Module 2

Market Structure, Market Failure and Intervention

Market Structure

Market Failure

Intervention
Market Structure

The Firm
The objective for this portion of the course is basically to examine the market system, which is
the process by which scarce resources are allocated. We have shown thus far that resources are
allocated through the market via a pricing mechanism. Therefore, we want to find out how are
prices determined. So far we have discovered that prices are determined by the interaction of
demand and supply.

The objective of any firm is to maximize profits, which is the difference between total revenue
(from the sale of output) and the opportunity cost of attracting resources to the firm. But the
other goals of the firm are growth, satisficing, sales and revenue maximization and market
dominance.

Profits:
1. Accounting Profit: - total revenue minus explicit costs. Accounting profit ignores the
opportunity costs of using one‟s resources.
2. Economic profit: - total revenue minus all costs (both explicit and implicit). Economic
profit accounts for opportunity cost.
3. Normal profit: - the accounting profit earned when all resources used by the firm earn
their opportunity cost.

Accounting profit above normal profit is economic profit.

Howdo firms select the optimal quantity of a particular resource?

Assume: Perfect competition (

Variable input (labour) wage rate (w)

Fixed factor (capital) interest rate (r)

Definitions

Production Function: - identifies the maximum quantities of a particular good or service that can

Be produced per period of time with various combinations of resources,

for a given level of technology.

Output

Input

Isocost Lines: - gives all the combinations of factors that yield the same cost.

TC w*L r *C

TC
With labour alone: TC w*L L
w

TC
With capital alone: TC r *C C
r

Graph of Isocost Line

Capital

Labour
 rise TC / r w
Slope Ratio of the factor prices
run TC / w r

Isoquant Line: - gives all the combinations of inputs that yield the same level of output.

Graph of Isoquant Line

Capital

Labour

Properties:

1. Convex to the origin 3. Negatively sloped

2. Do not intersect 4. Further from origin yields higher level of

output

Slope: the slope of the isoquant is called the Marginal Rate of Technical Substitution (MRTS).

MP L
MRTS
MP C

The MRTS is the rate at which the labour can be substituted for capital without affecting
output.The objective of the firm is to maximize profits. There are circumstances under which
maximizing profits is the same as minimizing costs. Therefore, the firm will choose its inputs
such that profit is maximized or cost is minimized.Now, how does the firm goes about achieving
these objectives?
Minimizing costs

1. For a given level of output, the firm will choose the lowest isocost curve that is tangent to the
given isoquant in order to minimize costs.

Maximizing profits

2. For a given cost, the firm will choose the highest isoquant that is tangent to the given isocost in order to
maximize profits.

Capital

Labour

Therefore, the input decision is determined by the slopes of the isocost and isoquant curves, i.e.,
the firm will choose its inputs such that the slope of the isocost curve is equal to the slope of the
isoquant curve.

w MP L
r MP C

This point is characterized as a point of tangency.