Step five: what happens next? Profit brings entry and a lower price; losses bring exit and a higher price; both stop at the lowest ATC.

Worked example — checking a classmate's work. A classmate writes: "At 30 dollars the workshop takes a loss, so it should shut down. It should make chairs until price equals average total cost. And in the long run it earns zero profit, so its owner earns nothing."

The shutdown claim. At 30 dollars the workshop loses 28 dollars by operating and 60 by closing, and 30 is above the lowest AVC of 22, so it operates.
The output claim. Output follows P = MC: at 30 dollars the 4th chair's MC of 22 is at most 30 and the 5th chair's 32 is more, so it makes 4 chairs.
The zero-profit claim. Zero economic profit means the owner earns a normal return on time and money, the same as the next-best use.

In words: the corrected statement is "at 30 dollars the workshop makes 4 chairs and operates at a loss of 28 dollars, smaller than closing's 60, and in the long run its owner earns exactly what the next-best use would pay."

One more trap waits next week. The rule MR = MC holds for every firm, but P = MC holds only because a price taker's marginal revenue equals the price. A seller who must lower its price to sell more has a marginal revenue below its price, so P = MC is the wrong rule for it.

Misconception check. Students often treat P = MC as the rule for every firm. The cure: MR = MC is the rule for every firm, and it reads P = MC only for a price taker, whose marginal revenue is the market price. Ask first whether the firm can sell more without cutting its price.

Key terms

Perfect competition — A market with many buyers and many sellers, an identical product, buyers and sellers who know the going price, and free entry and exit, so that no single firm can move the price. (first used: 1. Name the traits: what makes a market perfectly competitive)
Price taker — A firm too small to affect the market price, which can sell as much as it wants at that price and nothing at a higher one, so it takes the price as given. (first used: 1. Name the traits: what makes a market perfectly competitive)
Free entry and exit — The condition that new firms can start selling in a market, and existing firms can leave it, without legal or cost barriers standing in the way. (first used: 1. Name the traits: what makes a market perfectly competitive)
Marginal revenue — The change in total revenue from selling one more unit of output; for a price taker every unit sells at the market price, so marginal revenue equals the price. (first used: 2. See why price equals marginal revenue)
Profit-maximizing rule — The rule that a firm earns the most profit by producing the quantity where marginal revenue equals marginal cost (MR = MC), making every unit that adds at least as much to revenue as to cost. (first used: 3. Apply the output rule: MR = MC, which reads P = MC)
P = MC rule — The profit-maximizing rule as it reads for a price taker: because marginal revenue equals the price, the firm produces where price equals marginal cost, on the rising part of the marginal-cost curve. (first used: 3. Apply the output rule: MR = MC, which reads P = MC)
Break-even price — The price equal to the lowest point of a firm's average total cost, at which revenue exactly covers every cost and economic profit is zero. (first used: 5. Find the break-even price)
Shutdown rule — The short-run rule that a firm keeps operating while the price covers average variable cost, even at a loss, and shuts down when the price falls below the minimum of average variable cost, losing only its fixed cost. (first used: 7. State the shutdown rule)
Shutdown price — The price equal to the lowest point of a firm's average variable cost; below it, operating loses more than closing does. (first used: 7. State the shutdown rule)
Long-run competitive equilibrium — The resting point of a perfectly competitive market after entry and exit have finished: the price equals the minimum of average total cost and each firm earns zero economic profit. (first used: 8. Follow the long run: entry and exit)

Summary

A perfectly competitive firm is a price taker: the market sets the price.
For a price taker, marginal revenue equals the market price.
Every firm maximizes profit where MR = MC; for a price taker that reads P = MC.
Choose output on the rising part of marginal cost.
Profit equals total revenue minus total cost, or price minus ATC, times quantity.
The break-even price is the lowest ATC; the shutdown price is the lowest AVC.
Between the two, a firm operates at a loss smaller than its fixed cost.
Entry after profits and exit after losses push the long-run price to the lowest ATC.
Zero economic profit means a normal return, not zero income.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A small tomato farm (an illustrative case) sells crates of tomatoes at a wholesale market where it is a price taker. Its fixed cost is 36 dollars a day, and its total cost is 36, 54, 66, 90, and 132 dollars for 0 to 4 crates. Compute its marginal cost for each crate, and decide how many crates it sells when the market price is 45 dollars a crate.
Using the farm's numbers, compute its profit at 45 dollars a crate two ways: as total revenue minus total cost, and as (P − ATC) × Q.
The price at the farm's market falls to 27 dollars a crate. Its lowest average variable cost is 15 dollars, at 2 crates. Decide how many crates it sells, compute its profit or loss, and say whether it should stay open today.
The farm's lowest average total cost is 30 dollars a crate, at 3 crates. Explain in two or three sentences what entry or exit does to the market price in the long run if it starts at 45 dollars, and what the farm's economic profit is once the market settles.

Answers (worked reasoning — read after attempting)

Marginal cost subtracts each total from the next: 54 − 36 = 18, 66 − 54 = 12, 90 − 66 = 24, and 132 − 90 = 42 dollars. At a price of 45 dollars every crate's marginal cost is at most 45, including the 4th crate's 42, so the farm sells 4 crates. Marginal cost is rising from the 3rd crate on, so the choice sits on the rising part, as the rule requires.
Total revenue is 45 × 4 = 180 dollars, so profit is 180 − 132 = 48 dollars. Average total cost at 4 crates is 132 ⁄ 4 = 33 dollars, so profit is also (45 − 33) × 4 = 12 × 4 = 48 dollars. The farm earns 12 dollars above average cost on each of 4 crates.
At 27 dollars the 3rd crate's marginal cost of 24 is at most the price and the 4th crate's 42 is more, so the farm sells 3 crates. Revenue is 27 × 3 = 81 dollars, and 81 − 90 = −9 dollars, a loss of 9. Closing would lose the fixed cost of 36 dollars. The price of 27 is above the lowest AVC of 15, so the farm stays open and loses 9 rather than 36. Shutting down because of any loss would be the classic slip.
At 45 dollars farms earn an economic profit, so new farms enter, the market supply curve shifts right, and the price falls. Entry stops when the price reaches the lowest ATC of 30 dollars a crate. At that price the farm's economic profit is zero, which means its owners earn a normal return on their time and money, not nothing.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, and the quiz — and next week the monopoly model shows how the MR = MC rule reads for a seller with no close rivals.

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