I n t h I s c h a p t e r y o u w I l L

I n S o m e I n d u s t r i e s , E x e c u t i v e s
F o r e s e e To u g h Ti m e s A h e a d ;
A K e y C u l p r i t : H i g h P r o f i t s
B
Y
B
ERNARD
W
YSOCKI
, J
R
.
MONTEREY, CALIF.—About 20 execu-
tives are huddled in a conference room
with a team of management consultants,
and the mood is surprisingly somber.
It’s a fine summer day, the stock
market is booming, the U.S. economy is
in great shape, and some of the com-
panies represented here are posting
stronger-than-expected profits. Best of
all, perhaps, these lucky executives are
just a chip shot away from the famed
Pebble Beach golf course. They ought to
be euphoric.
Instead, an undertone of concern is
evident among these executives from
Mobil Corp., Union Carbide Corp. and
other capital-intensive companies. In be-
tween golf, fine meals and cigars, they
hear a sobering message from their
hosts.
“I feel like the prophet of doom” is
the welcoming line of R. Duane Dickson,
a director of Mercer Management Con-
sulting and host of the meeting. “It’s our
belief that the downturn has started. I
can’t tell you how far it’s going to go. But
it could be a very ugly one.”
For two days, the executives and
their advisers discuss what they expect
in their industries between now and
2000: growing overcapacity, world-wide
product gluts, price wars, shakeouts,
and consolidations. . . .
One man who attended the Pebble
Beach meeting, Joseph Soviero, a Union
Carbide vice president, cites an odd but
basic problem in chemicals: the strong
profits of the past few years. “The prof-
itability that the industry sees during the
good times has always led to overinvest-
ing, and it has this time,” Mr. Soviero
says. He adds that the chemicals busi-
ness cycle is alive and has peaked. At
Union Carbide, he says, “we always talk
about the cycle” and try to manage it.
So far, demand isn’t a big problem.
In many industries, it is still growing
steadily, though slowly. What is develop-
ing is too much supply, stemming from
the recurring problem of overinvestment.
. . . The next few years will bring fierce
competition and falling prices.
S
OURCE
:
The Wall Street Journal,
August 7, 1997,
p. A1.
I N T H E N E W S
Entry or Overinvestment?

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C H A P T E R 1 4
F I R M S I N C O M P E T I T I V E M A R K E T S
3 1 1
Thus, for these two reasons, the long-run supply curve in a market may be up-
ward sloping rather than horizontal, indicating that a higher price is necessary to
induce a larger quantity supplied. Nonetheless, the basic lesson about entry and
exit remains true. 
Because firms can enter and exit more easily in the long run than in the
short run, the long-run supply curve is typically more elastic than the short-run supply
curve.
Q U I C K Q U I Z :
In the long run with free entry and exit, is the price in a 
market equal to marginal cost, average total cost, both, or neither? Explain 
with a diagram.
C O N C L U S I O N : B E H I N D T H E S U P P LY C U R V E
We have been discussing the behavior of competitive profit-maximizing firms. You
may recall from Chapter 1 that one of the 
Ten Principles of Economics
is that rational
people think at the margin. This chapter has applied this idea to the competitive
firm. Marginal analysis has given us a theory of the supply curve in a competitive
market and, as a result, a deeper understanding of market outcomes.
We have learned that when you buy a good from a firm in a competitive mar-
ket, you can be assured that the price you pay is close to the cost of producing that
good. In particular, if firms are competitive and profit-maximizing, the price of a
good equals the marginal cost of making that good. In addition, if firms can freely
enter and exit the market, the price also equals the lowest possible average total
cost of production.
Although we have assumed throughout this chapter that firms are price tak-
ers, many of the tools developed here are also useful for studying firms in less
competitive markets. In the next three chapters we will examine the behavior of
firms with market power. Marginal analysis will again be useful in analyzing these
firms, but it will have quite different implications.
◆
Because a competitive firm is a price taker, its revenue is
proportional to the amount of output it produces. The
price of the good equals both the firm’s average revenue
and its marginal revenue.
◆
To maximize profit, a firm chooses a quantity of output
such that marginal revenue equals marginal cost.
Because marginal revenue for a competitive firm equals
the market price, the firm chooses quantity so that price
equals marginal cost. Thus, the firm’s marginal cost
curve is its supply curve.
◆
In the short run when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily if
the price of the good is less than average variable cost.
In the long run when the firm can recover both fixed
and variable costs, it will choose to exit if the price is
less than average total cost.
◆
In a market with free entry and exit, profits are driven to
zero in the long run. In this long-run equilibrium, all
firms produce at the efficient scale, price equals the
minimum of average total cost, and the number of firms
adjusts to satisfy the quantity demanded at this price.
◆
Changes in demand have different effects over different
time horizons. In the short run, an increase in demand
raises prices and leads to profits, and a decrease in
S u m m a r y

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3 1 2
PA R T F I V E
F I R M B E H AV I O R A N D T H E O R G A N I Z AT I O N O F I N D U S T R Y
demand lowers prices and leads to losses. But if firms
can freely enter and exit the market, then in the long run
the number of firms adjusts to drive the market back to
the zero-profit equilibrium.
competitive market, p. 292
average revenue, p. 294
marginal revenue, p. 294
sunk cost, p. 298
K e y C o n c e p t s
1.
What is meant by a competitive firm?
2.
Draw the cost curves for a typical firm. For a given
price, explain how the firm chooses the level of output
that maximizes profit.
3.
Under what conditions will a firm shut down
temporarily? Explain.
4.
Under what conditions will a firm exit a market?
Explain.
5.
Does a firm’s price equal marginal cost in the short run,
in the long run, or both? Explain.
6.
Does a firm’s price equal the minimum of average total
cost in the short run, in the long run, or both? Explain.
7.
Are market supply curves typically more elastic in the
short run or in the long run? Explain.
Q u e s t i o n s f o r R e v i e w
1. What are the characteristics of a competitive market?
Which of the following drinks do you think is best
described by these characteristics? Why aren’t the
others?
a.
tap water
b.
bottled water
c.
cola
d.
beer
2. Your roommate’s long hours in Chem lab finally paid
off—she discovered a secret formula that lets people do
an hour’s worth of studying in 5 minutes. So far, she’s
sold 200 doses, and faces the following average-total-
cost schedule: