7.

The Theory of Firm and Market Structure

- The particular environment of a firm, the
characteristics of which influence the firms pricing
and output decisions.
- Market structure:
- Perfect competition
- Monopoly
- Monopolistic competition
- Duopoly
 1. Perfect Competition
A theory of market structure based on four assumptions:
(1)There are many sellers and many buyers, none of which is
large in relation to total sales or purchases.
(2)Each firm produces and sells a homogeneous product.
(3)Buyers and sellers have all relevant information with
respect to prices, product quality, sources of supply, and
so on.
(4)There is easy entry into and exit from the industry.

A Perfectly Competitive Firm is a Price Taker

A seller that does not have the ability to control the

price of the product it sells; it takes the price
determined in the market.
 Market Demand Curve and Firm Demand Curve

The market, composed of all buyers and sellers, establishes the

equilibrium price. (a)
A single perfectly competitive firm then faces a horizontal (flat, perfectly
elastic) demand curve. (b)
Marginal Revenue (MR)
The Demand Curve and the Marginal Revenue Curve for a
Perfectively Competitive Firm

By computing marginal revenue, we find that it is equal to price.

By plotting columns 1 and 2, we obtain the firms demand curve;
By plotting columns 2 and 4, we obtain the firms marginal revenue curve.
The two curves are the same.
Quantity of Output Produce

The firms demand curve is

horizontal at the
equilibrium price. Its
demand curve is its
marginal revenue curve.
The firm produces that
quantity of output at which
MR = MC.
Profit-Maximization Rule

Profit is maximized by producing the quantity of output at

which MR = MC.
For Perfect Competition, profit is maximized when P = MR
= MC*
* This condition is unique for perfect competition and does
not hold for other market structures.
Resource Allocative Efficiency

Producing a goodany gooduntil price equals

marginal cost ensures that all units of the good
are produced that are of greater value to buyers
than the alternative goods that might have been
produced.
A firm that produces the quantity of output at
which price equals marginal cost (P = MC) is
said to exhibit resource allocative efficiency.
For a perfectly competitive firm, profit
maximization and resource allocative efficiency
are not at odds.
 Perfect Competition in the
Short-run
Profit Maximization and Loss
Minimization for the Perfectly
Competitive Firm: Three
Cases I

In Case 1, TR TC and the

firm earns profits.
It continues to produce in
the short run.
 PerfectCompetitioninthe
Shortrun
ProfitMaximizationand
LossMinimizationforthe
PerfectlyCompetitive
Firm:ThreeCasesII

In Case 2, TR < TC and

the firm takes a loss.
It shuts down in the short
run because it minimizes
its losses by doing so; it is
better to lose $400 in fixed
costs than to take a loss of
$450.
 PerfectCompetitioninthe
Shortrun
ProfitMaximizationand
LossMinimizationforthe
PerfectlyCompetitive
Firm:ThreeCasesIII
In Case 3, TR < TC and
the firm takes a loss.
It continues to produce in
the short run because it
minimizes its losses by
doing so; it is better to
lose $80 by producing
than to lose $400 in fixed
costs by not producing.
What Should a Perfectly Competitive Firm Do
in the Short Run?

The firm should produce in the short run as long as price

(P) is above or equal to average variable cost (AVC).
It should shut down in the short run if price is below
average variable cost.
Perfect Competition The Shutdown Decision
A perfectly competitive firm produces in the short run as long as price is
above average variable cost
P AVC Firm produces
A perfectly competitive firm shuts down in the short run if price is less
than average variable cost
P < AVC Firm shuts down
We can summarize the same information in terms of total revenue and
total variable costs.
A perfectly competitive firm produces in the short run as long as total
revenue is greater than total variable costs.
TR TVC Firm produces
A perfectly competitive firm shuts down in the short run if total revenue
is less than total variable costs
TR < TVC Firm shuts down
Perfect Competition A Review I
Perfect Competition A Review II
The Perfectly Competitive Firms
Short-Run Supply Curve

The short-run supply curve

is that portion of the firms
marginal cost curve that
lies above the average
variable cost curve.
Short-Run Market (Industry) Supply Curve

The horizontal addition of all existing firms short-run supply

curves
Deriving the Market (Industry) Supply Curve for a Perfectly
Competitive Market
Perfect Competition -Long-Run Equilibrium I

Long-run competitive equilibrium exists when:

there is no incentive for firms to enter or exit the
industry,
there is no incentive for firms to produce more or
less output, and
there is no incentive for firms to change plant size.
Perfect Competition -Long-Run Equilibrium II

1. Economic profit is zero: Price (P) is equal to

short-run average total cost (SRATC).
P = SRATC
2. Firms are producing the quantity of output at
which price (P) is equal to marginal cost (MC).
P = MC
3. No firm has an incentive to change its plant size to
produce its current output; that is, at the quantity of
output at which P = MC, the following condition holds:
SRATC = LRATC
Perfect Competition -Long-Run Equilibrium III

The condition where:

P = MC = SRATC = LRATC.
There are zero economic profits, firms are producing the
quantity of output at which price is equal to marginal cost,
and no firm has an incentive to change its plant size.
Productive Efficiency
The situation that exists when a firm produces its output at
the lowest possible per-unit cost (lowest ATC).
The perfectly competitive firm does this in the long-run.
Long-Run Competitive Equilibrium in the Market and the
Firm

P = MC (the firm has no incentive to move away from the quantity of

output at which this occurs, q1);
P = SRATC (there is no incentive for firms to enter or exit the industry);
and
SRATC= LRATC (there is no incentive for the firm to change its plant
size).
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Long-Run (Industry)
Supply (LRS) Curve
Graphic representation of the quantities of output that the
industry is prepared to supply at different prices after the
entry and exit of firms are completed.
Constant-Cost Industry I

An industry in which
average total costs do not
change as (industry) output
increases or decreases
when firms enter or exit the
industry, respectively.
 Constant-Cost Industry II
Start at long-run
competitive equilibrium
(point 1).
Demand increases, price
rises from P1 to P2, and
there are positive
economic profits.
Consequently, existing
firms increase output and
new firms are attracted to
the industry.
Input costs remain
constant as output
increases, so the firms
cost curves do not shift.
Profits fall to zero through
a decline in price.
Increasing-Cost Industry I

An industry in which average

total costs increase as
output increases and
decrease as output
decreases when firms enter
and exit the industry,
respectively.
 Increasing-Cost Industry II
Start at long-run competitive
equilibrium (point 1).
Demand increases, price rises
from P1 to P2, and there are
positive economic profits.
Consequently, existing firms
increase output and new firms
are attracted to the industry.
Input costs increase as output
increases. Profits are squeezed
by a combination of rising costs
and falling prices.
The new equilibrium price (P3)
for an increasing- cost industry is
higher than the old equilibrium
price (P1).
Decreasing-Cost Industry I

An industry in which average

total costs decrease as
output increases and
increase as output
decreases when firms enter
and exit the industry,
respectively.
Decreasing-Cost Industry II

Start at long-run competitive

equilibrium (point 1).
Demand increases, price rises
from P1 to P2, and there are
positive economic profits.
Consequently, existing firms
increase output and new firms
are attracted to the industry
Input costs decrease as output
increases. The new equilibrium
price (P3) for a decreasing-cost
industry is lower than the old
equilibrium price (P1).
Role of Profit
Profit serves as an incentive by prompting or encouraging
certain behavior.
As a signal, profit acts a little like a neon sign, identifying
where resources are most welcome. It is as if profit tells
others where resources are best allocated.
Do Higher Costs Mean Higher Prices?

Each firm in the industry is a price taker; furthermore, only one firm
has experienced a rise in marginal costs.
Because this firm supplies only a tiny percentage of the total market
supply, the market supply curve is unlikely to undergo more than a
negligible change. And if the market supply curve does not change,
neither will equilibrium price.
In short, a rise in costs incurred by one of many firms does not mean
consumers will pay higher prices.
If many of the firms in the industry experienced a rise in costs, the
market supply curve would have been affected, along with price.
Will the Perfectly Competitive Firm
Advertise?

The firm is a price taker and sells all they want at the
going price. Why advertise? Advertising has costs and
no benefits.
A perfectly competitive industry might advertise in the
hope of shifting the market demand curve to the right.