Week 10: Market Structures

• KEY CONCEPT
• A market structure is an economic model that helps economists
examine the nature and degree of competition among businesses in
the same industry.
Market Structure
• Market structure – identifies how a market is made up in terms of:
• The number of firms in the industry
• The nature of the product produced
• The degree of monopoly power each firm has
• The degree to which the firm can influence price
• Profit levels
• Firms’ behaviour – pricing strategies, non-price competition, output levels
• The extent of barriers to entry
• The impact on efficiency
• WHY THE CONCEPT MATTERS
• The level of competition in a market has a major impact on the prices of
products. The more sellers compete for your money, the more
competitive prices will be.
Market Structure
Perfect Pure
Competition Monopoly

More competitive (fewer imperfections)

Less competitive (greater degree

of imperfection)
The further right on the scale, the greater the degree
of monopoly power exercised by the firm.
Market Structure
• Importance:
• Degree of competition affects the consumer – will it benefit
the consumer or not?
• Impacts on the performance and behaviour of the
company/companies involved
 What Is Perfect Competition?

The Characteristics of Perfect Competition

• KEY CONCEPTS
• Economists classify markets based on how competitive they are
• Market structure—economic model of competition within an industry
• Perfect competition—ideal model of a market economy
• economists assess how competitiveness of market by where it falls short
The Characteristics of Perfect Competition
• Characteristic 1: Many Buyers and Sellers
• No one buyer or seller has power to control price in the market
• Many sellers means buyers can choose a producer with better price
• Many buyers means sellers can all sell product at market price
• lack of demand will not cause sellers to lower prices
The Characteristics of Perfect Competition
• Characteristic 2: Standardized Product
• Standardized product—one producer’s product is identical to another’s
• Perfect substitutes include
• agricultural products, such as wheat, eggs, milk
• basic commodities, such as notebook paper, gold
• Price is only basis for consumer choice
The Characteristics of Perfect Competition
• Characteristic 3: Freedom to Enter and Exit Markets
• Producers can enter market when profitable and exit when unprofitable
• Regulations do not restrict businesses from entering or exiting
The Characteristics of Perfect Competition
• Characteristic 4: Independent Buyers and Sellers
• Neither buyers nor sellers join together to influence price
• Supply and demand set the equilibrium price
• Independent action ensures that market stays competitive
The Characteristics of Perfect Competition
• Characteristic 5: Well-informed Buyers and Sellers
• Buyers can compare prices
• Sellers know what competitors charge, what buyers willing to pay
• Price taker—seller that accepts market price set by supply and
demand
Demand Curves for the Firm and the Industry
• The demand curves facing the firm is different from the industry
demand curve.
• A perfectly competitive firm’s demand schedule is perfectly
elastic even though the demand curve for the market is
downward sloping.
 8.3 MARGINAL REVENUE, MARGINAL COST,
AND PROFIT MAXIMIZATION

Demand and Marginal Revenue for a Competitive Firm

The demand d curve facing an individual firm in a competitive market

is both its average revenue curve and its marginal revenue curve.
Along this demand curve, marginal revenue, average revenue, and
price are all equal.
Profit Maximization by a Competitive Firm

MC(q) = MR = P
 The Revenue of a Competitive Firm
 Total revenue (TR) TR = P x Q

TR
 Average revenue (AR) AR = =P
Q
 Marginal revenue (MR):
∆TR
The change in TR from MR =
∆Q
selling one more unit.

FIRMS IN COMPETITIVE MARKETS 16

ACTIVE LEARNING 1
Calculating TR, AR, MR
Fill in the empty spaces of the table.

Q P TR AR MR

0 $10 n/a

1 $10 $10

2 $10

3 $10

4 $10 $40
$10
5 $10 $50
17
ACTIVE LEARNING 1
Answers
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n/a
$10
1 $10 $10 $10
Notice that $10
2 $10 $20 $10
MR = P $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
18
 MR = P for a Competitive Firm
 A competitive firm can keep increasing its output
without affecting the market price.
 So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

FIRMS IN COMPETITIVE MARKETS 19

 Profit Maximization
 What Q maximizes the firm’s profit?
 To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
 If MR > MC, then increase Q to raise profit.
 If MR < MC, then reduce Q to raise profit.

FIRMS IN COMPETITIVE MARKETS 20

 Profit Maximization
(continued from earlier exercise)

At any Q with Q TR TC Profit MR MC

Profit =
MR > MC, MR – MC
increasing Q 0 $0 $5 –$5
raises profit. $10 $4 $6
1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

FIRMS IN COMPETITIVE MARKETS 21

 MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR. Costs
So, increase Q MC
to raise profit.
At Qb, MC > MR.
So, reduce Q P1 MR
to raise profit.
At Q1, MC = MR.
Changing Q Q
Q a Q1 Qb
would lower profit.
FIRMS IN COMPETITIVE MARKETS 22
8.4 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

Figure 8.3
A Competitive Firm Making a
Positive Profit
In the short run, the
competitive firm maximizes
its profit by choosing an
output q* at which its
marginal cost MC is equal to
the price P (or marginal
revenue MR) of its product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output,

whether lower at q1 or
higher at q2, will lead to
lower profit.
 MC and the Firm’s Supply Decision
If price rises to P2,
then the profit- Costs
maximizing quantity
MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2

FIRMS IN COMPETITIVE MARKETS 24

 The Marginal Cost Curve Is the Supply Curve
 The marginal cost curve is the firm's supply curve above the point
where price exceeds average variable cost.
 The Marginal Cost Curve Is the Supply Curve
 The MC curve tells the competitive firm how much it should
produce at a given price.

• The firm can do no better than producing the

quantity at which marginal cost equals price
which in turn equals marginal revenue.
Figure 2 Marginal Cost as the Competitive Firm’s Supply
Curve

Price
This section of the
firm’s MC curve is MC
also the firm’s supply
curve.
P2

ATC
P1
AVC

0 Q1 Q2 Quantity
Copyright © 2004 South-Western
The Marginal Cost Curve Is the Firm’s Supply
Curve

$70 Marginal cost

C
60
50
Cost, Price

40 A
30
20 B

10
0 1 2 3 4 5 6 7 8 9 10 Quantity
 Firms Maximize Total Profit
 When we speak of maximizing profit, we refer to maximizing total
profit, not profit per unit.
 Firms do not care about profit per unit; as long as an increase in
output will increase total profits, a profit-maximizing firm should
increase output.
 Profit Maximization Using Total Revenue and
Total Cost
 Profit is maximized where the vertical distance between total
revenue and total cost is greatest.
 At that output, MR (the slope of the total revenue curve) and MC
(the slope of the total cost curve) are equal.
Profit Determination Using Total Cost and
Revenue Curves

TC TR
$385 Loss
Total cost, revenue 350
315 Maximum profit =$81 Profit
280
245
210 $130
175
140
105
70
35 Loss
0
1 2 3 4 5 6 7 8 9 Quantity
8.3 MARGINAL REVENUE, MARGINAL COST,
AND PROFIT MAXIMIZATION

● profit Difference between total revenue and total cost.

π(q) = R(q) − C(q)
● marginal revenue Change in revenue resulting from a
one-unit increase in output.
Figure 8.1
Profit Maximization in the Short Run

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve)
is equal to marginal cost (the
slope of the cost curve).
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
 Shutdown vs. Exit
 Shutdown:
A short-run decision not to produce anything because of market
conditions.
 Exit:
A long-run decision to leave the market.
 A key difference:
 If shut down in SR, must still pay FC.
 If exit in LR, zero costs.

FIRMS IN COMPETITIVE MARKETS 33

 A Firm’s Short-run Decision to Shut Down
 Cost of shutting down: revenue loss = TR
 Benefit of shutting down: cost savings = VC
(firm must still pay FC)
 So, shut down if TR < VC
 Divide both sides by Q: TR/Q < VC/Q
 So, firm’s decision rule is:
Shut down if P < AVC

FIRMS IN COMPETITIVE MARKETS 34

 A Competitive Firm’s SR Supply Curve
The firm’s SR
supply curve is
Costs
the portion of
its MC curve MC
above AVC. If P > AVC, then
firm produces Q ATC
where P = MC.
AVC

If P < AVC, then

firm shuts down
(produces Q = 0). Q

FIRMS IN COMPETITIVE MARKETS 35

 The Irrelevance of Sunk Costs
 Sunk cost: a cost that has already been committed and cannot
be recovered
 Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
 FC is a sunk cost: The firm must pay its fixed costs whether it
produces or shuts down.
 So, FC should not matter in the decision to shut down.

FIRMS IN COMPETITIVE MARKETS 36

 A Firm’s Long-Run Decision to Exit
 Cost of exiting the market: revenue loss = TR
 Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
 So, firm exits if TR < TC
 Divide both sides by Q to write the firm’s
decision rule as:

Exit if P < ATC

If the cost of exiting is greater than the benefit, the firm
should exit.
FIRMS IN COMPETITIVE MARKETS 37
 A New Firm’s Decision to Enter Market
 In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
 Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC

FIRMS IN COMPETITIVE MARKETS 38

 The Competitive Firm’s Supply Curve

The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC

FIRMS IN COMPETITIVE MARKETS 39

ACTIVE LEARNING 2
Identifying a firm’s profit
A competitive firm
Determine
this firm’s Costs, P
total profit. MC

Identify the P = $10 MR

area on the ATC
graph that
$6
represents
the firm’s
profit.
Q
50
40
ACTIVE LEARNING 2
Answers
A competitive firm
Costs, P
Profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
= $200 50
41
ACTIVE LEARNING 3
Identifying a firm’s loss
Determine A competitive firm
this firm’s Costs, P
total loss, MC
assuming
AVC < $3.
ATC
Identify the
area on the $5
graph that
P = $3 MR
represents
the firm’s
Q
loss. 30
42
ACTIVE LEARNING 3
Answers
A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30
43
 Determining Profit and Loss From a Graph
 Find profit per unit where MC = MR.

• To determine maximum profit, you must first

determine what output the firm will choose to
produce.
• See where MC equals MR, and then drop a
line down to the ATC curve.
• This is the profit per unit.
 Determining Profits Graphically
Price MC Price MC Price MC
65 65 65
60 60 60
55 55 55
50 50 50 ATC
45 45 ATC 45
40 D A P = MR 40 40 Loss P = MR
35 35 35
P = MR
30 Profit B ATC 30 30 AVC
25 C AVC 25 AVC 25
20 E 20 20
15 15 15
10 10 10
5 5 5
0 0 0
1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 56 7 8 9 10 12
Quantity Quantity Quantity
(a) Profit case (b) Zero profit case (c) Loss case

Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

 Market Supply: Assumptions
1) All existing firms and potential entrants have identical costs.
2) Each firm’s costs do not change as other firms enter or exit the market.
3) The number of firms in the market is
 fixed in the short run
(due to fixed costs)
 variable in the long run
(due to free entry and exit)

FIRMS IN COMPETITIVE MARKETS 46

 The SR Market Supply Curve
 As long as P ≥ AVC, each firm will produce its profit-maximizing
quantity, where MR = MC.
 Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.

FIRMS IN COMPETITIVE MARKETS 47

 The SR Market Supply Curve
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

FIRMS IN COMPETITIVE MARKETS 48
 Entry & Exit in the Long Run
 In the LR, the number of firms can change due to
entry & exit.
 If existing firms earn positive economic profit,
 new firms enter, SR market supply shifts right.
 P falls, reducing profits and slowing entry.
 If existing firms incur losses,
 some firms exit, SR market supply shifts left.
 P rises, reducing remaining firms’ losses.

FIRMS IN COMPETITIVE MARKETS 49

 The Zero-Profit Condition
 Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
 Zero economic profit occurs when P = ATC.
 Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
 Recall that MC intersects ATC at minimum ATC.
 Hence, in the long run, P = minimum ATC.

FIRMS IN COMPETITIVE MARKETS 50

 Why Do Firms Stay in Business if Profit = 0?
 Recall, economic profit is revenue minus all costs – including
implicit costs, like the opportunity cost of the owner’s time and
money.
 In the zero-profit equilibrium,
 firms earn enough revenue to cover these costs
 accounting profit is positive

FIRMS IN COMPETITIVE MARKETS 51

 The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min. supply
ATC

Q Q
(firm) (market)
FIRMS IN COMPETITIVE MARKETS 52
 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
FIRMS IN COMPETITIVE MARKETS 53
 Why the LR Supply Curve Might Slope Upward
 The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or exit the market.

 If either of these assumptions is not true,

then LR supply curve slopes upward.

FIRMS IN COMPETITIVE MARKETS 54

 1) Firms Have Different Costs
 As P rises, firms with lower costs enter the market
before those with higher costs.
 Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
 Hence, LR market supply curve slopes upward.
 At any P,
 For the marginal firm,
P = minimum ATC and profit = 0.
 For lower-cost firms, profit > 0.
FIRMS IN COMPETITIVE MARKETS 55
 2) Costs Rise as Firms Enter the Market
 In some industries, the supply of a key input is
limited (e.g., amount of land suitable for farming
is fixed).
 The entry of new firms increases demand for this
input, causing its price to rise.
 This increases all firms’ costs.
 Hence, an increase in P is required to increase
the market quantity supplied, so the supply curve
is upward-sloping.

FIRMS IN COMPETITIVE MARKETS 56

 A Real World Example
 Owners of the Ames chain of department stores decide to close
over 100 stores after experiencing two years of losses (a shutdown
decision).
 A Real World Example
 Initially, Ames thought the losses were temporary.

• Since price exceeded average variable cost,

it continued to produce even though it was
losing money.
 A Real World Example
 After two years of losses, its prospective changed.

• The company moved from the short run to the

long run.
 A Real World Example
 They began to think that demand was not temporarily low, but
permanently low.

• At that point they shut down those stores for

which P < AVC.
 A Real World Example:
A Shutdown Decision

Price
MC

ATC

Loss AVC
P = MR

Quantity
 CONCLUSION: The Efficiency of a
Competitive Market
 Profit-maximization: MC = MR
 Perfect competition: P = MR
 So, in the competitive eq’m: P = MC
 Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
 So, the competitive eq’m is efficient, maximizes
total surplus.
 In the next chapter, monopoly: pricing &
production decisions, deadweight loss, regulation.

FIRMS IN COMPETITIVE MARKETS 62

Competition in the Real World
• KEY CONCEPTS
• No perfectly competitive markets; none meet all conditions
• Imperfect competition—market structures that lack one or more of the
conditions
• Some markets come close, such as some wholesale farm products
Competition in the Real World
• Example 1: Corn
• Thousands of growers; decide only how much to produce at market price
• Many buyers; standardized product; wholesale price easy to determine
• In reality, several factors can interfere:
• government subsidies; farmers or buyers sometimes band together
Competition in the Real World
• Example 2: Beef
• Many producers; each cut of beef is standard
• sellers can adjust only their production
• Competition somewhat imperfect because
• ranchers may join together to influence price
• producers may say products differ due to factors such as feed