THEORY OF THE

FIRM AND MARKET

STRUCTURE

THEORY OF THE FIRM AND MARKET

STRUCTURES
A market structure is a classification system for the
key traits of a market.
There are 4 types of market structure; perfect
competition, monopoly, monopolistic competition
and oligopoly.

DETERMINATION OF EQUILIBRIUM OF
A FIRM

There are 2 approaches to determine the profitmaximizing level of output:

The Total Revenue-Total Cost Method (The Aggregate

Approach)
The equilibrium point would be at output where
difference between total cost and total revenue is the
greatest. It is also known as the profit maximization
point.
The break-even point of a firm occurs when total cost
is equal to total revenue.

THE TOTAL REVENUE-TOTAL COST METHOD (THE

AGGREGATE APPROACH)

Break-even

Profit max point

Break-even

THE MARGINAL REVENUE-MARGINAL COST

METHOD (MARGINAL APPROACH)
The firm can maximize profit when its marginal
revenue equals marginal cost. The output
produced is known as optimum output.
Moreover, marginal cost must cut marginal
revenue from below.

THE MARGINAL REVENUE-MARGINAL COST

METHOD (MARGINAL APPROACH)

Profit max MR = MC

QUICK COMPARISON BETWEEN FOUR

MARKETS
Key
characteristics

Perfect
Competition

Monopolistic
Competition

Oligopoly

Monopoly

No. of Sellers

Large number of
sellers

Many sellers

Few sellers

One single seller

Price decision
(Price control)

Price taker
(no control over
P)

Price taker
(little control)

Price maker
(some control)

Price maker
(complete control)

Type of product

Homogenous/
Identical

Slightly
differentiated

Differentiated

Unique

Barriers to Entry

No barriers/ Easy
entry & exit

No barriers/ Easy
entry & exit

Difficult of entry &

exit

Completely
blocked for entry

Type of SR profit

Supernormal/
normal/
subnormal profi

Supernormal/
normal/
subnormal profit

Supernormal/
normal/
subnormal profit

Supernormal/
normal/
subnormal profit

Type of LR profit

Normal profit

Normal profit

Supernormal
profit

Supernormal
profit

Demand curve

Horizontal,
D=MR=AR=P

Downward
sloping (elastic)
P=AR=D>MR

Downward
sloping or kinked
D curve

Downward
sloping (inelastic)
P=AR=D>MR

PERFECT COMPETITION (PURE

COMPETITION)

A market structure characterized by a large number

of small firms, a homogenous product and very
easy into or exit from the market.

Characteristics
a) Large number of sellers and buyers
There are many small firms, so their size is small
relative to the size of the market. There are also
many buyers in the market.
b) Homogeneous product
All firms produce a standardized or homogeneous
product. Advertising is totally absent in this market.

c)

d)

e)

f)

Very easy entry and exit

No restriction is imposed. Firms face no barriers to
entry and exit.
Firm is price taker
Price is determined through market forces (demand
and supply) and firms have no power to control the
price.
Perfect knowledge of market
Both the sellers and the buyers have perfect
knowledge about the market situation. This means
that they know the prevailing prices in the market.
Perfect mobility of factors of production
Factors of production especially labor are free to
move from one place to another without any
restrictions or rules from the government.

The Demand of Perfect Competition

The individual firms demand curve is perfectly elastic

(horizontal) at the market equilibrium price.

SHORT-RUN EQUILIBRIUM

Short-run is a time period in which there is no

change in the fixed inputs.

In short-run, the perfect competitive firms can

attain 3 possible profits.

Economic profit (Supernormal profit)

Normal profit
Economic loss (subnormal profit)

Economic Profit
(Supernormal Profits)
Economic profit is a
situation where total
revenue is greater than
total cost.
Conditions to attain
economic profit:

a)

MR = MC = Price
P=AR > ATC
TR > TC

b)

Normal Profit
Normal profit is a
situation where total
revenue equals total
cost.
Conditions to attain
normal profit:

MR = MC = Price
P=AR = ATC
TR = TC

c)

Economic Loss
A loss occurred when
total cost is greater than
total revenue.
Conditions to get a loss:

MR = MC = Price
P=AR < ATC
TR < TC

SHUT DOWN POINT IN THE SHORT RUN

IMPORTANT : In SR the firm should continue production as

long as AR is greater than or equal to AVC. (or TR greater
than or equal TVC) or total loss is less than TFC

The firm will continue its operation because it can cover the
total variable cost and a part of total fixed cost.

The firm must shut down its operation because it

cannot cover all of its variable costs.

DERIVING THE SHORT-RUN SUPPLY CURVE

P

MC = S
a

P1
P2

b
c

P3

D1 = MR1
D2 = MR2
D3 = MR3

D1

D3
O

D2

O
Q (millions)

(a) Industry

Q (thousands)

(b) Firm

DERIVING THE INDUSTRY SHORT-RUN SUPPLY CURVE

S
a

P1

P2

P3

D1 = MR1
D2 = MR2
D3 = MR3

D1

D3
O

D2

O
Q (millions)
(a) Industry

Q (thousands)
(b) Firm

LONG-RUN EQUILIBRIUM

In long run, the firm can earn normal profit. There are 2
reasons:

If firms in PC market earn economic profit in SR, this will

encourage them to expand production. New firms also will
enter the market. As a result, SS will increase and P will fall.

A loss in SR will force the firms to reduce production/shutdown

and therefore some existing firms will leave the market. So SS
will decrease and P is forced to go up.

LONG-RUN EQUILIBRIUM UNDER PERFECT

COMPETITION
P

New firms enter

S1

Supernormal profits(MC
In SR

Se

LRAC
P1

AR1

D1

PL

ARL

DL

O
Q (millions)
(a) Industry

Profits return
to normal in LR

QL
Q (thousands)
(b) Firm

LONG-RUN EQUILIBRIUM UNDER PERFECT

COMPETITION

Firms leave market

Se

Economic loss in SR

S1

(MC
LRAC

PL

ARL

DL

P1

AR1

D1

Q (thousands)

Q (millions)
(a) Industry

QL

Profits return
to normal in LR

(b) Firm

LONG-RUN EQUILIBRIUM OF THE

FIRM UNDER PERFECT
(SR)MC
COMPETITION

(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

SHUT DOWN POINT IN THE LONG RUN

When average total cost is greater than average

revenue, the firm must cease production because
this shows that the firm is inefficient, mismanaged
and is not able to earn any profit for a long period
of time.