Lesson 4

MARKET STRUCTURES

Learning Outcomes

At the end of this lesson, you should be able to:

 Differentiate between perfect competition and imperfect competition
 Determine the profit and output maximization point
 Determine the type of profit in short run and long run equlibrium

4.1 THEORY OF FIRMS

Firm
 An organization that combines all resources for the production of goods and services.

Industry
 A group of firms that produces or sells similar products in the same market

Market structure
 The way in which an industry is organized
4 types of market structure;

i. perfect competition
ii. monopoly
iii. monopolistic competition
iv. oligopoly

Theory of firms will show how each market determines price and output to be produced.

4.2 FIRM’S OBJECTIVE AND EQUILIBRIUM

Conventional

Objective
 To maximize profit
 To attain production efficiency whereby cost is minimized
There are 2 approaches to maximize profit;

I. Aggregate approach [ TR & TC ]

Profit is maximized when the difference between TR and TC is the largest

TR = P x Q

Profit () = TR - TC

Q P TR TC 
1 10 15
2 10 20
3 10 27
4 10 35
5 10 45
6 10 57
7 10 70
8 10 85

Cost / revenue TC

B
TR

Output

Types of profit

1. Supernormal  /Economics  TR > TC

2. Normal  / Breakeven points TR = TC

3. Subnormal  / Losses TC > TR

II. Marginal approach [ MR & MC]

Profit is maximized when MR = MC

Q TR MR TC MC
1 10 15
2 20 20
3 30 27
4 40 35
5 50 45
6 60 57
7 70 70
8 80 85

Cost / revenue

MC

MR

Output

Identify the profit maximization point?

4.3 TYPES OF MARKET STRUCTURE

I. PERFECT COMPETITION
II. IMPERFECT COMPETITION
i. MONOPOLY
ii. MONOPOLISTIC COMPETITION
iii. OLIGOPOLY

4.4 PERFECT COMPETITION

Characteristics

1. Large number of sellers and buyers

2. Each firm is a “price-taker” – no control over price, price is determined by the
market
3. Produce homogenous / identical goods
4. Freedom of entry and exit
5. Perfect knowledge
6. Perfect mobility of factors of production
7. Non price competition
8. Absence of transportation cost

Demand curve for a perfect competition firm

 Since seller charges the same price at every output level, demand is a perfectly
elastic curve (horizontal line)

Price S Price

P P MR = AR = D

D
Quantity Quantity
Short run equilibrium

 In the short run, firms may earn one of the 3 types of profit;

1. Supernormal profit (AR@P > AC)

MR = MC
Price MC
Find the profit -
maximizing output
AC and price
10 AR = MR =D
7
Q = 20 units
Quantity P = RM10
20 TR = 10 x 20 = 200
TC = 7 x 20 = 140
 = 200 – 140 = 60

2 Normal profit (AR@P = AC) / Breakeven point

Price MR = MC
MC
Find the profit -
maximizing output
AC and price

10 AR = MR Q = 20 units
P = RM10
Quantity TR = 10 x 20 = 200
20 TC = 10 x 20 = 200
 = 200 – 200 = 0

3. Subnormal profit (AR@P < AC) / Loss

Price MR = MC
MC
Find the profit -
maximizing output
AC and price

12 Q = 20 units
10 AR = MR P = RM10
Quantity TR = 10 x 20 = 200
20 TC = 12 x 20 = 240
 = 200 – 240 = -40
 Shut down (cease) point in the short run

 It is the minimum point for a firm to cover its average variable cost.
 The decision to continue or cease operation is based on the lesser amount of losses.

i. If P  min. AVC
 Firm should continue operation
 Loss is smaller if firm continue operation
 TR can cover TVC and part of TFC

Price/Cost (RM) MC
AC
AVC

P = AR = MR

Qty

ii. If P = min. AVC

 Firm may choose to continue or cease operation

Price/Cost (RM) MC
AC
AVC

P = AR = MR

Qty
 iii. If P  min. AVC
 Firm should cease operation
 Loss is smaller if firm stop operation
 TR can cover part of TVC only

Price/Cost (RM) MC
AC
AVC

P = AR = MR

Qty

Note : If continue operation, firm earns TR and has to bear TFC and TVC
Loss = TR - TC

If cease operation, firm earns 0 revenue but still has to bear TFC
Loss = amount of TFC
Long run equilibrium

In the LR, firm only earns normal profit or 0 economic profit because;

i. If in the SR firms earn supernormal profit;

 Attract new firms to enter the market (freedom of entry)
 Existing firms expand production
 Thus, supply will 
 When S  D, create surplus, market price will 
 Profits also 
 Becomes normal profit in the LR

ii. If in the SR firms incur subnormal profit;

 Weak firms will leave the market (freedom of exit)
 Surviving firms  production
 Thus, supply will 
 When S  D, create shortage, market price will 
 Start to cover losses
 Reach normal profit in the LR

iii. If in the SR firms earn normal profit;

 Firms neither enter nor exit the market
 Continue earning normal profit until in the LR

LRMC
Price
LRAC

P* AR = MR

Quantity
*Q

*Q is the profit maximizing output (MR = MC) and also

the optimizing output (maximum output at the minimum AC)
4.5 MONOPOLY

Characteristics

1. Single seller and many buyers

2. Firm has the power to control market price – “price maker”
3. Unique product - no close substitute
4. Blocked entry – government regulation
5. Ability to do price discrimination

How monopoly arises? (Barriers to entry)

1. Exclusive ownership of resources/control over material

2. Government regulations and laws/government franchises
3. To achieve the benefits of economies of scale/cost establishing an efficient plant
4. Patent and copyright

Monopolist’s demand curve

 Monopoly firm sells good at different prices

 To sell more goods, firm has to lower price

Price

* D - downward sloping curve

Quantity
MR AR = P = *D
Short run equilibrium

 In the short run, firm may earn one of the 3 types of profit;

1. Supernormal profit (AR > AC)

Price
MR = MC
MC
Find the profit -
AC maximizing output
10 and price
8

AR Q = 20 units
MR P = RM10
Quantity TR = 10 x 20 = 200
20
TC = 8 x 20 = 160
 = 200 – 160 = 40
2. Normal profit (AR = AC) / Breakeven point

Price
MR = MC
MC
AC Find the profit -
maximizing output
10 and price

Q = 20 units
MR AR P = RM10
Quantity TR = 10 x 20 = 200
20 TC = 10 x 20 = 200
 = 200 – 200 = 0

3. Subnormal profit (AR < AC) / Loss

Price
MR = MC
MC AC
Find the profit -
10 maximizing output
8 and price

Q = 20 units
MR AR P = RM8
Quantity TR = 8 x 20 = 160
20 TC = 10 x 20 = 200
 = 160 – 200 = -40
 Long run equilibrium

 In the long run, a monopoly firm may earn supernormal profit due to blocked entry.

Price

LRMC

LRAC
P
AC

AR = P
MR
Quantity
Q

PRICE DISCRIMINATION

Types of price discrimination

1. First degree – when a firm charges different price for each unit and charges each buyer
the maximum price that he is willing to pay for each unit.
 E.g – auction

2. Second degree – when the goods are grouped into blocks and each block is charged at a
different price.
 E.g – electricity rate, parking rate

3. Third degree – when a monopolist charges different prices to different consumers for the
same good.
 The most common type of price discrimination
 E.g – telephone calls, transportation fare, movie ticket (adult price is higher than
children), etc.

Conditions to practice price discrimination

1. The single seller has the monopoly power/existence of monopoly

2. Markets must be separated (resell of product cannot take place)
3. Each market has different price elasticity
4. Cost of separating the market must be low
5. Legal sanction
4.6 MONOPOLISTIC COMPETITION

Characteristics

1. Large number of sellers (but less than the number of sellers in p. comp firm)
2. Firm has some power to control price
3. Differentiated product – similar in nature but differ in terms of packaging, brand name,
quality, after-sale service
4. Easy entry and exit
6. Non price competition – firms compete in areas other than price
A type of behavior designed to increase firm’s demand without changing the price. E.g.
advertising and product differentiation

Monopolistic’s demand curve

Price

* D - downward sloping curve

(more elastic than monopoly’s)

Quantity

MR AR = P = *D

Short run equilibrium

In the short run, firms may earn one of the 3 types of profit;

1. Supernormal profit (AR@P > AC)

Price MR = MC
MC
Find the profit -
10 AC maximizing output
and price
8

AR
MR Q = 20 units
20 Quantity P = RM10
TR = 10 x 20 = 200
TC = 8 x 20 = 160
 = 200 – 160 = 40
2. Normal profit (AR@P = AC)

Price
MR = MC
MC
AC Find the profit -
maximizing output
10 and price

Q = 20 units
MR AR P = RM10
Quantity TR = 10 x 20 = 200
20 TC = 10 x 20 = 200
 = 200 – 200 = 0

3. Subnormal profit (AR@P < AC)

Price
MR = MC
MC AC
Find the profit -
10 maximizing output
8 and price

Q = 20 units
MR AR
Quantity P = RM8
20 TR = 8 x 20 = 160
TC = 10 x 20 = 200
 = 160 – 200 = -40
Long run equilibrium

 In the LR, monopolistic comp. firms only earn normal profit due to easy entry & exit.

i. If in the SR firms earn supernormal profit;

 New firms enter the market, supply , Price, profit , reach normal profit
in the LR

ii. If in the SR firms incur subnormal profit;

 Firms leave the market, supply , Price, losses , reach normal profit in the
LR

iii. If in the SR firms earn normal profit;

 No firm enter or exit the market, maintain normal profit

Price

LRMC
LRAC

P=AC

MR AR=MR=P
Quantity
Q
4.6 OLIGOPOLY

Characteristics

1. A few large firms

2. Price rigidity – price is stable/static for a long period of time.
3. Homogenous or differentiated product
4. Difficult entry
5. Mutual interdependence – firm makes decision based on the action of other firm

Types of oligopoly

i. Perfect oligopoly – produce homogenous product such as steel, copper

ii. Imperfect oligopoly – produce differentiated product such as car, petrol, tires.

SWEEZY’S MODEL
Kinked demand curve

Assumptions

1. Price increase will be ignored

When one firm raises its price, other firms will not follow - lose large market
share

2. Price decrease will be matched

When one firm lowers its price, other firms will follow - gain small market share

Oligopolist’s demand curve

Price

P2 D1 – firm’s demand curve

D2 – industry’s demand curve
P

P1
D1
D2 Quantity
Q
Based on the assumptions above,

At price level above P, corresponding demand curve is D1

At price level below P, corresponding demand curve is D2

Therefore, actual demand curve is kinked and equilibrium price is rigid at P;

Price

Vertical gap AR = P = D
of MR
MR Quantity
Q

MR curve is below AR curve.

Since AR curve has 2 different elasticities, MR will be disjointed at the kinked point
(vertical gap of MR).

Firm’s equilibrium

Price

MC
50

AC
25
17
8
MR AR Quantity
40

Profit is maximized when MR = MC

As long as MC curve intersects at the vertical gap of MR curve, the profit maximizing
quantity and price will be at the ‘kink’
If the amount of MC is within RM 8 to RM 25, the equilibrium output will be 40 units
and price will be RM 50.

Q = 40 units
P = RM 50
TR = 50 x 40 = 2000
TC = 17 x 40 = 680
 = 1320

Since there is no competition in terms of price (price is rigid), firm will try to minimize
cost in order to maximize profit.
 TUTORIAL 4: MARKET STRUCTURES

COST AND REVENUE

1. The following is a cost schedule for a single firm.

a) Complete the table

Output TVC TFC TC AFC AVC AC MC

0 300 - - - -
1 100
2 75
3 60
4 147.5
5 700
6 540

b) Given that price is RM 80, fill in the column below for TR and MR.

Output 0 1 2 3 4 5 6
TR

MR

c) Based on the marginal approach model, the profit maximizing output is ________ unit because
_____________.

d) At that profit maximizing output, total revenue is RM ________ and total cost is RM _______.

e) The type of profit is called _______________ and the amount is RM _______.

f) Is the firm operating in the short run or long run? ______________.

g) The stage where the LRAC is declining is due to the _____________________.

PERFECT COMPETITION
 2. A firm operating in a perfectly competitive industry faces cost curves as shown in
the diagram below.

Price/cost

AR =MR

Output
On the diagram;
i) Label the cost curves in the box provided

a) mark ‘Q’ for the profit maximizing output.

b) mark ‘P’ for the equilibrium price.
c) mark ‘AC’ for average cost at the profit maximizing output
d) mark ‘AVC’ for average variable cost at the profit maximizing output

e) The type of profit earned by this firm is _________________ profit.

f) Is the firm operating in the short run or long run? ___________________

ii) Given that Q = 20 units, P = RM 12, AC = RM 14, and AVC = RM 9, compute;

a) TR
b) TC
c) TFC
d) TVC
e) Losses if continue operation
f) Losses if cease operation

g) Should the firm continue or cease operation? ________________

PERFECT AND IMPERFECT COMPETITION

3. The diagram below shows a long run equilibrium.

Revenue/cost

B
33
30
24
10
Quantity
20 30

a) Label curves A and B.

b) Assign label ARpc to the demand curve of a perfect competition firm and ARm
to the demand curve of a monopoly.

c) The profit maximizing output for a perfect competition firm is _______ units and price
is RM ________

d) The profit maximizing output for a monopoly firm is _______ units and price is
RM ________

e) Total revenue for a monopoly firm is RM _____________ and total cost is RM ______

f) The type of profit for the perfect competition firm is ______________

g) The ______________ firm is considered efficient because the firm ______________

h) The monopoly firm earned such profit in the long run because ___________________

i) List the 3 assumptions in order for price discrimination to be successful.

OLIGOPOLY

4. The diagram below shows the revenue and cost curves for a firm in an oligopoly market.

Price

MC
50

24 AC
20
10 AR
MR output
100 130 160

a) State the equilibrium output and price

b) Compute total revenue, total cost and profit.

c) Identify the type of profit earned by the firm above.

d) If marginal cost decreases to RM 12 and average cost to RM 15, determine

the new equilibrium output and price.

e) Calculate the new profit.

f) At the ‘kinked’, price level is considered as __________

g) Name the model above and state the 2 assumptions associated with the model.