Price-taking behavior, which is the hallmark of competitive markets, arises because each individual firm in the market is so small relative to the total market that it cannot affect the market price of the good or service it produces by changing its output. Furthermore, all firms produce a homogeneous or perfectly standardized commodity, and thus no buyer would be willing to pay more than the going market price for any firm’s output. For this reason, firms in competitive markets face perfectly elastic demand curves and possess no market power to change price. Managers of competitive firms can only choose output (or inputs) to make the most of market-determined prices over which they have no control. While the conditions of perfect competition do not precisely describe real-world markets, many markets come so close to the situation that firms face nearly horizontal demand curves and behave as price-takers. This chapter provides the profit-maximizing rules for managers who operate as price-takers.

Managers who operate in competitive markets are likely to feel somewhat helpless in their efforts to deliver profits to the firm’s owners. Managers in competitive markets possess little or no market power because there are so many firms producing goods or services that buyers view as essentially identical. As price-takers, the managers can only react to market-determined prices by adjusting output to maximize any profits or minimize any losses that may occur in the short run. In the long run, the prospects for earning profit are slim because entry into competitive markets is unrestricted and any short-run profits will be competed away by entry of new firms. Possibly the best news managers can provide owners of firms in competitive industries is that any period of negative profits in the short run will likely disappear in the long run as some of the incumbent firms will exit the industry, driving prices up and eventually eliminating the losses. Over a long enough period, the owners are likely to earn, on average, just enough revenue to cover all the explicit costs of production and have just enough revenue left to pay themselves what they could have earned by putting their resources to the best alternative use.

In the next two chapters we will examine markets in which price-setting firms facing downward-sloping demand curves (instead of horizontal demand curves) can earn economic profit in the long run as well as in the short run. These firms can earn long-run profits because barriers exist to block partially or completely the entry of new firms.