MARKET STRUCTURES AND

PROFIT MAXIMIZATION
 CONTENTS OF THIS UNIT
4.1.    Competitive Market
4.1.1.  Characteristics/ Behavioral Assumptions
4.1.2.  Derivation of the individual firm's demand curve
4.1.3 . Total, Average and Marginal Revenue
4.1.4.  Profit Maximization in a Perfectly Competitive Market
• The Total Revenue- Total cost Approach
• The Marginal Approach
4.2.    Overview of Theories of Imperfect Competition
4.2.1. Monopoly
4.2.2.  Oligopoly
4.2.3.  Monopolistic Competition
4.2.4. Profit Maximization in an Imperfectly Competitive
Market
Market Structure

• The opportunity for profit may be limited by

the structure of the industry.
• Market structure is the number and
relative size of firms in an industry.
• Perfect competition is market in which no
buyer or seller has market power.
- Monopoly is a firm that produces the
entire market supply of a particular good
or service.
Market Structure

Imperfect competition

Perfect Monopolistic Oligopoly Duopoly Monopoly

competition competition
 Basic Difference Between Perfect and
Imperfect Market Structure
• Their basic difference lies on the fact that firms have a
market power in the latter case than the former. But it
doesn’t mean that there is no competition in the latter.
1. Firms have market power when the following conditions
exist.
a. Firms can influence price in attempts to increase profits.
b. The existence of profits does not attract new firms into the
industry.
2. The following conditions are required for market power.
 a. A few firms control the product.
 b. There are limitations on the entry of new firms.
Perfectly Competitive Market
• It is a market structure with the following
characteristics
– Many sellers and buyers in the market
– Homogeneous products
– Independent behavior
– Perfect information
– Free entry and exit
– Perfectly elastic demand curve /Individual
firms are price takers
Price Takers

• A perfectly competitive firm has no

market power and has no ability to alter
the market price of the goods it produces.
– Market Power - The ability to alter the market
price of a good or service.
• The output of a perfectly competitive firm
is so small relative to the market supply so
that it has no significant effect on the total
quantity or price in the market.
Market Demand Curves vs. Firm
Demand Curves
• It is important to distinguish between the market
demand curve and the demand curve
confronting a particular firm.
• While the actions of a single competitive firm are
negligible, the unified actions of many such firms
are not.
• The market demand curve for a product is
always downward-sloping.
- The demand curve confronting a perfectly
competitive firm is horizontal (perfectly elastic
demand curve).
Market Demand Curves vs. Firm
Demand Curves

The market (Industry) Demand facing a single firm

Market supply
PRICE

Equilibrium
pe price pe
Demand facing
single firm

Market demand

Quantity Quantity
 The Production Decision

• A competitive firm has only one decision to

make: how much to produce.
• The production decision is the selection
of the short-run rate of output (with
existing plant and equipment).
Output and Revenues
• In searching for the most desirable rate of
output, the distinction between total
revenue and total profit must be kept in
mind.
– Total revenue - The price of the good
multiplied by the quantity sold in a given time
period.

Total revenue = price X quantity

Output and Revenues

• The total revenue curve of a perfectly

competitive firm is an upward-sloping
straight line, with a slope equal to pe.
Total Revenue
Price Quantity Total
Revenue
$8 1 $ 8 $96
Total revenue
8 2 16
88
8 3 24
8 4 32 80
72

Total Revenue
8 5 40
8 6 48
8 7 56 64
8 8 64 56
8 9 72
48
40
32
24
16
8 pe= $8

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Output and Costs

• To maximize profits a firm must consider

how increased production will affect costs
as well as revenues.
• Producers are saddled with certain costs
in the short-run.
• Short-run - The period in which the quantity
(and quality) of some inputs cannot be changed.
Output and Costs
• Fixed costs are incurred even if no output is
produced.
• Fixed costs - Costs of production that do not change
when the rate of output is altered, e.g., the cost of basic
plant and equipment.
• Once a firm starts producing output, it incurs
variable costs as well.
• Variable costs - Costs of production that change when the
rate of output is altered, e.g. labor and material costs.
• The primary objective of the producer is to find
that one particular rate of output that
maximizes profits.
Profit Maximizing Rules

• The total approach- compares the total

revenue (TR) with total cost (STC)
• The marginal approach- compares
marginal revenue (MR) with marginal
cost (MC)
Total Profit
Revenues Or Costs (dollars per period)

Total cost Total revenue

fits
r o
Pr
s

e s
ss
Lo

f h g
Output (units per period)
The Gap Between Revenue and Cost must be the
Highest for Profit Maximization such as at q* as per
the Total Approach
Costs (TC)
Revenues (TR)
Costs,
Revenue

(a)

0 Output
per week
Profits
(b) 0
q1 q* q2 Output
per week
Profits
Profit-Maximizing Rule

• The best single rule for maximizing short-

run profits is straightforward:
• Never produce a unit of output that costs
more than it brings in.
Marginal Revenue = Price
• The contribution to total revenue of an additional
unit of output is called marginal revenue.
• Marginal revenue (MR) is the change in total
revenue that results from a one-unit increase in
the quantity sold.
Marginal Change in total revenue
=
revenue Change in output

• For perfectly competitive firms, price equals

marginal revenue.
Marginal Revenue = Price
Rate of Total Marginal
Output Price Revenue Revenue
0 $13 $0
1 13 13 $13
2 13 26 13
3 13 39 13
4 13 52 13
5 13 65 13
Marginal Cost

• A firm’s goal is not to maximize revenues,

but to maximize profits.
• Marginal revenue is compared to marginal
costs to determine the best level of output.
• What an additional unit of output brings in
is its marginal revenue (MR).
-What it costs to produce is its marginal cost
(MC).
Marginal Cost

Rate of Marginal Average

Output Total Cost Cost Cost
0 $10
1 15 $ 5 $15.00
2 22 7 11.00
3 31 9 10.33
4 44 13 11.00
5 61 17 12.20
Profit-Maximizing Rate of Output

• According to the profit-maximization rule

a firm should produce at that rate of output
where marginal revenue equals marginal
cost.
Profit-Maximizing Rate of Output
• If marginal cost exceeds price, total profits
decline if the additional output is produced.

 If marginal cost is less than price, total

profits increase if the additional output is
produced.
 Profits are maximized at the rate of output
where price equals marginal cost.
Short-Run Profit-Maximization
Rules for Competitive Firm

Price > MC  increase output

Price = MC  maintain output
and maximize profit
Price < MC  decrease output
Profit-Maximizing Rate of Output
$18
Marginal cost
16
p = MC Profits decreasing
Price or Cost (per bushel)

14 MRB
12 Price (= MR)
Profits increasing
10
8
Profit-maximizing
6
rate of output
4 MCB
2

0 1 2 3 4 5 6 7
Quantity (bushels per day)
Adding Up Profits

• Profits can be computed in two ways.

• Total profit is the difference between total
revenue and total cost.
Total profit = total revenue – total cost
Adding Up Profits
• Total profit is average profit times the
number sold.

Profit per unit = price – ATC

Total profit = profit per unit X quantity
Total profit = (p – ATC) X q
Adding Up Profits

• The profit-maximizing producer never

seeks to maximize per-unit profits.
 What counts is total profits, not the amount
of profit per unit.
 Alternative Views of Total Profit

Total revenue and total cost Price and average cost

$90 $18
Revenue or Cost (dollars per day)

Average total
80 16 cost

Price or Cost (per unit)

70 14
Total revenue Price
60 12 Total Profit
Maximum Profit per
50 total profit 10 unit
40 8
30 Total cost 6 Cost per unit
20 4 Marginal cost
10 2

0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7
Rate of Output Rate of Output
The Shutdown Decision
• The short-run profit maximization rule
does not guarantee any profits.
• Fixed costs must be paid even if all output
ceases.
• A firm should shut down only if the losses
from continuing production exceed fixed
costs.
Price vs. AVC

• Where price exceeds average variable

cost but not average total cost, the profit
maximizing rule minimizes losses.
• When price does not cover average
variable costs at any rate of output,
production should cease.
• The shutdown point is that rate of output
where price equals minimum AVC.
The firm will opt for Q > 0 providing

P  Q  TVC
or, dividing by Q,
TVC
P  AVC
Q
 The Shutdown Point
Profit Loss Shutdown
18 MC
16 MC
Price ATC MC
ATC ATC
14 X (=MR)
12
Price or Cost

AVC AVC
10 Price
8 Y
6 AVC
4 Price
shutdown point
2
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity Quantity Quantity
Numerical Example( See page 89)
Given : market price 250
Total Cost = 6000+400q-20q2+Q3
Should the firm produce at this price.
The Firm’s Short-Run Supply Curve
• The firm’s short-run supply curve is the
relationship between price and quantity
supplied by a firm in the short-run.
• For a price-taking firm, this is the positively
sloped portion of the short-run marginal
cost curve.
• For all possible prices, the marginal cost
curve shows how much output the firm
should supply.
Short-Run Supply Curve

$18
16
14 X
12
10 Shutdown
Price

Y
8 point
6 Marginal cost Short-run supply curve
4 curve = for competitive firm
2

0 1 2 3 4 5 6 7
Quantity Supplied
Long run Equilibrium of the firm and
industry
• All factors are variable
• New firms can enter the industry
• Firms can leave the industry
• Thus, the firm will not incur losses in the
long
• Long run(LR) equilibrium conditions:
1. Price(AR)= LMC= MR
2. Price= Average cost
Cont…

• Hence, in the LR the firm will be in

equilibrium if price =AR=LMC=LAC=MRm
• The firm is making normal profit
• See fig 2.7 in your module.
• Equilibrium of the industry is when quantity
demanded equal with quantity at the
minimum point of LAC .
Theories of Imperfect
Competition
• It includes
• monopoly, monopolistic competition
and oligopoly
Monopoly
• Introduction
• A monopoly is a single seller of a product
with no close substitutes.
• This part examines how a market controlled
by a single producer behaves.
– What are the basic characteristics of such a
market?
– What price will a monopolist charge?
– How much will the monopolist produce?
Monopoly

• is a market, which has the following

characteristics/ behavioral assumptions.
– Single seller
– Firm and industry
– Market power
– Unique products
– Price Discrimination
– Blocked entry
Monopolies derive their market power from
barriers to entry including

• Economic barriers
– Economies of scale
– Capital requirements
– Control of Natural Resources
• Legal barriers
– patents, copyrights
• Artificial barriers/ Deliberate Actions
– Through hiding information and technologies, controlling strategic
resources, collusion, lobbying governmental authorities, and even
may use force
• Technological barriers
– Natural Monopoly
– Technological superiority
• Franchise and licenses- A franchise is a contract that gives a single
firm the right to sell its goods within an exclusive market. A license is
a government-issued right to operate a business.
Market Power

• Market power is the ability to alter the

market price of a good or service.
• Firms with market power confront
downward-sloping demand curves.
• Competitive firms face a horizontal
demand curve.
 Firm vs. Industry Demand
The competitive firm The industry

Demand facing
competitive firm
$13 $13
Price

Market
demand

0 Quantity 0 Quantity
Monopoly

• The demand curve facing the monopoly

firm is identical to the market demand
curve for the product.
• Monopoly is a firm that produces the
entire market supply of a particular good
or service.
Price and Marginal Revenue

• A monopoly faces a different profit

maximizing situation than competitive
firms.
– Profit-maximization rule – Produce at that
rate of output where MR = MC.
• Unlike competitive firms, marginal revenue
for a monopolist is not equal to price.
Price and Marginal Revenue
• Marginal revenue is the change in total
revenue that results from a one-unit
increase in the quantity sold.

Marginal Change in total revenue TR

= =
revenue Change in quantity sold q
Price and Marginal Revenue

• So long as the demand curve is

downward-sloping, MR will always be less
than price.
 The MR curve lies below the demand
(price) curve at every point but the first.
Price and Marginal Revenue

Quantity Price Total Marginal

Revenue Revenue
1 $13 $13 —
2 12 24 $11
3 11 33 9
4 10 40 7
5 9 45 5
6 8 48 3
7 7 49 1
Price and Marginal Revenue
$14 A
B
12 C
b D
Price (per basket)

10 E
c F
8 G Demand
d (= price)
6
e
4
f Marginal revenue
2
g
0 1 2 3 4 5 6 7 8 9 10
Quantity (baskets per hour)
Mathematical relation

• Mathematical relation of MR, AR and P is

shown on page 99 of your module.
Profit Maximization

• We need to find the intersection of

marginal cost and marginal revenue.
• This will give us the profit-maximizing rate
of output.
• Only one price is compatible with the
profit-maximizing rate of output.
Profit Maximization
$14
13 Average
12 total cost
Price or Cost (per basket)

11 D
10
9 Profits
8
7 d
6
5 Demand
4
3 Marginal
2 cost Marginal
1 revenue
0 1 2 3 4 5 6 7 8 9
Quantity (baskets per hour)
The Monopoly Price

• The intersection of the marginal revenue

and marginal cost curves establishes the
profit-maximization rate of output.
• The demand curve tells us how much
consumers are willing to pay for that
output.
 Initial Conditions in the Monopolized Market

Monopoly outcome Competitive

$1200 W 1200 A market supply
Competitive
outcome
1000 C 1000 X
Average total cost
Price (per computer)

Price (per computer)

800 800
M Market
demand
600 B 600

400 Demand 400

curve facing
single plant
Marginal
200 cost 200
Marginal revenue
of single plant
0 200 400 800 1200 1600 0 24,000
Quantity (computers per month) Quantity
(computers per month)
Monopoly Profits
• Total profit equals average profit per unit
times the number of units produced.

Profit per unit = price – average total cost

Profit per unit = p – ATC
Total profits = profit per unit X quantity
Total profits = (p – ATC) X q
Monopoly Profits

• A monopoly receives larger profits than a

comparable competitive industry by
reducing the quantity supplied and
pushing prices up.
Monopoly Profits
Marginal cost
$1200 W
Average total cost
1000 C
Profit
800
M Demand curve
Price

600 B
K
400

200
Marginal revenue

0 200 400 600 800 1000 1200 1400

Quantity
Long run(LR) Equilibrium of Monopoly

• The magnitude of the LR profits of a

monopoly depends up on the cost
conditions and the demand curve
• See fig 6.4 page 103.
• Equilibrium level of out put(LMC=MR) may
not have the lowest LR :AC.
Monopolist supply

• The suply curve for a perfectly competitive

firm was the marginal cost curve.
• But in monopoly these is no supply curve.
• This unique relationship of price and
quantity supplied does not exist.
• There is no uniqe relationship between
price and quantity.
Cont….

• The reason is the same output can be sold

at infinite number of different price or the
same price may be charged for various
quantities supplied depending on the price
elasticity of demand.
• See panal A and B on page 104
Multi plant monopolist

• Assumptions for simplicity

• The firm has two plants
• The firm is aware of its AR and MR curves
• Thus , in order to produce the profit maximization
level of out put, the monopoly firm will operate
each plant in such a manner that MC in each plant
equals to the common MR.
• See numerical examples on page 106.
Other concepts of monopoly

• Price discrimination
• Social cost of monopoly
Monopolistic Competition (M.C.)
• Introduction
• In monopolistic competition, many
companies compete in an open market to
sell products which are similar, but not
identical.
• Key questions answered in this part include:
– What are the unique features of
monopolistic competition?
– How are the market outcomes affected by
this market structure?
 M.C. is a market structure, which has the
following basic characteristics
• Large number of sellers
• Product differentiation-Features that make one product
appear different from competing products in the same
market.
• Independent behavior- The relative independence of
monopolist competitors means that they don’t have to worry
about retaliatory responses to every price or output change.
• Freedom of entry & exit
• None Price Competition- such as advertising the difference
in their products or by supplying other services attached to
the sale of the product .
• Non-price competition is a way to attract customers
through style, service, or location, but not a lower price.
Ctd.

• A distinguishing structural characteristic of monopolistic

competition is that there are “many” firms in the industry.
• Monopolistic competition is a market in which many
firms produce similar goods or services but each
maintains some independent control of its own price.
• “Many” is somewhere between the “few” of oligopolies or
the “hordes” that characterize perfect competition.
• Each producer in monopolistic competition is large
enough to have some market power.
• A monopolistically competitive firm confronts a
downward-sloping demand curve for its output.
Ctd.
• Each firm has a distinct identity – a brand
image.
• Consumers perceive its output to be
somewhat different than others in the
industry.
• By differentiating their products,
monopolistic competitors establish brand
loyalty.
• Brand loyalty gives producers greater
control over the price of their products.
Ctd.

• By differentiating their products,

monopolistic competitors establish brand
loyalty.
• Brand loyalty gives producers greater
control over the price of their products.
• Each firm only has a monopoly on its
brand image.
• It still competes with other firms offering
close substitutes.
• Brand loyalty makes the demand curve
facing the firm less price-elastic.
• Brand loyalty implies that consumers shun
substitute goods even when they are
cheaper.
• Each monopolistically competitive firm will
establish some consumer loyalty
• A symptom of brand loyalty is the price
differences between computers which are
essentially the same.
Short-Run Price and Output
• The monopolistically competitive firm’s
production decision is similar to that of a
monopolist.
– Production decision - The selection of the
short-run rate of output (with existing plant
and equipment).
• As always, the profit-maximizing rate of
output is achieved by producing the
quantity where MR = MC.
Entry and Exit

• With low barriers to entry, new firms will

enter the market if there is economic profit.
– Economic profit – The difference between
total revenues and total economic costs.
Equilibrium in Monopolistic Competition
The short run
Price or Cost (dollars per unit)

MC
F ATC
pa

ca Demand
K

MR
0 qa
Quantity (units per period)
 Price and Output in Monopolistic
Competition

The Firm’s Short-Run Output and Price Decision

A firm that has decided the quality of its product and its
marketing program produces the profit-maximizing
quantity at which its marginal revenue equals its marginal
cost (MR = MC).
Price is set at the highest price the firm can charge for the
profit-maximizing quantity.
The price is determined from the demand curve for the
firm’s product.
Equilibrium in Monopolistic Competition

Figure 13.2 shows a short-

run equilibrium for a firm in
monopolistic competition.
It operates much like a
single-price monopoly.
Price and Output in Monopolistic
Competition

The firm produces the

quantity at which marginal
revenue equals marginal
cost
and sells that quantity for
the highest possible price.
It makes an economic
profit (as in this example)
when P > ATC.
Price and Output in Monopolistic
Competition

Figure 13.4 shows a firm in

monopolistic competition in
long-run equilibrium.
If firms incur an economic
loss, firms exit to achieve
the long-run equilibrium.
Price and Output in Monopolistic
Competition

Monopolistic Competition and Perfect Competition

Two key differences between monopolistic competition
and perfect competition are:
 Excess capacity
 Markup
A firm has excess capacity if it produces less than the
quantity at which ATC is a minimum.
A firm’s markup is the amount by which its price exceeds
its marginal cost.
Price and Output in Monopolistic
Competition

Excess Capacity
Firms in monopolistic
competition operate with
excess capacity in long-
run equilibrium.
The downward-sloping
demand curve for their
products drives this result.
Price and Output in Monopolistic
Competition
Markup
Firms in monopolistic
competition operate with
positive mark up.
Again, the downward-
sloping demand curve for
their products drives this
result.
Price and Output in Monopolistic
Competition

In contrast, firms in
perfect competition have
no excess capacity and
no markup.
The perfectly elastic
demand curve for their
products drives this
result.
Price and Output in Monopolistic
Competition
Is Monopolistic Competition Efficient
Because in monopolistic competition P > MC, marginal
benefit exceeds marginal cost.
So monopolistic competition seems to be inefficient.
But the markup of price above marginal cost arises from
product differentiation.
People value variety but variety is costly.
Monopolistic competition brings the profitable and possibly
efficient amount of variety to market.
Oligopoly

• Oligopoly is a market in which a few firms produce all or most of

the market supply of a particular good or service.
• Oligopoly describes a market dominated by a few large,
profitable firms.
Collusion
• Collusion is an agreement among members of an oligopoly to set
prices and production levels. Price- fixing is an agreement among
firms to sell at the same or similar prices.
Cartels
• A cartel is an association by producers established to coordinate
prices and production.
Oligopoly
• is a market structure, which has the
following basic characteristics
– Few Large Firms
– Market power
– Identical or Differentiate Products
– Interdependence
– Barriers to Entry
Profit Maximizing Output & Price

• A firm in an Oligopoly market maximizes

profit like a firm in all other market
structures at MR=MC and MC is rising.
• Profit-maximization rule – Produce at that rate
of output where marginal revenue equals
marginal cost.
•
Maximizing Oligopoly Profits
Price or Cost (dollars per unit)

marginal average
cost cost

Profit-
maximizing
price Market
Profits demand
Average cost J
at profit-
maximizing marginal
output revenue
Profit-maximizing output
0
Quantity (units per period)
Characteristics of Market Structures
Market Structure
Perfect Monopolistic
Characteristics Oligopoly
Competition Competition
Number of firms Very large Many Few
number
Barriers to entry None Low High
Market power None Some Substantial
(control over price
Type of product Standardized Differentiated Standardized
or
differentiated
Characteristics of Market Structures
Market Structure
Perfect
Characteristics Duopoly Monopoly
Competition
Number of firms Very large Two One
number
Barriers to entry None High High
Market power None Substantial Substantial
(control over price
Type of product Standardized Standardized Unique
or
differentiated
Determinants of Market Power

• The determinants of market power include:

– Number of producers.
– Size of each firm.
– Barriers to entry.
– Availability of substitute goods.
Determinants of Market Power
• The numbers and size of firms determine
the extent that firms can withstand
pressures and threats to change prices or
product flows.
• The barriers to entry determine to what
extent the market is a contestable market.
• Contestable market – An imperfectly competitive
industry subject to potential entry if prices or profits
increase.
• The availability of substitute goods weakens any
firm’s market power.
THANK YOU.