Chapter four: Market structure

4.1 Perfect Competition

Definition and Assumptions of p.c market.
Perfect competition is a market structure
characterized by a complete absence of
rivalry among the individual firms.
Assumptions
1) Large number of sellers and buyers.
2) Products of the firms are homogeneous.
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 Continue….

This means the products supplied by all the

firms in the market have uniform physical
characteristics (are uniform in terms of
quantity, quality
Implies that the individual firm in pure
competition is a price taker
3) Free entry and exit of firms
4) The goal of all firms is profit
maximization
5) No government regulation
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 Continued….

That is all buyers and sellers have complete

information about.
The price of the product
Quality of the product etc

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 4.2 Costs under perfect
competition

In P.C unit cost (AVC &AC) have U –shape due to

the law of variable proportions (in the short run)
and the law of returns to scale (in the long run).

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 4.3 Demand and revenue
functions under perfect
competition

Due to the existence of large number of sellers

selling homogenous products, each seller is a
price taker in perfectly competitive market.
That is, a single seller cannot influence the
market by supplying more or less of a
commodity

Hence, the demand function that an individual

seller faces is perfectly elastic ( or horizontal
line)
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 continued…
Graphically
The demand curve that a
perfectly competitive firm
faces is horizontal line
with intercept at the
market price.
This indicates that sellers
sells any quantity
demanded at the ongoing
market price and buyers
buy any amount they
want at the ongoing
market price. 6
 Continued …..
Thus, given the horizontal demand function at
the ongoing market price,
The total revenue of a firm operating under
perfect competition is given by the product of
the market price and the quantity of sales, i.e.,
TR = P*Q
 Since the market price is constant at P*, the
total revenue function is linear and the amount
of total revenue depends on the quantity of
sales
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 Continued…

The marginal revenue (MR) and average

revenue (AR) of a firm operating under perfect
competition are equal to the market price.
TR= PQ
By definition, MR is the change in total revenue
that occurs when one more unit of the output is
sold, i.e.
MR= ∆TR/ ∆Q and
Hence MR=P
AR = TR/ Q = P.Q/Q = P
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 Continued..
Thus, the AR curve,
MR curve and the
demand curve of an
individual firm
operating under
perfectly competitive
market overlap,
hence both equals to
market price (P*)

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 4.4 Short run equilibrium of the firm in P.C

A firm is said to be in equilibrium when it

maximizes its profit () when Profit is defined
as the difference between total cost and total
revenue of the firm:
= TR-TC
The level of output, which maximizes the profit
of the firm, can be obtained in two ways:
 Total approach
 Marginal approach
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 Continued….

Total approach: In this approach, the profit

maximizing level of output is at level of output
at which:-
the vertical distance between the TR and TC
curves is maximum.
And Provided that the TR curves lies above the
TC curve at this point.

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 Continued…

The profit maximizing

output level is Qe
because at this point,
output level of the
vertical distance between
the TR and TC curves (or
profit) is maximum.
For all out put levels
below Q0 and above Q1
profit is negative because
TC is above TR.
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 Continued…

Marginal Approach
In this approach the profit maximizing level of
output is at the level of output at which:
MR=MC and
MC is increasing

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 Marginal Approach

the profit maximizing out put

is Qe, where MC=MR and MC
curve is increasing.
At Q*, MC=MR, but since MC
is falling at this output level,
it is not equilibrium out put.
For all output levels ranging
from Q* to Qe the marginal
cost of producing additional
unit of output is less than the
MR obtained from selling this
output. Hence the firm
should produce additional
output until it reaches Qe. 14
 4.5 Firms profit and ATC in perfect.C
Whether the firm gets positive or zero or
negative profit depends on the level of ATC at
equilibrium thus;
If the ATC is below the market price at equilibrium, the
firm earns a positive profit equal to the area between
the ATC curve and the price line up to the profit
maximizing output
If the ATC is equal to the market price at equilibrium, the firm gets
zero .
If the ATC is above the market price at equilibrium, the firm earns
a negative profit (incurs a loss) equal to the area between the ATC
curve and the price line
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Graphical indication

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 5.6 Short run supply curve of the
industry

The word ’industry’ is defined as group of firms

producing homogeneous products.
Thus, the industry supply is the total supply or
market supply.
The industry –supply curve is the horizontal
summation of the supply curves of the
individual firms.
That is, the total quantity supplied in the
market at each price is the sum of the
quantities supplied by all firms at that price.
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 4.6.1 Shut down point in the SR&LR
In the short run firm shutdown when TR is
below its AVC

In the long run firms shut down when its TR is

below its minimum ATVC, hence all inputs are
variable

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 4.7 Perfect. C and optimal resource
allocation

In the perfect competition, the optimality is shown by the following

conditions
 The out put is produced at the minimum feasible cost. That is all
firms produce at the minimum of their LAC.
Consumers pay the minimum possible price which just covers the
marginal cost of production, so that the consumers are not
exploited.
Plants are used at full capacity in the long- run so that there is no
waste of resources. That is, at the long run equilibrium the short
run average cost is also minimum
Firms earn only normal profits.
These conditions justify the fact that perfect competition results in
optimal resource allocation.
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 2. Price and output determination under
monopoly

Monopoly is quite opposite to perfectly

competitive market.
It is defined as: a market situation in which
a single seller sells a product or provides
a service for which there is no close
substitute
Common characteristics of monopoly
1)Single seller and many buyers
2)Absence of close substitutes
A product produced by a monopolist has no close 20
 Continued……..

3)Price maker
4)Barrier to entry
In monopoly, new competitors can not freely
enter in to the market due to some barriers which
can be economical, technical, legal or other type
of barriers.
2.2 .Causes for the emergence of monopoly
 Ownership of strategic or key inputs
A firm may own or control the entire supply of a
raw material required for the production 21
 Continued..

Exclusive knowledge of production

technique.
Most of the beverage (soft drink) companies
such as Coca Cola Company have maintained
monopoly power over supply of their product
partly due to exclusive knowledge of the
ingredient chemicals required for the
production of their product.
Patents and copyright
 Patents and copyrights are government
supported barriers to entry 22
 Continued…
Economies of scale may operate (i.e. the
long run average cost may fall)
 A firm is said to have economies of scale if its
long run average cost is declining.
As a result firms charge a lower price than
the new firms to deter new entry

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 2.3. Profit maximization of
monopoly in the short run

The, profit maximization under monopoly

involves determination of the price and output
combination that yields the firm maximum
possible profit.
The maximum profit can be determined in two
ways:
Total approach
Marginal approach

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 2.4 Monopoly in the long run

In perfectly competitive market there is free entry in

the long run ( firms earn normal profit) P= MR= MC
Nevertheless, entrance is barred by several factors in
monopoly.
Moreover, a perfectly competitive firm can earn only
normal profit in the long run.
How ever, the monopolist firm can, get a positive profit
even in the long run because there are entry barriers
that discourage new firms to enter the industry.
By expanding its plant size, how ever, it is determined
by market demand.
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 Graphically indications

initially the monopolist builds the

plant size having the costs SAC1
and SMC1 equivalence of MR
leads into producing and
marketing output levels Q1 at P1,
since the monopolist is making a
positive profit, it decide to
continue its operation and looks
for a more profitable plant size in
the long run.
This long run plant is attained
when LMC=MR, and the
corresponding output level and
price are Qe and Pe respectively.
However, price set by monopoly is
above MC & AC, which affects the
well being of the society. 26
 2.5 The multi- plant monopolist

For many firms, however, production takes place in two

or more different plants whose operating costs can
differ.
Some reasons are:
 To minimize transport cost,
 to approach the consumers
 For easy distribution .
 To reduce cost of production like transportation of factor
inputs.
 However, the operating costs of these plants can also
vary due to many reasons such as- variation in prices of
raw materials, wage of labors and etc. 27
 2.6 Equilibrium of multi plant
monopoly.
In short, the condition of equilibrium in multi- plant
monopolist is at the point where MR = MC of multi plant
monopolist
However, to allocate the total output among each plant,
the condition must satisfy:
MC1 = MR = of multi plant monopolist
MC2 = MR = of multi plant monopolist
MR = MC1 =MC2
Let Q1 and C1 be the output and production cost of plant (1 ) and C1 = f (Q1)
-Q2 and C2 be the output and production cost of plant-(2) and C2 = f (Q2) and
Total out put (QT) = Q1 + Q2 is the total output of the firm.
All output, whether they are produced in plant 1 or in plant2 will be sold at uniform market
price, Say P then the total profit of the monopolist is given as:-
 = P. QT – C1 – C2 28
 = PQ + PQ – C –C ,
 2.6.1 Production decision of
monopoly firm
If the monopolist incur loss in the short run (SAC>P)
and if no super normal profit in the long run given the
market size, the monopolist must stop operation (shut
down).
If the monopolist makes (P> SAC) in the short run the
monopolist continue & expand different plant size to
maximize profit in the long run.
A monopolist maximizes its long run profit when it
produces and sells the output level where LMC = MR
The monopolist may reach optimal plant size or even
may exceed the optimal size if the market demand
allows him
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 2.7. Price Discrimination
Price discrimination refers to the charging of different prices for the
same good. But not all price differences are price discrimination.
A firm has said to be price discriminating if it is charging different
prices for the same commodity without any justification of cost
differences
Degrees (types) of price discrimination
1-First degree price discrimination (Perfect price
discrimination)
 Ideally, a firm would like to charge each customer the maximum
price that the customer is writing to pay for each unit bought or
reservation price
 the consumers’ reservation prices are different due to the
differences in their economic status or the value they attach to a
commodity
 For example, a doctor who knows his patients’ paying capacity
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charges high price for the richest patients’ and low price for the
 Continued..
2-Second degree price discrimination (block
pricing)
 The act of charging different prices for different
quantities of purchases (based on volume of quantity
purchased)
3-Third degree price discrimination (multi-market
price discrimination)
 the firm may divide potential customers in to two or
more groups and set a different price for each group
 All units good sold to customer with in a group (in one
market) are sold at a single price, but prices will differ
among the different groups or markets.
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