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Theory of the Firm:
Market Structures
(1) Perfect Competition
• Market structure describes the characteristics of
market organization that influence the behavior
of firms within an industry
• There are four market structures that we will
study in detail
–1. Perfect competition (perfectly
competitive markets)
–2. Monopoly
–3. Monopolistic Competition
–4. Oligopoly
We will assume that for all
Firms………
• firm’s behavior (choice of output) is
guided by its goal of
• profit maximization
• Yet, firms may not always make a profit; in some
cases, they are making a loss and until they decide to
shut down, they are interested in producing the
quantity that will make the loss as small as possible
• Loss minimization involves determining
the level of output that the firm should
produce to make loss as small as possible
Reminder: Profit π
• What is profit?
• π = TR − TC
– But costs include both explicit costs and implicit
costs (i.e. economic costs using the notion of
opportunity cost)
• Thus in economics, economic
(abnormal/positive) profit is defined as
– Total Revenue – Economic Cost or
– Total Revenue – (Sum of explicit and implicit
costs)
• Economic profits take into account of all costs
(explicit plus implicit) into consideration
Two approaches to analyzing Profit
Maximization (Loss Minimization)
• Approach 1: Profit maximization based on
the total revenue and total cost approach
– We know that profit = total revenue – total cost
(economic cost, the sum of explicit and implicit
cost)
– The firms profit maximization rule is to produce
the level of output where TR – TC is as large as
possible (in case of loss, to produce the output
where difference between TR and TC is small as
possible)
Revenues
• Revenues are the payments firms receive
when they sell the goods and services they
produce over a given period of time = sales
• Three fundamental revenue concepts:
– Total Revenue – obtained by multiplying the price
at which a good is sold (P) by the number of units
of the good sold (Q) TR = P x Q
– Marginal Revenue – is the additional revenue
arising from the sale of an additional unit of
output MR = △ TR /△ Q
– Average Revenue – is revenue per unit of output
sold AR = TR / Q
Mathematically…
• MR is the slope of the TR curve
• AR is always equal to the P of the product!
• The definitions of the revenues given above
apply to all firms and group of firms (market
structure, industries) BUT the analysis of the of
revenues is not the same for all firms because
this depends on whether or not the firm has any
control over the price at which it sells its
product…
1. Model of Perfect
Competition
• this model does not exist in reality but it will
be used as the benchmark to analyze the
other models and in helping design different
policies and interventions
(continued)
• Although perfectly competitive markets are
rarely observed in the real world as the
assumptions are hardly ever fully met, some
industries are close to the model
• Eg Some agricultural commodities e.g. wheat,
corn, livestock
– Silver and gold
– Nails, pins, clips
– Money market (financial markets and foreign
exchange market)
Assumptions of Perfect Competition
• The model of perfect competition is based on the
following assumptions:
•
•
•
•
There is a large number of firms (and buyers)
All firms produce identical or homogenous products
There is perfect and complete information
There is perfect resource mobility
PRICE-TAKERS ie Firms under
perfectly competitive market
structure have no control over price
–There is free entry and exit to the
industry/market
• 
PRICE-TAKERS
– The individual firm, being small under a lot
competitors, can do nothing to influence its price
– It must accept Pe and sell whatever output will
maximize profits for them
– If the firm raises its price above Pe, it will not sell
any output because the buyers will buy the
homogenous product elsewhere at a cheaper
price. On the other hand, since it can sell all it
wants at Pe, there is no incentive to lower their
price below it as they have nothing to gain
The Demand Curve (AR Curve) for Firms in PC Market
• Consider a market or industry for a product
produced under the perfect competition
market structure
• The Pe is determined by the standard D and S
as follow
• Now, given the nature of PC Markets, each
firm within this industry faces a demand curve
for the product as follows
• The FIRM’s demand curve is perfectly elastic
(PED is infinite), appearing horizontal at Pe
Revenue Curves where the firm has
no control over price
• As you can see, the price at which the good is sold does
not change across different levels of output
• This data can be plotted as follow
MR and AR of Firms in Perfect
Competition
• The above finding implies that no matter how
much output the firm in the perfectly
competitive market sells, P = MR = AR and
these are constant at the level of the
horizontal demand curve
Cost Curves for Firms in Perfect Comp.
• The costs curves are the same curves introduced earlier
with the law of diminishing returns (in the SR) and returns
to scale (in the LR) explaining the U shaped curves
• These will be assumed to be the same basic shape
whatever the level of competition
Combining the Revenue and Cost Curves Together:
Profit Maximization in the Short Run
 Handouts and graphs
SR and LR equilibria
•
•
•
•
SR equilibrium is where…….
MR=MC
But in the LONG-RUN
(defined as where new firms can enter the
industry/market or where existing firms can
quit (exit) the market)
The mechanism of achieving LR
Equilibrium in PC Market
Movement to the LR equilibrium
• In the long run, all the firm’s resources are
variable. Not only can the firm change its size
(increase or decrease fixed inputs), but it can also
decide to sell its resources and business and
leave the industry altogether. Similarly, new firms
can enter the industry to compete as well
• This free entry and exit of firms into the industry
is the key to understanding the firm’s operation in
the long run in Perf. Comp. Markets
• …………………. new handout
The long run outcome …
• With free entry and exit into the market,
• if firms are earning abnormal (positive) profits in the short run,
• this sends a signal and incentives for other firms to enter the business
(e.g. the next trend: iPhone and the App business).
• The profits lead the process of entry for firms into the market
•  the price falls
• and this reduces the short run profits of the firms
• And in the case of short run losses (e.g. outdated trend: tamagochi, iPod,
CDs): if firms are making losses in the short run,
• the losses lead to a process of exit of some firms from the market
•  the price rises
• and thus remaining firms’ losses are reduced
Economic Profit in the SR to Normal Profit in the LR
• Assume that a Perf. Comp. market is in short run
equilibrium where each firm in the industry is earning
economic profit
• But now, once they move into the long run, they can vary
all their inputs and moreover, new firms who would like to
be in a profitable business would enter the market as well
• As new firms enter, this would shift the industry/market
supply curve to the right, causing output to increase and
market price to fall to a new level
• And this new entry would continue until the firms are
earning zero economic profit (normal profit)
• i.e. where P = minimum ATC or the break even price
• This is shown as follows
• At the initial industry equilibrium, where D and S1 intersects,
P1 is the market price accepted by all firms
• Using the MC=MR rule, Q1 is produced and each firm obtains
a profit equal to (a – b) per unit of output
• As industry supply increases (with new entry), P falls to P2
Firms now earn zero economic profits (they earn normal
profit). Their economic profits and losses are eliminated
and they earn just enough revenue to cover economic costs
Economic Profit in the SR to Normal Profit in the LR
• Now, assume that a Perf. Comp. market is in a short run
equilibrium where some firms are making an economic
loss ( P above the minimum AVC but below the minimum
ATC)
• In the short run, because they have the fixed costs to
cover, they remain in the industry. But once they move
into the long run, they no longer have any fixed
inputsthe firms are free to leave the industry
• This would shift the industry supply curve to the left,
causing output to decrease and market price to rise
• As the price increases, the losses of the remaining firms
are reduced until the price reaches to P2 = minimum
ATC where they are no longer making any losses (earning
normal profit). There are no further reasons or incentive
to exit the market
In the LR Equilibrium …
• Once the industry and firms within it find themselves in the
LR equilibrium, they will remain here until something from
outside the system causes a disturbance
• That is, when the ceteris paribus assumption (factors aside
from P) changes
– The D shifters/determinants (e.g. tastes, income, etc.)
– The S shifters/determinants (e.g. technology, resource prices,
natural disasters, etc.)
• In real life, there is constant disturbance and the market is
changing constantly
• Firms therefore find themselves in situations making
economic profits and losses regularly (realistic portrayal)
• The LR equilibrium is more of a theoretical concept that
helps firms plan for the future
Note: shut down price and break even price
in the SR and LR
• In the SR, the firm continues to produce as long as
the price is greater than minimum AVC as they
have the fixed cost to cover. That is, it is better to
have a loss which is less than the fixed costs
• In the SR, they shut down only when the loss is
greater than variable costs i.e. when P < minimum
AVC
• But in the LR, firms shut down when P < minimum
ATC. This is because there are no fixed costs in the
LR.
• Thus, the break even price and shut down price
are the same in the LR
EFFICIENCY ANALYSIS……
• of the perfectly competitive firm, which profit
maximizes, in:
• A) the short run
• B) the long run
Technically (Productively) Efficient
level of output…..
• Is NOT necessarily where profits
are maximised
• It is where COSTS are MINIMIZED
• at the minimum point on the AC
(or ATC) curve
Productive (technical) efficiency
In more detail……..
– ……… occurs when production takes place at the
lowest possible cost. It is achieved when production
occurs at minimum ATC
– This means that resources are being used
economically and are not being wasted. Production of
the good uses up the least amount of resources
possible
–Does the perfectly competitive firm
achieve this?
–In the SR: No
But in the LR: Yes
Allocative Efficiency Analysis of
Perfectly
Competitive Markets
ALLOCATIVE EFFICIENCY
•
Definition Optimum allocation of scarce resources
•
ALLOCATIVE EFFICIENCY occurs when
• MC = Price= MU (or MB)
• Assuming that Price reflects the marginal utility/benefit to
the consumermore simply expressed as:
• MC = Price
• Does the perfectly competitive firm achieve this?
Also notice:
Marginal cost
C
$70
Cost, Price
60
50
A
40
30
B
20
10
0
1
2
3
4
5
6
7
8
9 10 Quantity
 The Marginal Cost Curve
= the firm’s Supply Curve
• The marginal cost curve tells the competitive
firm how much it should produce at a given
price.
• The MC curve is the firm's supply curve
above the point where price exceeds average
variable cost
Efficiency Analysis of Perfectly Competitive
Market in the Short Run
• For the short run,, when a firm is earning an
economic profit (or minimizing loss), the firm
achieves allocative efficiency as P = MC but the
firm fails to achieve productive efficiency
because ATC is higher than its minimum at the
level of output where they produce
• Only if the firm happens to produce an output
which earns normal profit (zero economic profit),
will it achieve productive efficiency
Efficiency Analysis of PC Market in the Long Run
• The long run equilibrium position of a firm in the PC Market is shown
again as follows
• The firm is achieving both allocative and productive efficiency in the LR
equilibrium. At the profit max output, Qe, P = MC and ATC is at its minimum
• The industry as a whole is also achieving AE as the sum of CS and PS is
maximized at the market equilibrium  NO WELFARE LOSS
• This finding is essential, as we will see later that Perf. Comp. is the only
market structure which achieves AE and PE in the long run
•  EFFICIENCY (filling in words)
In summary: Allocative Efficiency &
Perfect Competition
• If consumers are rational and utility maximizing, it can be assumed that
they will consume up to the point where:
• MB = Price or MU= P
i.e. the Demand curve represents the MB of each unit
• If firms are profit-maximizing and in perfect competition, they will
produce up to the point where
i.e. the Supply curve represents the MC of each unit
• MC = MR = P
• 
MB=P=MC
• and ALLOCATIVE EFFICIENCY has been achieved
•
Defined simply as where MC=P
• e.g. If MB>MC then _________________________ should be produced in
order to use society's scarce resources in the most efficient way.
• BUT ………
WHO gets the goods?
Evaluating the Perf. Comp. Market
Structure
Insights and positive outcomes:
• It leads to allocative efficiency or the “best” and “optimal”
allocation of resources for the goods and services the society
wants
• It leads to productive efficiency (in the LR) where
production is conducted at the lowest possible cost, avoiding
waste in the use of resources (minimum point of ATC)
• Low prices for consumers from productive efficiency and
absence of economic profits due to free entry of firms
• Competition (also due to free entry of firms) leading to the
closing down of inefficient producers with bad management
and inefficient use of inputs to produce outputs higher AC
(i.e. because the price set at the minimum of ATC for the
efficient firm) and incentivises firms to find ways to lower
costs and improve quality
• Models and responds to the changes/shifts in demand and
supply determinants through achieving new long run
equilibriums
• Limitations of the model:
•
Unrealistic assumptions  problems (eg many small firms,
homeogeneous good, freedom of entry, freedom of exit)
• Limited possibilities to take advantage of economies of scale
i.e. a firm could lower average costs as it grows and produces
more and more. But in Perf. Comp., it is assumed that all firms
are small and there are many of them, which prevents them
from growing large enough to take advantage of economies of
scale
• Lack of product diversity--all firms produce the identical
homogenous product. However, consumers prefer variety
• Limited ability to engage in research and development since
there are no economic profits in the long run and because all
innovations will, theoretically, be copied if they are profitable No
entry barriers lack of Dynamic Efficiency
• Waste of resources in the process of long run adjustment i.e.
continuous opening and closing of firms can lead to waste of
resources (assumes no costs of transaction and adjustment)
• PLUS consider:
WHO gets the goods?
Suppose aim is NOT
π maximisation
• In reality, firm’s operations can be motivated by other
aims
– Revenue maximization – with separation of management
from ownership, CEOs tend to care more about sales while
owners/shareholder care more about profits
– Growth maximization – firms can be more interested in the
change, the sense of progress (start to end). Growing firm
signifies economies of scale, market power, diversification,
reduction in risks, etc.
– Managerial utility maximization – CEOs maybe interested
more in sales, benefits, employment, etc.
– Satisficing – not just one of profit, revenue, growth or
managerial utility but reach a satisfactory level in each of them
– Ethical and environmental concern and corporate social
responsibility – image, to avoid regulation and taxes. Rising
consumer awareness of corporate behavior and environment
REVIEW: Profit Maximization Using Total
Revenue and Total Cost
• Profit is maximized where the vertical distance
between total revenue and total cost is
greatest.
• At that output, MR (the slope of the total
revenue curve) and MC (the slope of the total
cost curve) are equal.
Review: Profit Determination Using Total Cost
and Revenue Curves
Total cost, revenue
TC
Loss
$385
350
315 Maximum profit =$81
280
245
210
$130
175
140
105
Profit =$45
70
Loss
35
0
1 2 3 4 5 6 7 8 9
TR
Quantity
REVIEWThree Steps in Analyzing the
Profit Maximization (Loss
Minimization) Process
• 1) compare MR with MC to determine the profit
maximization output
• The firm should increase output so long as
MR>MC (and vice-versa)
• the PROFIT-MAXIMISING or equil. level of
output is where MC =MR
•
(second-order condition is that MC cuts MR from below)
• 2) compare AR (or price) and ATC to determine
the amount of profit (or loss) per unit of output
• 3) find the total profit (total loss) by multiplying
the Q produced to the value obtained in (2)
Review Determining Profits Graphically
MC
MC
MC
Price
Price
Price
65
65
65
60
60
60
55
55
55
ATC
50
50
50
ATC
45
45
45
40
40 D
A
P = MR 40
P = MR
Loss
35
35
35
P = MR
Profit
30
30
30
B ATC
AVC
25
25 C
25
AVC
AVC
E
20
20
20
15
15
15
10
10
10
5
5
5
0
0
0
1 2 3 4 5 6 7 8 910 12
1 2 3 4 5 6 7 8 9 10 12
1 2 3 4 5 6 7 8 9 10 12
Quantity
Quantity
Quantity
(b) Zero profit case
(a) Profit case
(c) Loss case
Recap
• Perfectly competitive markets achieve
allocative efficiency at the market equilibrium
(both SR and LR) where
• MB or MU = MC=P
– Here, the sum of consumer and producer surplus
(social surplus) is at its _____________
– Note: the two interest groups: consumers and
producers are brought together through MB and
MC, respectively
– And there is no other allocation of resources
where we are able to make some better off
without making others worse off
In perfect competition….
• The demand curve facing the firm is equal to the
Price (P) level
• In other words, D or MB (marginal benefit) is equal
to P
• Thus, through substituting P for MB, we can restate
the condition of allocative efficiency as
P = MC
– The interest of consumers (their D and MB) are reflected
in the P and the MC is the firm’s supply curve or the
reflection of the interest and profit decision-making
process of the firms.
– note: we assume there are no externalities. If there are,
Allocative Efficiency is achieved when MSB = MSC (to be
studied in 2016)
Let’s think about the P = MC condition again
• The price, P paid by consumers reflects the
marginal benefit they derive from consuming one
more unit of the good and shows the amount of
money they are willing to pay to buy one more unit
• Marginal cost, MC, measures the value or the
opportunity cost of the resources used to produce
one more unit of the good by the firms
• Thus, when P = MC, there is equality between
what consumers are prepared to pay to get one
more unit and what it costs to produce it. There is
a balance of interest, an equilibrium
• What would happen if P > MC?
– Here, the additional unit of the good is worth more
to the consumer than it costs to produce. There is
an underallocation of resources to its production
and some consumers will be better (without making
other worse off) if more of it were produced
• Vice versa, what if P < MC ?
– The additional unit of the good costs more to
produce than it is worth to consumers and there is
an overallocation of resources to the good.
Consumers will be better off if output were reduced
• Resources are allocated efficiently only when P = MC