Chapter Three: Market Structures and Determination of Price and Output

3.1. Introduction
The Firm, its objective and market structure

 The objective of a consumer is maximization of utility; likewise, the firms produce goods
and service and sell the product to consumers. Consumer demand for goods and services
determines the revenue side of a business operation. Production theory has been used to
derive the cost conditions faced by firms. Brought together, revenue and cost determines
the behavior of a profit maximizing business firm. The most important factor that
determines firm’s choice of price and output is the market structure. The term market
structure refers to the organizational features of an industry that influence firm’s behavior
in its choice of price and output. Economists have found it useful to classify markets in to
two broad general types.

1. perfectly competitive market structure

2. Imperfect Market structures include: monopoly, monopolistic competition and oligopoly,

this Classification is mainly based on

1. the numbers of firms in the industry,

2. the nature of products and

3. the nature of entrance of new firms. In this unit, we investigate how price and output are
determined in perfectly competitive markets in the short as well as long run periods.
Perfect competition is a market structure characterized by a complete absence of rivalry
among the individual firms, because there are so many firms in the industry

3.2. Perfectly Competitive Market Structure

3.2.1. Assumptions / characteristics of the model/

A perfectly competitive firm has the following characteristics:

 Large number of sellers and buyers:

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  under perfect competition the number of sellers is assumed to be too large
that the share of each seller in the total supply of a product is very small.

 Therefore, no single seller can influence the market price by changing the
quantity supply.

 Similarly, the number of buyers is so large that the share of each buyer in the total
demand is very small and that no single buyer or a group of buyers can influence
the market price by changing their individual or group demand for a product.

 Therefore, in such a market structure, sellers and buyers are not price makers
rather they are price takers i.e. the price is determined by the interaction of the
market supply and demand forces.

Market equilibrium; and demand curve of a firm in perfect market

 Homogeneous product: -

 homogeneity of the product implies that buyers do not distinguish between

products supplied by the various firms of an industry.

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  Product of each firm is regarded as a perfect substitute for the products of
other firms. Therefore, no firm can gain any competitive advantage over the
other firm.

 Perfect mobility of factors of production: -

 factors of production are free to move from one firm to another throughout the
economy.

 This means that labor can move from one job to another and from one region to
another. Capital, raw materials, and other factors are not monopolized.

 Free entry and exit: -

 there is no restriction or market barrier on entry of new firms to the industry, and
no restriction on exit of firms from the industry.

 A firm may enter the industry or quit it on its accord. A firm can enter or exit an
industry/market with no cost.

 Perfect knowledge/ information: -

 There is perfect knowledge about the market conditions. All the buyers and sellers
have full information regarding the prevailing and future prices and availability of
the commodity.

 No government interference: -

 government does not interfere in any way with the functioning of the market.

 There are no discriminator taxes or subsidies, no licensing, no allocation of inputs

by the procurement, or any kind of direct or indirect control.

 That is, the government follows the free enterprise policy. Where there is
intervention by the government, it is intended to correct the market imperfection.

3.2.2. Demand curve, Price, Average revenue (AR) and Marginal revenue
(MR) of a firm

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We have seen that a perfectly competitive firm faces a horizontal demand curve for
its product. This has a number of implications; A perfectly competitive firm can’t
affect the market price by changing its output. A firm is simply a price - taker not
price – maker, it simply accepts the market price. A firm has no market power, all
firms have equal market power, i.e., is zero. Price, AR and MR of a firm are
always equal in prefect market; P = MR = AR. AR = TR/Q = (P*Q) /Q = P,

MR = dTR/dQ = d(PQ)/dQ = P* dQ/dQ = P; P = AR =MR, from this we can

conclude that the demand curve of individual firm under perfect is also the AR and
the MR curves. Given P is a market price

A horizontal demand curve also shows, the price elasticity of demand for a
competitive firm is perfectly elastic; Ed = ∞. The response is so high that for slight
change in price, TR of the firm will become zero (its total sale becomes zero).

3.2.3. Short-Run Equilibrium

the Short Run Equilibrium of a firm - A profit maximizing firm is in equilibrium at

the level of MC equal to MR (the marginal approach). And short – run equilibrium
is based on the following assumptions

 Capital is fixed and labor is variable

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  Price of inputs are given

 Price of the commodity is fixed, and

 The firm is faced with short run cost curves.

There are two approaches of profit maximization;

 Total Approach and

 Marginal Approach.

Total Cost and Revenue Approach:

According to this approach profit is maximized when the vertical difference

between total revenue (TR) and total cost (TC) is the largest. symbolically;

∏= TR - TC and TR = P x Q ;

Where: ∏ = profit TR = Total revenue, TC = Total cost,

P = price of output, Q = quantity of output.

It can be shown graphically by assuming linear total revenue function as follows;

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The marginal Approach Marginal Cost (MC) and Marginal Revenue (MR

According to this approach, given other things being constant, such as prices. That is , any
rational firm a produces an output level where at least it’s MR is equal to its MC. At
equilibrium, a firm could maximize profit or minimizes its loss or earn zero profit by producing
that level of output where the following conditions are fulfilled;

 The first order condition (F.O.C); MR = MC. MR = MC; but, MR = dTR/dQ and MC
= dTC/dQ; Hence, dTR/dQ = dTC/dQ

 The second order condition (S.O.C); dMR/dQ < dMC/dQ . MC should be increasing at a
higher rate than MR.

Graphically,

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 Price of a commodity is fixed by the market forces in a perfectly competitive market, the
firms have horizontal demand curve as shown.

As shown by the line Pe = MR and also P = MR = AR - all are equal in perfect market.

At point E the equilibrium condition is satisfied; MR =MC; it also implies that; Pe = MR

=MC= AR , at point E. Qe is the equilibrium level of output – it is a best or most
preferred level output t a firm can produce given its MC function and the market price.

Total Profit (π) , Equilibrium of a Firm , Price and AC

In the short run, equilibrium of a firm doesn’t necessarily tell us the level of profit the firm is
earning. The equilibrium condition, MR = MC, only tell us how much has to produce or it is the
determination of the best possible level of output level given the circumstances (prices and cost
function) a firm faced.

 MC of a firm doesn’t help to know the total profit.

 In the short run, total profit of a firm depends on AC of production relative to market
price of the product.

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  Accordingly, the total profit (π) of the firm could be positive, zero or negative at
equilibrium based on the AC of the firm relative to price.

Observe the following relationship between P & AC of a competitive firm π = TR – TC = (AR).

Q - Q*AC [Because TR=Q*(TR/Q)=Q*AR,TC=Q*(TC/Q)=Q*AC]

 Since under perfect market P = AR, then

π = P*Q – Q*AC = Q* (P – AC)

Thus; if

 P > AC, then π > 0,

 P = AC, then π = 0 and

 P < AC, then π < 0

Case 1 – when market price greater than AC ( P > AC , π > 0)

The firm equilibrium at point E where the condition is satisfied (MR = MC) with P > AC; thus,

π > 0; the firm will earn positive profit.

π = TR – TC = (AR).Q - Q*AC , since under perfect market P = AR, then

π = P*Q – Q*AC = Q(P – AC), thus , π > 0 if P > AC, Output level Qe is, therefore,
profit maximize, or called equilibrium output level. At this output, the firm is at equilibrium and
is making positive profit. Firm’s maximum total profit is shown by the area of a rectangle,
PeERA.

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Graphically

Case 2 – when P = AC ; π = 0 ( break –even point)

In the short run, a firm may not always earn abnormal/positive profit. If the firm is at
equilibrium with its short run average cost (SAC) is equal to price. The equilibrium condition is
MR = MC which satisfied at point E with output, Qe. The SAC curve is also tangent to P = MR
line, at this point, where P = SAC. Thus, the firm makes normal profit/zero profit. Note that at
point E: P = MR = SMC = SAC = AR and π = 0

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Graphically

Case 3 - when P < SAC and π < 0

If AC is above the price or if a firm at equilibrium where P > AC the firm incurs losses in the
short run (π < 0). It is shown graphically as follows. Given P e is market price; at point E,
equilibrium condition is satisfied ; Pe = MC = MR ; But AC > Pe , thus, the firm is at
equilibrium with negative profit or π < 0. The total loss the firm is shown by the area of a
rectangle PeREE’.

Graphically

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Shut –down or close – down points

In case a firm is making loss it must cover its short run average variable cost (SAVC). A firm
unable to cover its minimum AVC will have to close down. The MC/MR intersects AVC at its
minimum level as shown in the figure below. Given Mkt price is Pe ; at point E, MC = MR = Pe
and Pe = AVC , hence, the firm is at shut- down. Note also that at point E, TR = VC and Loss =
TFC amount. Loss = TR – (FC +VC) = TR – TFC –TVC; Since TR = TVC, Then; Loss = - TFC
amount.

Graphically

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3.2.4. The supply curve of the firm and the industry

The supply curve of a competitive firm is derived on the basis of its equilibrium output and from
the MC curve. As such the supply curve of a perfectly competitive firm is derived from its MC
curve that lies above point where it intersects with AVC curve. The equilibrium output
determined by the intersection of MR and MC curves, is the optimum supply by a profit
maximizing (or cost minimizing) firm.

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According to the figure, at point M, MC = AVC = Price, P1 and Q1 is the minimum supply of
the firm. A firm can’t produce below the point where MC = AVC or below point M. As the
price increases above P1, firm will increase its output moving along its MC curve. When
price increases to P2, the equilibrium point moves along its MC curve from M to R and when
price is P3 equilibrium is at point K; and output increases to Q2 then to Q3 and so on, the
supply curve is derive by plotting this information or simply taking MC curve above point M.

2.2.4. Short Run equilibrium of the industry/ market

The industry/market supply curve is a horizontal summation of the supply curves of the
individual firms. If all firms have identical supply curve the industry supply curve can be
obtained simply by multiplying the individual supply at various prices by the number of
firms. In short run, however, the individual supply curves may not be identical, if so, the
market supply curve can be obtained by summing horizontally the individual supply curves.
An industry is in equilibrium in the short-run when market is cleared at a given price.

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 In short run equilibrium of the industry,

 some individual firms may make pure profit,

 some normal profits and

 some may make even losses depending on their cost and revenue conditions, as
we will discuss in the next sub-topic, this situation will however not continue in
the long-run.

3.3. Long-Run Equilibrium

The short-run, by definition is a period in which:

 Firms cost and revenue curves are given

 Firms cannot change their size, their capital is fixed

 Existing firms cannot leave the industry, and

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  New firms cannot enter the industry.

In contrast, long run is a period in which these constraints are relaxed.

 It permits change in technology and employment of both, labor and capital.

3.3.2. Equilibrium of the firm in the long run

To show the long run equilibrium, let us begin with a short-run situation. Suppose
that short run price is given at OP1 and the short-run average and marginal cost as
SAC1 and SMC1 [panel (A) & panel (B)]. Given the price OP1, the firms are in
equilibrium at point E1. It may be noticed that the firms are making abnormal
profit. Abnormal profit brings about two major changes in the industry.

 First,

 existing firms get incentive to increase the scale of their production. This
phenomenon is shown by SAC1 and SMC1.

 Second,

 attracted by the abnormal profit, new firms enter the industry. For these
reasons, the industry supply curve SS1, shifts out ward to SS2 (panel A).

 The shift in supply curve brings down the market price to OP2 which is the
long-run equilibrium price. Thus, equilibrium price is once again determined
in the market.

Graphically

Given the new equilibrium market prices OP2, firms attain their equilibrium in
the long run where AR = MR = LMC = LAC = SMC = SAC.

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3.3.3. Equilibrium of the industry in the long run

An important condition for the industry to be in equilibrium is that it produces the

level of output at which the quantity demanded equals to the quantity supplied of a
product. This is achieved at which all firms are in equilibrium producing at the
minimum point of their LAC curve and making just normal profits. Under these
condition there is no further entry or exit of firms in the industry, given the
technology and factor prices.

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Graphically

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