Fundamentals of Economics - Chapter 7

CHAPTER 7
THEORY OF THE FIRM AND MARKET

STRUCTURE
LEARNING OUTCOMES
At the end of the chapter, you should be able to:

 Describe total approach and marginal approach
 Explain perfect competition characteristics and equilibrium in the
short run and long run
 Explain monopoly characteristics and equilibrium in the short run
and long run
 Describe all types of price discrimination
 Differentiate the differences between monopoly and perfect
competition
 Explain monopolistic competition characteristics and equilibrium in
the short run and long run.
 Explain oligopoly characteristics, the concept of kinked demand
curve (assumptions) and equilibrium in the short run.
Fundamentals of Economics All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2017 1–3
THEORY OF THE FIRM
 A firm is an institution that hires or buys FOP and

organizes them to produce and sell final goods and
services.
 A firm is engaged in the production process with the
objective of maximizing profit.
 The main goals of a firm are:
(i) Minimizing cost, and
(ii)Maximizing profit

THEORY OF THE FIRM (cont.)
Equilibrium of a Firm
 A firm is in equilibrium when it earns maximum profit or
minimum losses.
 At equilibrium level, a firm has no tendency to increase
or decrease output.
 Equilibrium of output is the output level that gives
maximum profit.

Total Approach
It involves Total Revenue (TR) and Total Cost (TC)
which is the simplest method.
A firm is in equilibrium if the difference between TR and

TC is at its maximum.
There are two types of market:
(i)Perfect Market
(ii)Imperfect Market

The highest
profit is the
profit
maximizing
output

The highest
profit is the
profit
maximizing
output

Marginal Approach
It involves Marginal Revenue (MR) and Marginal Cost
(MC).
A firm is in equilibrium when MR = MC.
A firm can continue to increase profit up to the point at
which MR = MC.
There are two types of market:
(i)Perfect Market
(ii)Imperfect Market

MR curve is perfectly elastic or horizontal

The profit maximization is obtained when
MR = MC.
Profit maximizing
output is
obtained when
MR = MC

• MR curve is downward sloping as

output increases
• The profit maximization is obtained
when MR = MC
Profit maximizing
output is obtained
when MR=MC

MARKET STRUCTURE

PERFECT COMPETITION
CHARACTERISTICS
1) LARGE NUMBER OF SELLERS
• The number of buyers and sellers are large and the size of each firm is
small
• Therefore, no single buyer and seller can influence the market price
• The firm is a price taker and the price is fixed
• If firm sells a high price, there would be no demand
• If firm sells at low price, they will face a loss
2) HOMOGENOUS/IDENTICAL/STANDARDIZED PRODUCT
•The goods are homogenous and identical in terms of quantity, packaging,
color and design
•This means, the firm cannot control price in the market
•They cannot charge different price for the same products.

PERFECT COMPETITION (cont.)
CHARACTERISTICS
3) PRICE TAKER
• The firm have no significant control over the market price.
• Once the market determined the price, the price will be fixed.
4) VERY EASY ENTRY AND EXIT
• There are no restriction on the entry of new firms to the industry or the
exit of firms
• If firms in the industry are making profits, the new firms will enter the
market
• If firms in the industry are making losses, some of the existing firms will
exit from the industry

Price Determination in
Perfect Competition
Firms under perfect
competition are price takers
and they cannot influence the
price.
Therefore, the demand
curve of perfect competition is
perfectly elastic which is
horizontal.
The price under perfect
competition market is always
constant.

Perfect Competition Short Run Equilibrium (Profit Maximization)

There are three possibilities of short-run profit:
(1) Supernormal Profit (Economic Profit)
The profit earned when TR > TC.
It is also realized when the P (AR) > AC.
(2) Subnormal Profit (Economic Losses)
The losses incurred because TR < TC.
It is also happens when P (AR) < AC.
(3) Normal Profit (Breakeven/Zero Profit)
The profit necessary for firm to stay in business.
Normal profit is achieved when TR = TC.
It is also achieved when P (AR) = AC.

(1) Supernormal Profit

It is achieved because
P(AR) > AC where TR >
TC at the point of
equilibrium MR = MC

(2) Normal Profit

Firm earns a normal
profit means they
neither making profit nor
losses.
Breakeven or normal
profit happens when
P(AR) = AC where TR =
TC at the point of
equilibrium MR = MC.

(3) Subnormal Profit

Firm is making a loss
because P (AR) < AC
where TR < TC at the
point of equilibrium
MR = MC.

Shutdown
Condition
If the P(AR) < AC,
there are two
possibilities:
(a)A firm should
continue the
production
(b)A firm should shut
down the production


Long Run
Equilibrium
Firms in the perfect
competition will only
earn normal profits in
the long run due to
the freedom of entry
and exit.

Effect of Entry
In the short run, when a firm earns supernormal profit,
this will attract new firms to enter the industry.
The number of firms will increase and the production will
also increase.
The supply curve will shift to the right from S0 to S1.
The price will fall and individual firms will earn normal
profit because the demand curve falls from LRAR = LRMR
= D to LRAR1 = LRMR1 = D1.
The individual firm earns normal profit in the LR due to
the effect of entry.


Effect of Exit
In the short run, when a firm earns subnormal profit (loss), some
of the existing firms are no longer interested to stay in the industry.
Some firms will leave and go to other industries, which are more
profitable.
The number of firms will decrease and the production will also
decrease.
This causes the supply curve to shift to the left from S 1 to S0.
The price will increase and the individual firms’ demand curve
rises from LRAR1 = LRMR1 = D1 to LRAR = LRMR = D.
The individual firm only earns a normal profit in the LR due to the
effect of exit.

MONOPOLY
CHARACTERISTICS
(1) Single Seller and Large Number of Buyers
 Monopoly exists when a firm is the sole producer of the whole industry.
 The firm is the only producer of the goods and services to be purchased
by a large number of buyers.
 Monopolist face no competition in the industry.
(2) Unique Product/No Close Substitutes
 A firm produces a unique product which has no close substitutes.
 For example Tenaga Nasional Berhad (TNB) which is the only electricity
supplier in Malaysia.
(3) Barrier to Entry
 Monopolist face no competitors because of barriers to entry of new firms
joining the industry.

MONOPOLY (cont.)
CHARACTERISTICS
(4) Price Maker
 A firm faces no competition since this firm is the only producer of the
unique product.
 They have full power to control the market price.
(5) Advertising
 The need of advertising depends on the types of product the firm is
producing.
 For instance if the products are water supply and electricity, no
advertisement is needed. However for products such as luxury cars and
luxury brands, there is a need for advertisement.

MONOPOLY (cont.)
Monopoly Demand Curve

The demand curve for a monopoly firm is downward
sloping which depends on the law of demand.
The firm’s demand curve represents the industry’s
demand curve since there is only one firm in the industry.
When a monopolist sets a price for a product, he will
consider the elasticity of demand for the product.

MONOPOLY (cont.)
 The demand curve for a monopoly firm is downward

sloping which depends on the law of demand.
 The firm’s demand curve represents the industry’s
demand curve since there is only one firm in the
industry.
 When a monopolist sets a price for a product, he will
consider the elasticity of demand for the product.
 The monopolist will fix a higher price if demand is
inelastic to gain more revenue, whereas a lower price
will be fixed if the demand is elastic.

MONOPOLY (cont.)
Average Revenue and Marginal Revenue

The AR curve is also a demand curve of monopoly firm.
AR curve is downward sloping because the monopolist
firms are price makers and they can control either price or
quantity but not both.
The MR curve is also downward sloping but steeper than
AR curve.
MR curve always lies below the AR curve due to the
assumption that the monopolist firms can either control price
or output but not both.

MONOPOLY (cont.)

MONOPOLY (cont.)
Short Run Equilibrium

A firm in a SR will enjoy three types of profits:
The profit earned when TR > TC.
It is also realized when the P (AR) > AC.
The losses incurred because TR < TC.
It also happens when P (AR) < AC.
The profit necessary for a firm to stay in business.
Normal profit is achieved when TR = TC.
It is also achieved when P (AR) = AC.

MONOPOLY (cont.)

MONOPOLY (cont.)

MONOPOLY (cont.)

MONOPOLY (cont.)
Monopoly Long Run Equilibrium

In the LR, a monopolist will only earn supernormal profit
due to barriers to entry.
They receive supernormal profit in the LR because:
(i)There is no competition since the goods produced are
unique and have no close substitutes.
(ii)A monopolist can make all necessary changes to cost
due to restriction on entry of new firms into the industry.

MONOPOLY (cont.)
 The intersection of the

LRAC and the LRMC is the
equilibrium point E.
 The equilibrium output is M
and the price is at A where
the firm is earning
supernormal profit equal to
ABCD since LRAC > LRAC.
 The firm will continue to
earn supernormal profits in
the long run due to barriers
to entry.

MONOPOLY (cont.)
Price Discrimination
Price discrimination refers to the selling or the charging
of different prices to different buyers for the same good if
it finds it profitable and possible.
Example: A theme park operator will charge a higher

price for adults and a lower price for children for entry.

MONOPOLY (cont.)
 There are three degrees of price discrimination:
(1) First Degree Price Discrimination

 First degree price discrimination is practiced when a
monopolist charges separate prices for each unit of goods
and services sold and charges each buyer the maximum
price that he or she is willing to pay.
 Example: In Auction Market, where the highest bidder will

take product.

MONOPOLY (cont.)
 There are three degrees of price discrimination:
(2) Second Degree Price Discrimination

 Second degree price discrimination occurs when the
products are divided into different blocks and charged
different prices for each block. This is done to keep the
consumer satisfied and prevent new entrants.
 Example: Electricity Bills, Water Bills or Income Tax
Returns.

MONOPOLY (cont.)
There are three degrees of price discrimination:
(3) Third Degree Price Discrimination

In third degree price discrimination, the market are divided
into many sub-markets or sub-groups.
The price to be charged depends on the price elasticity of
demand
Example: A movie ticket for adults is charged at a higher
price than for children; Ticket to the Zoo where adults pay
more than children, also for transportation services and
entertainment sectors.

MONOPOLY (cont.)
(3) Third Degree Price Discrimination Diagram:

MONOPOLISTIC COMPETITION
CHARACTERISTICS
(1) Relatively Large Number of Sellers
 There are a relatively large number of sellers but not as large as perfect
competition.
(2) Goods Produced Have Close Substitutes/Differentiated Products
 The firm produces differentiated products with many close substitutes
available in the market.
 The products are differentiated in terms of packaging, design, labelling,
advertising and brand names, e.g. Palmolive, Lux and Dettol shower gel.

(cont.)
CHARACTERISTICS
(3) Easy Entry And Exit
 There is relatively easy entry of new firms in the industry but not as free as
perfect competition due to the existence of product differentiation.
(4) Less Power To Control Price
 The size of each firm is relatively small and therefore, each firm cannot
influence the market price.
 Hence, each firm follows an independent price-output policy

(cont.)
Monopolistic Competition Demand Curve

 The demand curve for a monopolistic competitive firm is
downward sloping due to product differentiation.
 Each monopolistic competition firm produces variety of
differentiated products with many close substitutes,
therefore the elasticity of demand for the product is quite
high.
 The demand curve of monopolistic competitive firm is
more elastic than the demand curve of monopolist firm
because in monopolistic competition there are many
firms that produce many substitute goods.
(cont.)
 The demand
curve of
monopolistic firm
is less elastic
compared to
perfect
competitive firm.
 The MR curve
lies below the
demand curve or
AR curve. Equilibrium quantity is achieved when MR = MC.
P* = 10
Q* = 100

(cont.)
Short Run Equilibrium

 A firm in a SR will enjoy three types of profits:
 The profit earned when TR > TC.
 It is also realized when the P (AR) > AC.
 The losses incurred because TR < TC.
 It also happens when P (AR) < AC.
 The profit necessary for a firm to stay in business.
 Normal profit is achieved when TR = TC.
 It is also achieved when P (AR) = AC.

(cont.)

(cont.)

(cont.)

(cont.)

OLIGOPOLY
CHARACTERISTICS
(1) Few Large Firms or Producers
 There are few large sellers in the market.
 Ex: Petroleum companies, such as Shell and Petronas.
(2) Homogeneous/Differentiated Products
 Oligopolies produce either standardized or differentiated products.
 Ex: Petroleum and cement produce homogeneous products whereas
automobile and electronic appliances supply differentiated products.
(3) Barriers To Entry
 There are barriers to entry and exit from the industry but not as
restrictive as a monopoly.

OLIGOPOLY (cont.)
CHARACTERISTICS
(4) Mutual Interdependence And Control Over Price
 Firms in oligopoly are interdependent on one another.
 Oligopolies have some control over price.
 The pricing and output policy of one firms is dependent on the pricing
and output policies of other firms.
 Each firm is affected by its rivals’ decision because they are mutually
interdependent.

OLIGOPOLY (cont.)
Price Rigidity and Kinked Demand Curve

The concept of kinked demand curve and price rigidity
was introduced by Professor Sweezy.
Therefore, the kinked demand curve is also known as the
Sweezy Model.
The price rigidity explains the behaviour of an
oligopolistic firm which has no incentive to either increase
or decrease the price of its products.

OLIGOPOLY (cont.)
 The theory of a kinked demand curve is based on two

assumptions:
(1) If an oligopolistic firm reduces the price of its product,
the rivals will react by reducing the price to avoid losing
customers.
(2) If an oligopolistic firm increases the price of its product,
the rivals will not increase their prices instead retain
the same prices, thereby gaining customers from firms
which increases their price.

OLIGOPOLY (cont.)
Short Run Equilibrium • If the MC reduces from MC0 to

MC1, the equilibrium price and
quantity remain unchanged.
• As long as the MC curve passes
through the gap of the MR,
equilibrium price and quantity will
be unchanged.
• The stability in price and quantity is
called price rigidity and explained
in the kinked demand curve.
• The kinked demand curve model
predicts that price and quantity
will be insensitive towards small
cost changes but will respond to
large change in cost.

OLIGOPOLY (cont.)
• AED is the demand curve = AR for

oligopoly firms.
• The kink occurs at point E.
• It assumes that rivals will match a
price cut but ignore a price
increase.
• Demand is elastic above the kink,
more customers switch to the rivals’
lower price (second assumption).
• Demand is inelastic below the kink
customers do not switch products
(First assumption).
• Since the oligopoly firm faces a kinked demand curve, the

firm has no incentive to increase or decrease its price.
• This explains the price rigidity concept.
• The kinked demand curve shows the characteristic of
mutual interdependence among oligopoly firms.

OLIGOPOLY (cont.)

OLIGOPOLY (cont.)


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CHAPTER 7

THEORY OF THE FIRM AND MARKET

At the end of the chapter, you should be able to:

 A firm is an institution that hires or buys FOP and

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

A firm is in equilibrium if the difference between TR and

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

MR curve is perfectly elastic or horizontal

Fundamentals of Economics All Rights Reserved

• MR curve is downward sloping as

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Perfect Competition Short Run Equilibrium (Profit Maximization)

Fundamentals of Economics All Rights Reserved

(1) Supernormal Profit

Fundamentals of Economics All Rights Reserved

(2) Normal Profit

Fundamentals of Economics All Rights Reserved

(3) Subnormal Profit

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Monopoly Demand Curve

Fundamentals of Economics All Rights Reserved

 The demand curve for a monopoly firm is downward

Fundamentals of Economics All Rights Reserved

Average Revenue and Marginal Revenue

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Short Run Equilibrium

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Fundamentals of Economics All Rights Reserved

Monopoly Long Run Equilibrium

Fundamentals of Economics All Rights Reserved

 The intersection of the

Fundamentals of Economics All Rights Reserved

Example: A theme park operator will charge a higher

Fundamentals of Economics All Rights Reserved

 There are three degrees of price discrimination:

(1) First Degree Price Discrimination

 Example: In Auction Market, where the highest bidder will

Fundamentals of Economics All Rights Reserved

 There are three degrees of price discrimination:

(2) Second Degree Price Discrimination

Fundamentals of Economics All Rights Reserved

There are three degrees of price discrimination:

(3) Third Degree Price Discrimination

Fundamentals of Economics All Rights Reserved

(3) Third Degree Price Discrimination Diagram: