Chapter 5 Theory of the Firm:

Market Structures and Determination of Price and Output

5.1 The Firm, its Objective and Market Structure

By assumption, the objective of a consumer is maximization of utility; likewise the

firms also has objective to achieve. The objective of business firms is to maximize profit
from the production and sell of goods and services.

In Production and Cost theories we have discussed about production and cost functions
and curves faced by firms. Brought together, revenue and cost determines the behavior of
a profit maximizing business firm. The most important factor that determines firm’s
choice of price and output is the market structure in which it operates.

The term market structures refers to the organizational features and characteristics of an
industry or market that influence firm’s behavior in its choice of price and output.
Economists broadly classified market structures into two:

a) perfectly competitive market structure

b) Imperfect Market structures; there are three forms of imperfect markets:

 pure monopoly market structure
 monopolistic competition market
 oligopoly market structure

This Classification of markets into perfect and imperfect depends on number factors or
characteristics that distinguish one market from another. These include: the numbers of
firms available in the industry, the nature of products supplied, condition entrance into a
market by of new firms, resources ownership and mobility, degree of access to
information and technology, etc.

In this unit, we investigate how price and output are determined in perfectly competitive
markets in the short as well as long run periods. Perfect competition is a market structure
characterized by a complete absence of rivalry among the individual firms, because there
are so many firms in the industry so that no personal recognition among individual firms
in a market.

5.2 Perfectly Competitive Market Structure

A perfectly competitive firm has the following characteristics:

1. Large number of sellers of the same product: under perfect competition there is
large number of sellers of a product. The number of firms is too large that the share of

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individual firm in the total supply of a product is very small. Therefore, no single seller
can influence the market price by changing the quantity supply. (Similarly, the number of
buyers is so large that the share of each buyer in the total demand is very small).
Therefore, in such a market structure, sellers and buyers are not price makers. Under
perfect market individual firm is a price taker (not price maker). A firm has no power to
determine or change the price of its product. Price of a product is determined by the
market through the interaction of market supply and demand forces.

Price Price
DD SS

Pe Pe Demand Curve

P = AR = DD

0 Qe Quantity 0 Q

a) The market Equilibrium b) Demand curve of a firm

Fig 4.1: Market equilibrium; and demand curve of a firm in perfect market

Usually the market demand and supply functions are given as;
Qd =a – bP(Demand function where Qd = quantity demanded, a and b are constant
numbers given, P market price)

Qs =bP (Market supply function)

The market price, P, and Quantity demand and supplied are determined by the
equilibrium of quantity demanded (Qd ) and quantity supplied (Qs ):

Qd =Qs ⤇ a – bP=bP

2. Homogeneous product: - the product supplies by firms in the market supply a

homogenous or identical product. Homogeneity of product implies the product of one
firm can’t be distinguished from products of other firms in the market. For buyers
products supplied by the various firms of an industry are identical; they can’t make
distinction between products supplied different firms in the market or in the given
industry.

Product of each firm is regarded as a perfect substitute for the products of other firms in
the industry/market. Therefore, no firm can gain any competitive advantage over the
other firm.

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3. Perfect mobility of factors of production: - there is no restriction in flows of factors
or inputs from place to place or from one industry to another. Factors of production are
free to move from one firm to another throughout the economy. This means that labor can
move from one job to another and from one region to another. Capital, raw materials, and
other factors are not monopolized.

4. Free entry and exit; there are no restrictions or market barriers on entry of new firms
to a given industry or for exit/leaving from an industry. A firm may enter the industry or
quit/leave it on its accord. There are no costs to be incurred for leaving from or entering
into an industry.

5. Existence of Perfect information/knowledge:-there is perfect information and

knowledge about the market conditions such as: supply, demand, prices, technology, etc.
All the buyers and sellers have full information regarding the prevailing and future prices
and other relevant market conditions. These information are freely available to all
economic agents in the given markets – information is free! There are no costs of
information to be incurred by individual agent.

There are no advertisement/promotion cots because no need for advertising a product

under perfect market by individual firm; no marketing research, no cost for research and
development (costs advanced for technological), no licensing costs, etc.

6. No government interference: a perfectly competitive market is free from any form of

government interventions and manipulations. Government does not interfere in any way
with the functioning of the market. There are no discriminator taxes or subsidies, no
licensing, no allocation of inputs by the procurement, or any kind of direct or indirect
control. That is, the government follows the free enterprise policy.

5.2.1 Demand curve, Price, Average revenue (AR) and Marginal revenue (MR) of an
individual firm

We have seen that a perfectly competitive firm faces a horizontal demand curve for its
product. This has a number of implications;

 A perfectly competitive firm can’t affect the market price by changing its output. A
firm is simply a price - taker not price – maker, it simply accept the market price.

 A firm has no market power, all firms have equal market power, ie, is zero.

 Price, AR and MR of a firm are always equal under prefect market; P=MR= AR .

R P ×Q
AR= = =P ,
Q Q

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 dR d ( P ×Q ) dQ
MR = = = P× =P ; then, P = AR =MR
dQ dQ dQ

 From this we can conclude that the demand curve of individual firm under perfect is
also the AR and the MR curves. Given P is a market price

Price

Pe Pe = AR =MR = DD curve

0 Q
4.2 Demand, AR and MR curve of a perfectly competitive firm

 A horizontal demand curve also shows, the price elasticity of demand for a competitive
firm is perfectly elastic; Ed = ∞.
 The response is so high that for slight change in price, TR of the firm will become zero.
( its total sale becomes zero).

5.2.2 Short Run Equilibrium of a Firm under perfect market

A) Equilibrium of a firm - A profit maximizing firm is in equilibrium at the level of MC

equal to MR (the marginal approach). And short – run equilibrium is based on the
following assumptions

 there are both fixed and variable inputs

 Prices are constant ( of inputs and output)
 There are two approaches of profit maximization; Total cost and total revenue
approach or marginal cost and Marginal revenue Approach.

i) Total Cost and Revenue Approach: according to this approach profit is maximized
when the vertical difference between total revenue (TR) and total cost (TC) is the
largest:

π = TR - TC ;
Where, π = profit, TR = P x Q;, TC = Total cost, P = price of output, Q = quantity of
output. It can be shown graphically by assuming linear total revenue function as follows;

TR, TC, TC
In the figure, at points A & C ,TR = TC and π = 0.
R C
In between points A & C , TR >TC , and π >0 .
At point B the firm maximizes its profit at the output Qe,
4 vertical distance between TR and TC curves is the
where the
widest. At output levels below Qa and greater than Qb, π < 0
and the firm incurs loss.
 A B

Profit curve

0 Qa Qe Qb Q

Simply taking points A, B and C, the profit curve drawn as follows

profit
Point B denotes the maximum total
B profit curve profit that corresponds with Qe units
of output.

Qa Qe Qb Q

Fig 4.3: The total approach of profit maximization

ii) The marginal Approach: Marginal Cost (MC) and Marginal Revenue (MR).

According to this approach, the profit maximizing level of output / equilibrium output of
a firm is determined based on its marginal revenue and marginal cost functions, given
other things being constant, such as prices. That is , any rational firm a produces an
output level where at least its MR is equal to its MC.

At equilibrium, a firm could maximize profit or minimizes its loss or earn zero profit by
producing that level of output where the following conditions are fulfilled;

 The first order condition (F.O.C); MR = MC. It is basic equilibrium condition

where the firm determines profit maximizing level of output for a given market
price.

MR=MC ; But, MR=dTR /dQ and MC=dTC/dQ

Hence, dTR /dQ=dTC /dQ

Price Price of a commodity is fixed by the market forces in a

perfectly competitive market, individual firm has horizontal
demand curve as shown.
MC
As shown by the line Pe = MR and also Pe =MR= AR - all
Pe E are equal in perfect market.

At point E the equilibrium condition is satisfied; MR =MC; it

also implies that; Pe=MR=MC= AR, at point E .

Qe - is the 5equilibrium level of output – it is a best or most

preferred level output a firm can produce given its MC
0 Qe Q

4.4 Short run Equilibrium of a firm

It can be seen in the figure below that MC curve intersect the P = MR line at point E,
from below, where MC = MR a perpendicular drawn from point E to the output axis
determines the equilibrium output at Qe. It can be seen in the figure that output Qe meets
both the first and the second order condition of profit maximization.

5.2.3 The Level Total Profit (π) , Equilibrium of a Firm , Price and AC

In the short run, equilibrium of a firm doesn’t necessarily tell us the level of profit the
firm is earning. The equilibrium condition, MR = MC, only tell us how much a firm has
to produce or it is the determination of the best possible level of output given the
circumstances – of prices and cost conditions - a firm faced. MC OF a firm doesn’t help
to know the total profit.

In the short run, total profit of a firm depends on AC of production relative to market
price of the product. Accordingly, the total profit (π) of the firm could be positive, zero or
negative at equilibrium based on the AC of the firm relative to price. Observe the
following relationship between P & AC of a competitive firm

π=TR – TC=( AR)×Q−Q× AC

[Because:TR=Q×(TR /Q)=Q × AR , and TC=Q ×(TC /Q)=Q × AC ]

Since under perfect market P= AR , then π=( P ×Q )−(Q × AC )=Q ×(P – AC )

Thus;
 if market price is greater than average cost, P > AC , then profit is positive π > 0
,

 if P = AC , then π = 0 , it said the firm is at break- even ( TR = TC)

 if P < AC , then profit is negative or the firm is at loss , π < 0

 if P = AVC , then TR = TC , profit is negative or the of the firm equal to its FC

amount. In other words, the firm can cover only its variable costs. The firm is said
to be at shut- down point. For a price below its AVC a firm can’t produce, it will
leave the market.

These cases are shown graphically below.

Case 1 – when market price greater than AC ( P > AC , π > 0)

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As shown in the fig below, the firm is in equilibrium at point E, where the condition is
satisfied (MR = MC) with P> AC ; thus, π >0; the firm will earn positive profit.

π=TR – TC=( AR)×Q−Q× AC , since under perfect market P = AR, then

π=P ×Q – Q × AC=Q(P – AC), thus, π > 0 if P > AC

Output level Qe is, therefore, profit maximizer, or called equilibrium output level. At this
output, the firm is at equilibrium and is making positive profit. Firm’s maximum total
profit is shown by the area of a rectangle, PeERA.

Price (P) SMC At point E , the equilibrium condition is

costs SAC satisfied; MC=MR=P e ; Since Pe > AC ,
the earn abnormal or positive profit , shaded
Pe E P = MR region.

0 Qe output (Q)

Fig 4.5: Super normal profit in the short run Equilibrium

Case 2 – when P = AC ; π = 0 ( break –even point)

In the short run, a firm may not always earn abnormal/positive profit. if the firm at
equilibrium with if its short run average cost (SAC) is equal to price. The equilibrium
condition is MR = MC which satisfied at point E with output, Qe. The SAC curve is also
tangent to P = MR line, at this point, where P = SAC. Thus, the firm makes normal
profit/zero profit. Note that at point E :
P=MR=SMC=SAC =AR∧π =0

Price, costs SAC

SMC Note that at point E; TR = TC and π = 0

Pe E Pe = MR = AR and called break - even point.

The firm operates at minimum AC, at

point E, produce Q e units of output.

0 Qe output, Q
Fig 4.6: A firm earning normal/ zero profit in the short run

Case 3 - when P < AC and π < 0 ; When market price is less than average cost

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If AC is above the price or if a firm at equilibrium where P < AC, the firm incurs losses
in the short run (π < 0). It is shown graphically as follows.
Price, costs
Given Pe is market price; at point E, equilibrium
MC AC
condition is satisfied ; Pe =MC=MR ; But AC > P e
B E’
Loss Thus, the firm is at equilibrium with negative profit, π <
Pe E 0.

The total loss the firm is shown by the shaded area of the
0. Qe output

Fig 4.7: A firm at equilibrium with negative profit (or incurring loss)

Shut –down or close – down point: where market price is equal AVC of the firm

In case a firm is making loss it must cover its short run average variable cost (SAVC). A
firm unable to cover its minimum AVC will have to close down. The MC/MR intersects
AVC at its minimum level as shown in the figure below.

In the fig below, Point E denotes the “shut –down point” because at any price below Pe,
better if firms to close down as it minimizes its loss. But production at point E, the firm at
least covers its VC; and its total loss equal to FC amount.
Price, costs
Given Market price is Pe ; at point E:
MC=MR=P e - Equilibrium condition
MC
AC Pe = AVC, Hence, the firm is at shut- down.
AC AVC
Note that at point E, TR=VC ¿ Loss=FC .
loss = FC
Pe E P=MR Loss=TR – (FC+VC)=TR – FC – VC ;

Since TR = VC, Then; Loss = FC amount

0 Qe
Fig 4.8: the shut down point

Numerical example 1. If the perfectly firm has the following total cost and MC
functions
3
2Q 2
C= −20 Q +250 Q+1000
3

dC
MC = =¿ 2 Q2 – 40Q + 250
dQ

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The market price of the product is given; P = birr 250

Then determine the equilibrium level of output that the firm should produce so as to
maximize its profit; and compute total profit of the firm.

Solution: - the equilibrium of the firm is where: MC = MR

We know that under perfect market, MR of a firm is equal to the market price.

Hence, MR = 250 birr, Then,

2
2 Q – 40Q + 250 = 250

2Q2 – 40Q = 100 - 100 and 2Q2 – 40Q = 0

32 Q2 = 40Q and 2Q = 40; thus,

40
Q= =20 units . Q=20units is the profit maximizing level of output for the firm.
2

If one interested to know the total profit of the firm earn at equilibrium, computed as:
3
2Q 2
Profit = R – C=P ×Q−( −20Q +250 Q+1000)
3

Profit = 250 ×20−(0.67 ×203−20× 202 +250 ×20+1000)

= 5000 - (5360 – 8000 + 5000+1000)

= 5000 – 3360 = 1640 birr

Derivation of supply curve of a firm

The supply curve of a competitive firm is derived (based on the equilibrium condition)
from the MC curve. As such the supply curve of a perfectly competitive firm is derived
from its MC curve that lies above point where it intersects with AVC curve (or the MC
curve above the shut dawn point).

The equilibrium output is determined by the intersection of MR and MC curves, is the

optimum supply by a profit maximizing (or cost minimizing) firm.
The MR is curve same as price line or MR = P in perfectly competitive market. The
derivation of supply curve of a firm is shown in figure below
As the figure shows, the firm’s SMC passes through point M, on its SAVC
(a) Equilibrium points (b) supply curve

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 Price Price
Costs SMC SAC SS

P3 K AVC K

P2 R R

P2 M M

0 Q1 Q2 Q3 Q 0 Q1 Q2 Q3 Q

Fig 4.9: derivation of supply curve of a perfectly competitive firm

Points M, R and K on the fig are equilibrium points. Accordingly, at point M, MC =

AVC = Price, P1 and Q1 is the minimum possible output that firm can produce, referred
as shut dawn output level. A firm can’t produce below the point where MC = AVC = P or
below point M. If price fall below P1, the will stop production or leave the market.

As the price increases above P1, firm will increases its output moving along its MC curve.
When price increases to P2, the equilibrium point moves along its MC curve from M to R
where at point R; P2 = MC and the corresponding equilibrium output is Q2.
When price is P3 equilibrium is at point K; where P 3 = MC at point K and the equilibrium
output is Q3; and so on.

The most important observation here is that for each equilibrium level of output and at
each equilibrium point price is equal to MC: P = MC ; thus, the supply curve is can be
derived by plotting this information or simply taking MC curve above point M ( above
the shut dawn point).

ii. Equilibrium of an industry/ the market

An industry is in equilibrium in the short-run when market is cleared at a given price i.e.
when the total supply of the industry equals the total demand for its product, the prices at
which market is cleared is the equilibrium price. The equilibrium purely determined by
the interaction of the market demand and supply.

Price
Point E is equilibrium point where the
DD SSmarket demand, DD and the market,
SS are equal;

Pe E DD = SS = Qe
Pe is the market equilibrium price
determined by interaction of market
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 Qe Q
Fig 4.10: the market equilibrium

The industry demand curve and supply curve intersect at point E determining equilibrium
price, Pe and output Qe. In short run equilibrium of the industry, some individual firms
may make pure profit, some normal profits and some may make even losses depending
on their cost and revenue conditions, as we will discuss in the next sub-topic, this
situation will however not continue in the long-run.

Long-run equilibriums of the firm and industry-

The short-run equilibrium of a competitive firm is analyzed based on assumptions of:

 firms cost and revenue curves are given
 firms cannot change their size, their capital is fixed
 Existing firms cannot leave the industry, and new firms cannot enter the industry.

In contrast, long run is a period in which these constraints disappear. It permits change in
scale of operation, technology and employment of both, labor and capital.

In this section we analyze the equilibrium of the firm and industry in long run. It may be
noted that the process through which firms and industry reach their respective
equilibrium position is a continuous process of adjustment and readjustment of price and
output with the changing conditions in the long run.

Equilibrium of the firm in the long-run

To show the long run equilibrium, let us begin with a short-run situation suppose (i) short
run price is given at P1, the market is at equilibrium at point E 1; and the industry is
characterized by positive profit. As shown in fig below the firm has SAC 1 and SMC1. At
the given the price P1, the firms are in equilibrium at point E with positive profit.

This Positive profit brings about two major changes or adjustment in the given industry
or market which discussed bellow.

 Expansion of existing firms – positive profit motivate existing firms or get an incentive
to increase scale of production by increasing output/ supply.

 Secondly, entry of new firms - attracted by the abnormal or positive profit, new firms
will start to enter into the given industry; this will increases the number of firms and
supply in the market.

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Both These phenomenon – that is, expansion of existing firms and entry of new - will
shift the market supply curve of the product to the right. Following the rise in market
supply and shift of supply curve to the right, the market price will fall.

These expansions of existing firms and entry of new firms will continue until the
increased market supply push down the market price to the point where, the industry
profit becomes zero. In other words, up to the point where the market price P = AC and
all forms simultaneously earn zero profit.

Price Costs & price

Panel (A) shift in market supply curve Panel (B)- Long run equilibrium of a firm
S1
LMC
P1 E1 S2 SMC SAC
LAC
Pe E2 P e E

D1
0 Q1 Q2 Q 0 Qe output

Fig 4. 11: Long –run equilibrium of a competitive firm

In competitive market, all firms in the given industry reach long run equilibrium
simultaneously where:
 firms produce at minimum feasible cost,(at minimum AC)
 Expansion or firm is size optimal, the firm is at Most Efficient Scale (MES):
SMC=LMC=SAC=LAC. Hence, there is no motive for further expansion.
 consumers pay minimum possible price which equals MC: P = MC
 plants operate at full capacity and all resources efficiently utilized
 all firms earn zero/normal profit: P = AC; thus , no motive for entry or exist
Perfectly competitive firms attain equilibrium in long run when the following conditions
are satisfied;
 SMC = LMC =MR = SAC = LAC = (P = AR)

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  and π = 0

Price P, Costs LMC LAC

DD
SS SMC SAC

Pe E Pe E

0 Qe Q 0 Q1 Q
Fig 4.12: Equilibrium of the industry Long run equilibrium of a firm

As both positive profit and loss disappear from the given market or industry, there will no
more entry or exist from the market. The industry /market become stable.

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