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# 7.

The Theory of Firm and Market Structure
- The particular environment of a firm, the
characteristics of which influence the firm’s 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

¾ The market, composed of all buyers and sellers, establishes the
equilibrium price. (a)
¾ A single perfectly competitive firm then faces a horizontal (flat, perfectly
elastic) demand curve. (b)

Marginal Revenue (MR) .

¾ By plotting columns 1 and 2. . ¾ The two curves are the same.The Demand Curve and the Marginal Revenue Curve for a Perfectively Competitive Firm ¾ By computing marginal revenue. we obtain the firm’s demand curve. we find that it is equal to price. we obtain the firm’s marginal revenue curve. ¾ By plotting columns 2 and 4.

Quantity of Output Produce The firm’s demand curve is horizontal at the equilibrium price. The firm produces that quantity of output at which MR = MC. Its demand curve is its marginal revenue curve. .

. For Perfect Competition.Profit-Maximization Rule Profit is maximized by producing the quantity of output at which MR = MC. profit is maximized when P = MR = MC* * This condition is unique for perfect competition and does not hold for other market structures.

profit maximization and resource allocative efficiency are not at odds. ¾ For a perfectly competitive firm.Resource Allocative Efficiency ¾ Producing a good—any good—until 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. ¾ A firm that produces the quantity of output at which price equals marginal cost (P = MC) is said to exhibit resource allocative efficiency. .

. ¾ It continues to produce in the short run. Perfect Competition in the Short-run Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases I ¾ In Case 1. TR TC and the firm earns profits.

. TR < TC and the firm takes a loss. it is better to lose \$400 in fixed costs than to take a loss of \$450. Perfect Competition in the  Short‐run Profit Maximization and  Loss Minimization for the  Perfectly Competitive  Firm: Three Cases II ¾ In Case 2. ¾ It shuts down 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. TR < TC and the firm takes a loss. . ¾ It continues to produce in the short run because it minimizes its losses by doing so. Perfect Competition in the  Short‐run Profit Maximization and  Loss Minimization for the  Perfectly Competitive  Firm: Three Cases III ¾ In Case 3.

¾ It should shut down in the short run if price is below average variable cost. .What Should a Perfectly Competitive Firm Do in the Short Run? ¾ The firm should produce in the short run as long as price (P) is above or equal to average variable cost (AVC).

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 Firm’s Short-Run Supply Curve The short-run supply curve is that portion of the firm’s 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: ¾ there is no incentive for firms to enter or exit the industry. ¾ there is no incentive for firms to produce more or less output. and ¾ there is no incentive for firms to change plant size.

Perfect Competition -Long-Run Equilibrium II 1. at the quantity of output at which P = MC. Firms are producing the quantity of output at which price (P) is equal to marginal cost (MC). P = MC 3. the following condition holds: SRATC = LRATC . No firm has an incentive to change its plant size to produce its current output. Economic profit is zero: Price (P) is equal to short-run average total cost (SRATC). that is. P = SRATC 2.

firms are producing the quantity of output at which price is equal to marginal cost. . ¾ There are zero economic profits.Perfect Competition -Long-Run Equilibrium III ¾ The condition where: P = MC = SRATC = LRATC. and no firm has an incentive to change its plant size.

. ¾ The perfectly competitive firm does this in the long-run.Productive Efficiency ¾ The situation that exists when a firm produces its output at the lowest possible per-unit cost (lowest ATC).

and SRATC= LRATC (there is no incentive for the firm to change its plant size). . q1).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. P = SRATC (there is no incentive for firms to enter or exit the industry).

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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.

price rises from P1 to P2. Constant-Cost Industry II ¾ Start at long-run competitive equilibrium (point 1). so the firms’ cost curves do not shift. ¾ Demand increases. existing firms increase output and new firms are attracted to the industry. and there are positive economic profits. . Profits fall to zero through a decline in price. Consequently. ¾ Input costs remain constant as output increases.

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. .

price rises from P1 to P2. ¾ The new equilibrium price (P3) for an increasing. and there are positive economic profits. Consequently. Increasing-Cost Industry II ¾ Start at long-run competitive equilibrium (point 1).cost industry is higher than the old equilibrium price (P1). ¾ Demand increases. . Profits are squeezed by a combination of rising costs and falling prices. ¾ Input costs increase as output increases. existing firms increase output and new firms are attracted to the industry.

. respectively.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.

existing firms increase output and new firms are attracted to the industry ¾ Input costs decrease as output increases. Consequently. and there are positive economic profits. price rises from P1 to P2. . ¾ Demand increases. The new equilibrium price (P3) for a decreasing-cost industry is lower than the old equilibrium price (P1).Decreasing-Cost Industry II ¾ Start at long-run competitive equilibrium (point 1).

profit acts a little like a neon sign. identifying where resources are most welcome.Role of Profit ¾ Profit serves as an incentive by prompting or encouraging certain behavior. . ¾ As a signal. It is as if profit tells others where resources are best allocated.

neither will equilibrium price. furthermore. ¾ In short. along with price. And if the market supply curve does not change. ¾ If many of the firms in the industry experienced a rise in costs. only one firm has experienced a rise in marginal costs. the market supply curve is unlikely to undergo more than a negligible change. the market supply curve would have been affected. a rise in costs incurred by one of many firms does not mean consumers will pay higher prices. ¾ Because this firm supplies only a tiny percentage of the total market supply.Do Higher Costs Mean Higher Prices? ¾ Each firm in the industry is a price taker. .

.Will the Perfectly Competitive Firm Advertise? ¾ The firm is a price taker and sells all they want at the going price. ¾ A perfectly competitive industry might advertise in the hope of shifting the market demand curve to the right. Why advertise? Advertising has costs and no benefits.