Business Economics

Lecture 5
Types of markets and firms
Part 1 (competitive firms and monopolistic
competitive firms)

1
Different types of market structure
• Competitive firms
• Monopolistic competition firms
• Monopoly firms
• Oligopoly firms

2
 The Four Types of Market Structure
Number of Firms?

Many
firms
One Type of Products?
firm Few
firms Differentiated Identical
products products

Monopoly Oligopoly Monopolistic Perfect

Competition Competition

• Tap water • Tennis balls • Novels • Wheat

• Cable TV • Crude oil • Movies • Milk
3
 Competitive Firms
 A perfectly competitive market has the
following characteristics:
 There are many buyers and sellers in the market.
 The goods offered by the various sellers are the
same.
 Firms can freely enter or exit the market.
 Negligible impacts for the action of an individual
buyer and seller on the market price.
 Each buyer and seller accept the market price as
given and both parties are price takers.
4
 Revenue of a competitive firm
• Total revenue for a firm is the selling price times the
quantity sold. TR = (P X Q)
• Total revenue is proportional to the amount of
output.
• Average revenue tells us how much revenue a firm
receives for the typical unit sold.
• In perfect competition, average revenue equals the
price of the good.
• Average revenue = TR /Q = P x Q / Q = P

5
 Revenue of a competitive firm
Marginal revenue is the change in total
revenue from an additional unit sold.
MR =TR/ Q

6
 Total, Average, and Marginal Revenue for a
Competitive Firm

Quantity Price Total Revenue Average Revenue Marginal Revenue

(Q) (P) (TR=PxQ) (AR=TR/Q) (MR=TR/ Q )
1 $6.00 $6.00 $6.00
2 $6.00 $12.00 $6.00 $6.00
3 $6.00 $18.00 $6.00 $6.00
4 $6.00 $24.00 $6.00 $6.00
5 $6.00 $30.00 $6.00 $6.00
6 $6.00 $36.00 $6.00 $6.00
7 $6.00 $42.00 $6.00 $6.00
8 $6.00 $48.00 $6.00 $6.00

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 Profit Maximization
 The goal of a competitive firm is to maximize profit.
 This means that the firm will want to produce the
quantity that maximizes the difference between total
revenue and total cost.
 Profit maximization occurs at the quantity where
marginal revenue equals marginal cost.
 MR > MC , firm will increase their quantity of outputs
 MR < MC, firm will decrease their quantity of outputs
 MR = MC, firm produces at the profit maximization
quantity of outputs

8
 Profit Maximization:
A Numerical Example

Price Quantity Total Revenue Total Cost Profit Marginal Revenue Marginal Cost
(P) (Q) (TR=PxQ) (TC) (TR-TC) (MR=TR/ Q ) MC=  TC /  Q
0 $0.00 $3.00 -$3.00
$6.00 1 $6.00 $5.00 $1.00 $6.00 $2.00
$6.00 2 $12.00 $8.00 $4.00 $6.00 $3.00
$6.00 3 $18.00 $12.00 $6.00 $6.00 $4.00
$6.00 4 $24.00 $17.00 $7.00 $6.00 $5.00
$6.00 5 $30.00 $23.00 $7.00 $6.00 $6.00
$6.00 6 $36.00 $30.00 $6.00 $6.00 $7.00
$6.00 7 $42.00 $38.00 $4.00 $6.00 $8.00
$6.00 8 $48.00 $47.00 $1.00 $6.00 $9.00

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Profit Maximization for the Competitive Firm...

Costs The firm maximizes profit

and by producing the quantity
Revenue at which marginal cost
equals marginal revenue.
MC

MC2

ATC
P=MR1 P = AR = MR
AVC

MC1

0 Q1 QMAX Q2 Quantity10
The Marginal-Cost Curve and the Firm’s
Supply Decision...
Costs This section of the
and firm’s MC curve is
Revenue
also the firm’s
MC
supply curve.
P2

P1 ATC

AVC

0 Q1 Q2 Quantity11
 Shutdown vs. Exit
 A shutdown refers to a short-run decision not to
produce anything during a specific period of time
because of current market conditions.
 Exit refers to a long-run decision to leave the
market.
• The firm considers its sunk costs when deciding
to exit, but ignores them when deciding whether
to shut down or not.
 Sunk costs are costs that have already been
committed and cannot be recovered.
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The condition for Shutdown(Short Run)
 The firm shuts down if the revenue it gets
from producing is less than the variable cost of
production.
 Shut down if TR < VC
 Shut down if TR/Q < VC/Q
 Shut down if P < AVC
 The portion of the marginal-cost curve that
lies above average variable cost is the
competitive firm’s short-run supply curve
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 The Firm’s Short-Run Decision to Shut
Down...
Costs
Firm’s short-run supply
curve.
MC
If P > ATC,
keep producing
at a profit.
ATC
If P > AVC,
keep producing AVC
in the short run.

If P < AVC,
shut down.

0 Quantity
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The conditions for Exit and Enter(Long Run)
 In the long-run, the firm exits if the revenue it would get
from producing is less than its total cost.
 Exit if TR < TC
 Exit if TR/Q < TC/Q
 Exit if P < ATC

 A firm will enter the industry if such an action would be

profitable.
 Enter if TR > TC
 Enter if TR/Q > TC/Q
 Enter if P > ATC

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 The Competitive Firm’s Long-Run Supply
Curve...
Costs
MC = Long-run S
Firm enters
if P > ATC

ATC

AVC

Firm exits
if P < ATC

0 Quantity
16
 Long Run Supply Curve
• The competitive firm’s long-run supply curve
is the portion of its marginal-cost curve that
lies above average total cost.

17
The Competitive Firm’s Long-Run Supply
Curve...
Costs
MC
Firm’s long-run
supply curve

ATC

AVC

0 Quantity
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Supply Curve(Short run and Long Run)

 Short-Run Supply Curve

 The portion of its marginal cost curve that lies
above average variable cost.
 MC > AVC

 Long-Run Supply Curve

 The marginal cost curve above the minimum
point of its average total cost curve.
 MC > ATC

19
Measuring Profit in the Graph for the
Competitive Firm...
Price a. A Firm with Profits

MC ATC
Profit

P P = AR = MR
ATC

0 Q Quantity
Profit-maximizing quantity 20
Measuring Profit in the Graph for the
Competitive Firm...
Price b. A Firm with Losses

MC ATC

ATC

P P = AR = MR

Loss

0 Q Quantity
Loss-minimizing quantity 21
 Supply in the competitive market
• Market supply equals the sum of the
quantities supplied by the individual firms in
the market.
 For any given price, each firm supplies a
quantity of output so that its marginal cost
equals price.
 The market supply curve reflects the
individual firms’ marginal cost curves.

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 The Short Run: Market Supply with a Fixed
Number of Firms...
(a) Individual Firm Supply (b) Market Supply

Price Price

MC Supply

$2.00 $2.00

1.00 1.00

0 100 200 Quantity 0 100,000 200,000 Quantity

(firm) (market)
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 Long Run: Market Supply with Entry
and Exit
 Firms will enter or exit the market until profit is driven
to zero.
 In the long run, price equals the minimum of average
total cost.
 The long-run market supply curve is a horizontal line at
this price.
 At the end of the process of entry and exit, firms that
remain must be making zero economic profit.
 The process of entry & exit ends only when price and
average total cost are driven to equality.
 Long-run equilibrium must have firms operating at
their efficient scale.
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 The Long Run: Market Supply with Entry and
Exit...

(a) Firm’s Zero-Profit Condition (b) Market Supply

Price Price

MC
ATC
P=
minimum Supply
ATC

0 Quantity 0 Quantity
(firm) (market)
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 Zero profits, the firm stays
 Profit equals total revenue minus total cost.
 Total cost includes all the opportunity costs of
the firm.
 In the zero-profit equilibrium, the firm’s
revenue compensates the owners for the time
and money spent to maintain the business
operation.

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 Increase in Demand in the Short Run...
(a) Initial Condition
Firm Market
Price Price

ATC
MC S1
A
P1 P P1 Long-run
supply

D1

0 Quantity 0 Q1 Quantity
(firm) (market)

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 Increase in demand in short run vs. long run

 An increase in demand raises price and

quantity in the short run.
 Firms earn profits because price now exceeds
average total cost.
 In reality, short run supply curve may not be a
horizontal line.
 Some resources used in production may be
available only in limited quantities.
 Firms may have different costs.

28
 Increase in Demand in the Short Run...
(b) Short-Run Response
Firm Market
Price Price

Profit MC ATC S1
B
P2 P2
A
P1 P1 Long-run
supply
D2
D1

0 Quantity 0 Q1 Q2 Quantity
(firm) (market)

29
 Increase in Demand in the Short Run...
(c) Long-Run Response
Firm Market
Price Price

MC ATC S1
B S2
P2
A C
P1 P1 Long-run
supply
D2
D1

0 Quantity 0 Q1 Q2 Q3 Quantity
(firm) (market)

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 Competitive firms summary
 Because a competitive firm is a price taker, its revenue
is proportional to the amount of output it produces.
The price of the good equals both the firm’s average
revenue and its marginal revenue. Ｐ＝ＡＲ＝ＭＲ
 To maximize profit a firm chooses the quantity of
output which marginal revenue equals marginal cost.
MR= MC
 This is also the quantity at which price equals marginal
cost.
 Therefore, the firm’s marginal cost curve is its supply
curve.

31
 Competitive firms summary
 In the short run when a firm cannot recover
its fixed costs, the firm will choose to shut
down temporarily if the price of the good is
less than average variable cost.
P < AVC
 In the long run when the firm can recover
both fixed and variable costs, it will choose to
exit if the price is less than average total cost.
P < ATC
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 Competitive firms suammry
 In a market with free entry and exit, profits
are driven to zero in the long run and all firms
produce at the efficient scale.
 Changes in demand have different effects over
different time horizons.

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 Types of firms in imperfect
competitive markets
 Monopolistic Competition
 Many firms selling products that are similar but
not identical.
 Oligopoly
 Only a few sellers, each offering a similar or
identical product to the others.

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 Monopolistic Competition
• Markets that have some features of
competition and some features of monopoly.
 Many sellers

 Product differentiation

 Free entry and exit

35
 Monopolistic Competition
• There are many firms (sellers) competing for the same
group of customers.
 Product examples include books, electronic products,
computer games, restaurants, cookies, furniture, etc.
• Each firm produces a product slightly different from
those of other firms.(eg.restaurants)
• Rather than being a price taker, each firm faces a
downward-sloping demand curve.
• Firms can enter or exit the market without restriction.
• The number of firms in the market adjusts until economic
profits are zero.

36
Monopolistic Competitors in the Short
Run...

(a) Firm Makes a Profit

Price
MC
ATC

Price
Average
total cost
Profit Demand
MR

0 Profit-
Quantity
maximizing quantity
37
Monopolistic Competitors in the Short
Run...
(b) Firm Makes Losses ATC
MC
Price
Losses

Average
total cost

Price

Demand
MR

0 Loss- Quantity
minimizing
quantity 38
 Short Run
Short-run economic profits encourage new
firms to enter the market.
 Increases the number of products offered.

 Reduces demand faced by firms already in the

market.
 Existing Firms’ demand curves shift to the left.

 Demand for the existing firms’ products fall,

and their profits decline.
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 Short Run
Short-run economic losses encourage firms to
exit the market:
 Decreases the number of products offered.

 Increases demand faced by the remaining

firms.
 Shifts the remaining firms’ demand curves to
the right.
 Increases the remaining firms’ profits.

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 Long Run Equilibrium
• Firms will enter and exit until the firms are
making exactly zero economic profits.
• As in a monopoly, price exceeds marginal cost.
 Profit maximization requires marginal revenue to
equal marginal cost.
 The downward-sloping demand curve makes marginal
revenue less than price
• As in a competitive market, price equals average
total cost.
 Free entry and exit drive economic profit to zero.

41
 A Monopolistic Competitor
in the Long Run...
Price
MC
ATC

P=ATC

Demand
MR
0
Profit-maximizing Quantity
quantity
42
 Monopolistic Competition
• There are two noteworthy differences
between monopolistic and perfect
competition—excess capacity and markup.

43
 Excess Capacity
 There is no excess capacity in perfect competition
in the long run.
 Free entry results in competitive firms producing
at the point where average total cost is minimized,
which is the efficient scale of the firm.
 There is excess capacity in monopolistic
competition in the long run.
 In monopolistic competition, output is less than
the efficient scale of perfect competition.
44
 Excess Capacity...

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
ATC ATC

P
P = MC P = MR
Excess capacity (demand
curve)
Demand

Quantity Quantity
Quantity Efficient Quantity = Efficient
produced scale produced scale
45
 Mark Up over Marginal Cost
 For a competitive firm, price equals marginal
cost.
 For a monopolistically competitive firm, price
exceeds marginal cost. (P > MC)
 Because price exceeds marginal cost, an extra
unit sold at the posted price means more
profit for the monopolistically competitive
firm.

46
 Markup Over Marginal Cost...

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
Markup MC MC
ATC ATC

P = MC P = MR
(demand
Marginal curve)
cost
MR Demand

Quantity Quantity
Quantity Quantity
produced produced
47
 Monopolistic versus Perfect Competition...

(a) Monopolistically Competitive Firm (b) Perfectly Competitive Firm

Price Price
MC MC
Markup ATC ATC

P = MC P = MR
Marginal (demand
cost curve)

MR Demand

Quantity Efficient Quantity Quantity produced = Quantity

produced scale Efficient scale
Excess capacity
48
 Monopolistic Competition
• Monopolistic competition does not have all the
desirable properties of perfect competition.
• There is the normal deadweight loss of monopoly
pricing in monopolistic competition caused by the
markup of price over marginal cost.
• monopolistic competition may be socially
inefficient is that the number of firms in the
market may not be the “ideal” one. There may
be too many or too few firms to entry.
49
 Externalities for Monopolistic Firms
Externalities of entry include:
 product-variety externalities.

 business-stealing externalities.

50
 Positive and negative Externality
• The product-variety externality:
Consumers get some consumer surplus from the
introduction of a new product, entry of a new firm
conveys a positive externality on consumers.
• The business-stealing externality: Because other
firms lose customers and profits from the entry of a
new competitor, entry of a new firm imposes a
negative externality on existing firms

51
 Advertising
• When firms sell differentiated products and charge
prices above marginal cost, each firm has an incentive
to advertise.
 Some critics argue advertising provides information to
consumers to manipulate people’s thoughts and taste.
 They also argue that advertising increases competition
by offering a greater variety of products and which is
different from the true products.
 The willingness of a firm to spend advertising dollars
can be a signal to consumers about the quality of the
product being offered.

52
 Brand Names
• Critics argue that brand names cause
consumers to perceive differences that do not
really exist.
 Economists have argued that brand names
may be a useful way for consumers to ensure
that the goods they are buying are of high
quality.
 providing information about quality.
 giving firms incentive to maintain high quality.

53
 Monopolistic firms summary
 A monopolistically competitive market is
characterized by three attributes: many firms,
differentiated products, and free entry.
 The equilibrium in a monopolistically
competitive market differs from perfect
competition in that each firm has excess
capacity and each firm charges a price above
marginal cost.

54
 Monoploistic firms summary
 Monopolistic competition does not have all of
the desirable properties of perfect
competition.
 There is a standard deadweight loss of
monopoly caused by the markup of price over
marginal cost.
 The number of firms can be too many or too
few.

55
 Monoploistic firms summary
 The product differentiation inherent in
monopolistic competition leads to the use of
advertising and brand names.
 Critics of advertising and brand names argue that
firms use them to take advantage of consumer
irrationality and to reduce competition.
 Defenders argue that firms use advertising and
brand names to inform consumers and to
increase competition on price and product quality.
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