Module 5: Market Structures I - Chapter 7 Notes

1. What are the Four Major Forms of Market Structure?

• Perfect competition, monopolistic competition, oligopoly, and monopoly.

2. The perfectly competitive firm has no market power because it cannot influence the price of the product. On
the other end of the spectrum is the monopoly firm that has market power because it can use price and
other strategies to earn larger profits that typically persist over longer periods of time. Between these two
benchmarks are the market structures of monopolistic competition and oligopoly. Firms have varying
degrees of market power in these market structures that combine elements of both competitive and
monopoly behavior

3. What is Perfect competition?

A market structure characterized by a large number of firms in the market, an undifferentiated product,
ease of entry into the market, and complete information available to all market participants.

4. What is a Price-taker?
• A characteristic of a perfectly competitive market in which the firm cannot influence the price of its
product, but can sell any amount of its output at the price established by the market.

5. How is perfect competition is a market structure characterized?

1. A large number of firms in the market
2. An undifferentiated product
3. Ease of entry into the market or no barriers to entry
4. Complete information available to all market participants

6. Draw the model of Perfect Competition?

• The perfectly competitive firm takes the equilibrium price set by the market and maximizes profit by
producing where price, which also equals marginal revenue, is equal to marginal cost. The level of profit
earned depends on the relationship between price and average total cost.

7. How do firms determine the Profit-Maximizing Level of Output?

Formula for Profit – 7.1 π = TR – TC
where
π = profit; TR = total revenue; TC = total cost
Because both total revenue and total cost vary with the level of output produced, profit also varies with
output. Given the goal of profit maximization, the firm will find and produce that level of output at which
profit is the maximum

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8. What is Profit maximization?
The assumed goal of firms, which is to develop strategies to earn the largest amount of profit possible.
This can be accomplished by focusing on revenues or costs or both factors.

9. What is the Profit-maximizing rule?

To maximize profits, a firm should produce the level of output where marginal revenue equals marginal cost.

10. What is the formula for the Profit-maximizing rule?

• 7.2 Produce that level of output where MR = MC
where
MR = marginal revenue = ΔTR/ΔQ
MC = marginal cost = ΔTC/ΔQ

Marginal revenue is the additional revenue earned by selling an additional unit of output, while marginal
cost is the additional cost of producing an additional unit of output. If a firm produces the level of output at
which marginal revenue equals marginal cost, it will earn a larger profit than by producing any other amount
of output.

11. What is Marginal revenue for the perfectly competitive firm?

The marginal revenue curve for the perfectly competitive firm is horizontal because the firm can sell all units
of output at the market price, given the assumption of a perfectly elastic demand curve. Price equals
marginal revenue for the perfectly competitive firm.

**Price equals marginal revenue for the perfectly competitive firm because the firm cannot lower the price
to sell more units of output, given that it cannot influence price in the market. If the price of the product is
$20, the firm can sell the first unit of output at $20. The marginal revenue, or the additional revenue that
the firm takes in from selling this first unit of output, is $20. The firm can then sell the next unit of output at
$20, given the price-taking characteristic of perfect competition. Total revenue from selling two units of
output is $40. The marginal revenue from selling the second unit of output is $40 – $20 or $20. Therefore,
the marginal revenue the firm receives from selling the second unit is the same as that received from selling
the first unit and is equal to the product price. This relationship holds for all units of output.**

12. What the formulas for Calculation of Profit?

13. Explain the Shutdown point for the perfectly competitive firm:
The price, which equals a firm’s minimum average variable cost, below which it is more profitable
for the perfectly competitive firm to shut down than to continue to produce.

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14. Explain FIGURE 7.2 The Supply Curve for the Perfectly Competitive Firm:

We show the zero-profit point for the perfectly competitive firm again in Figure 7.2 as output level Q2,
where price P2 equals average total cost. Suppose the price in the market falls to P1. The goal of profit
maximization means that the firm will now produce output Q1 because that is the output level where the
new price (P1), which is equivalent to marginal revenue (MR1), equals marginal cost. However, price P1 is
below the average total cost at output level Q1. Although the firm is earning negative economic profits or
suffering losses by producing output level Q1, it should continue to produce at this price because it is
covering all of its variable costs (P1 7 AVC) and some of its fixed costs. Remember that fixed costs are shown
as the vertical distance between AVC and ATC. The firm could not continue forever in this situation, as it
needs to cover the costs of its fixed input at some point. However, it is rational in this case for managers of
the firm to wait and see if the product price will increase.

If the price should fall still further to P0 (= MR0) and the firm produces output Q0 (where MR0 = MC), the firm
is just covering its average variable cost (P0 = AVC), but it is not covering any of its fixed costs. If the price
falls below P0 and is expected to remain there, managers would be better off shutting the firm down. By
shutting down, the firm would lose only its fixed costs. If it continued to operate at a price below P0, the firm
would lose both its fixed costs and some of its variable costs, as price would be less than average variable
cost. Thus, P0, the price that equals the firm’s minimum average variable cost, is the shutdown point for the
perfectly competitive firm.

15. What is Supply curve for the perfectly competitive firm?

The portion of a firm’s marginal cost curve that lies above the minimum average variable cost.

16. What is Supply curve for the perfectly competitive industry?

The curve that shows the output produced by all perfectly competitive firms in the industry at different
prices.

17. What does the Short Run in Perfect Competition look like?
• The short run is a period of time in which the existing firms in the industry cannot change their scale of
operation because at least one input is fixed for each firm. Firms also cannot enter or exit the industry
during the short run.

18. What is the Equilibrium point for the perfectly competitive firm?
The point where price equals average total cost because the firm earns zero economic profit at this point.
Economic profit incorporates all implicit costs of production, including a normal rate of return on the firm’s
investment.
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19. Explain FIGURE 7.3 Long-Run Adjustment in Perfect Competition: Entry and Exit

An increase in industry demand will result in a positive economic profit for a perfectly competitive firm.
However, this profit will be competed away by the entry of other firms into the market in the long run. The
zero economic profit point or the point where price equals average total cost is the equilibrium point for the
perfectly competitive firm.

20. What is zero-economic profit equilibrium?

•
• P = ATC

21. What is Economies of scale?

• Achieving lower unit costs of production by adopting a larger scale of production, represented by the
downward sloping portion of a long-run average cost curve.

22. What is FIGURE 7.5 Long-Run Adjustment in Perfect Competition: The Optimal Scale of Operation
• In the long run, the perfectly competitive firm has to choose the optimal scale of operation. This
decision, combined with entry and exit, will force price to equal long-run average cost.

23. What is Diseconomies of scale?

Incurring higher unit costs of production by adopting a larger scale of production, represented by the
upward sloping portion of a long-run average cost curve.

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24. What is Industry concentration?
A measure of how many firms produce the total output of an industry. The more concentrated the industry,
the fewer the firms operating in that industry.

25. What is Price-cost margin (PCM)?

The relationship between price and costs for an industry, calculated
by subtracting the total payroll and the cost of materials from the value of shipments and then dividing the
results by the value of the shipments. The approach ignores taxes, corporate overhead, advertising and
marketing, research, and interest expenses.

26. How can Managers in highly competitive industries can gain market power?
Adopting Strategies to Gain Market Power in Competitive Industries
Managers in highly competitive industries can gain market power by merging with other competitive
firms, differentiating products that consumers previously considered to be undifferentiated commodities,
and forming producer associations that attempt to change consumer preferences and increase demand for
output of the entire industry.

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