Chapter-7: Market Structure

- Perfect Competition
- Profit maximizing output in short run
- Losses and shutdown decision

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 Chapter-7: Market Structure
Profit Maximizing Output in the Shout Run:
Short run is defined as a period of time in
which at least one input is fixed.
- Capital stock is viewed as fixed input
- Number of production facilities &
- Size of the production facility do not change

The time period is short/long depends on:

- the nature of operation
- the characteristics of the industry

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 Chapter-7: Market Structure
Some examples: (Long Term)
- Production of electric power
- Expansion of Plant for Fertilizer
- Exploration of Gas generation
- Set up new Railway line
- Construction of Bridge like Padma
Bridge.
In contrast, economic profits in service
industries may attract new entrants in a
matter of weeks. 3
 Chapter-7: Market Structure
i. Demand: The firm in perfect competition
faces a horizontal demand curve at the
market price for its product.
This can be seen by evaluating the effects of
the firm’s decisions on market demand.
Using the following equations:
QD = 17,00,00,000 – 1,00,00,000P
The equation implies that quantity demanded
per period is reduced by 1 crore kgs per
taka increase in price
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 Chapter-7: Market Structure
QS = 7,00,00,000 + 1,50,00,000P
This equation indicates that a taka 1 price
increase results in 1.5 crore kgs extra
being supplied per period.
By solving these two equations for P and Q,
we get Price (P) = 4 and quantity (Q) is
13,00,00,000 kgs per period.
Suppose one supplier (like firm 2 in the Table
1) leaves the market, and the supply equation
for that single supplier is given by
q2=1000+1000P 5
 Chapter-7: Market Structure
Subtracting the second supply equation and we see the
new Qs as
QS = 6,99,99,000 + 1,49,99,000P
Therefore the new price will be 4.0002 and the new
equilibrium quantity will be 12,99,98,000 units.
Thus, Output decision of individual producer have no
significant impact on market price. If one supplier
remains in the market, the equilibrium price will be
Tk. 4.00. but if small producer leaves the market, the
price is still very close to Tk. 4.00.

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 Chapter-7: Market Structure
Market supply schedule
Total
Price firm 10000 Total market
per kg Firm -1 Firm-2 supply Firms supply
8 10000 9000 19000 10000 190000000
7 9500 8000 17500 10000 175000000
6 9000 7000 16000 10000 160000000
5 8500 6000 14500 10000 145000000
4 8000 5000 13000 10000 130000000
3 7500 4000 11500 10000 115000000
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 Chapter-7: Market Structure
Market Demand Schedule
Total
Price per customer 20000 Total market
kg Cust-1 Cust-2 demand customer Demand
3 8000 7000 15000 20000 300000000
4 7000 6000 13000 20000 260000000
5 6000 5000 11000 20000 220000000
6 5000 4000 9000 20000 180000000
7 4000 3000 7000 20000 140000000
8 3000 2000 5000 20000 100000000
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 Chapter-7: Market Structure
Price, cost per unit

MC AC

Pe = MR D

qm qc Quantity per period

Short run profit maximizing output in perfect competition

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 Chapter-7: Market Structure
Graphically shown in the previous diagram
that an individual firm can produce as
much as he can sell in the given price.
However, if the firm sets price above taka 4,
it will have no sales because consumers
will purchase from other suppliers.
Conversely there is no reason to sell below
taka 4 because the firm’s total output can
be sold at the market price which is taka 4
per kgs.
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 Chapter-7: Market Structure
ii. Costs: It is assumed that the firm has U- shaped
average and marginal cost curves, as shown in the
previous diagram.
The figure shows that as quantity increases from 0 to
qm units, average cost declines and then increase
beyond that point.
It is so important to remember that the cost curves of
the previous diagram include a normal rate of profit.
Thus, any time that the firm’s price is greater than
average cost, it is earning economic profit.

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 Chapter-7: Market Structure
iii. Equilibrium Output: Because price is
determine in the market and the product
is homogeneous, the only decision left to
the manager of a firm in a perfectly
competitive market is how much output
to produce.
The profit maximizing output is determined
where the extra revenue generated by
selling the last unit (at the market price)
just equals to the marginal cost.
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 Chapter-7: Market Structure
For a horizontal demand curve faced by
firms in the perfectly competitive market
such as that shown in the previous figure,
this condition is met by increasing the rate of
production to qc where price equals
marginal cost.
If the firm increases output beyond this point,
the additional revenue pe is less than the
extra costs as shown by the marginal cost
curve.
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 Chapter-7: Market Structure
In contrast, if production is reduced below qc
the loss of revenue is greater than the
reduction in cost and profit decreases.
The output rate qc represents the short-run
equilibrium for the competitive firm in
the sense that a profit-maximizing
manger has no incentive to alter output
as long as the demand and cost curve
remain unchanged.

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 Chapter-7: Market Structure
Example: Pizza Profits
A new pizza place, Fredrico’s opens in Chittagong
City. The average price of a medium pizza in
Chittagong is Tk. 10 and because of large number of
pizza sellers, this price will not be affected by the new
entrant in the market. The owner of Fredrico’s
estimates that monthly total costs, including a normal
profit, will be
TC= 1000+ 2Q+0.01Q2
To maximize total profit, how many pizzas should be
produced each month? In the short run, how much
economic profit will the business earn each month?

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 Chapter-7: Market Structure
Losses and Shutdown Decision:
Simply because profit maximization is the
objective of mangers is no guarantee
that a firm will actually earn economic
profit or even normal profit.
Why this happens:
- Oversupply
- Poor management
- Higher cost
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 Chapter-7: Market Structure
Therefore, the maximum profit may actually
be negative.
The course of action adopted by managers of
an unprofitable firm should be based on
a consideration of the alternatives.
i). One option would be to continue
producing at the least unprofitable
(smallest loss) rate of output.
ii). Another would be to shutdown operations
and producing nothing.
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 Chapter-7: Market Structure
The best choice is the alternative that
minimizes the firm’s losses.
In the short run, the consequences of shutting
down verses continuing production are
illustrate in the following table…
Consider Total cost =
Total fixed cost + Total variable cost
Marginal cost, average variable and average
total cost are shown there.
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 Chapter-7: Market Structure
Qty TFC TVC TC MC AVC ATC
0 5 0 5 - - -
1 5 5 10 5 5 10.00
2 5 9 14 4 4.50 7.00
3 5 12 17 3 4.00 5.67
4 5 14 19 2 3.50 4.75
5 5 17 22 3 3.40 4.40
6 5 21 26 4 3.50 4.33
7 5 26 31 5 3.71 4.43
8 5 32 37 6 4.00 4.63
9 5 39 44 7 4.33 4.89
Short-run output and cost data 19
 Chapter-7: Market Structure
Consider, the firm is facing horizontal
demand curve, therefore, the optimum
quantity depends on the market
determined price.
The decision rule is that the firm should
produce an additional unit of output if
the selling price is at least as great as the
marginal cost of production.
For example, if the price is taka 5, the firm
should produce seven(7) units because the
marginal cost of 7th unit is taka 5. 20
 Chapter-7: Market Structure
If the price increases to taka 6, the optimum quantity
would be 8 because the MC of 8th unit is taka 6.
What if the price declines to taka 3?
Applying to the same logic, it would seem that the firm
should produce 5 units.
Note that average variable cost at 5 unit is taka 3.40 and
total variable cost 17 taka. This Tk 17 is an expense that
could be avoided if the firm did not produce the 5 units of
output. Because the firm sells output for Tk. 3 per unit, its
total revenue is Tk 15. Hence, by producing, the firm adds
Tk. 15 to its total revenue but incur additional (and
avoidable) cost of Tk. 17. Adding the fixed cost of Tk. 5 to
the avoidable loss of Tk. 2 result in a total loss of Tk.7.
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 Chapter-7: Market Structure
At a price of Tk. 3, producing at any other output rate would cause equal or greater losses.
Analyze the cost and revenue structure at quantity 5, 4 and other units.

At 5th, VC= 17, TC = 22, TR = 15, loss = 7

At 4th, VC = 14, TC = 19, TR = 12, loss = 7
At 3rd, VC = 12, TC = 17, TR = 09, loss = 8
At 6th, VC = 21, TC = 26, TR = 18, loss = 8
However, the manager do have another option, they could shutdown the firm’s operation.
In this case, there will be no revenue and

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 Chapter-7: Market Structure
no variable cost but there will be taka 5
as fixed cost.
Between the two options,
(i) continue operation and loss of at least
taka 7
(ii) suspend operation conceive a loss of
taka 5
Or what?...
The decision is yours as manager………….?
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 Chapter-7: Market Structure
In general, the decision rule is that a firm
minimized its losses by shutting down
when price drops below average variable
cost.
Suppose, the firm can sell at a price of taka 4,
which is equal to MC at 6th unit.
TR will 24 and TC will be 26 and loss will be
2, at any output level loss is even more.
Again is it optimum decision to shutdown as
it was before at a price of tk 3…Y/N…?
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 Chapter-7: Market Structure
If the firm shuts down, it must pay the fixed
cost of taka 5, however, by producing 6th
units, it can minimizes loss and it is only
tk 2.
Therefore, the firm minimizes loss by
continuing to produce.
The key to decision is an examination of price
in relation to variable cost.
As long as price exceeds average variable cost
the firm is better off if it continues to produce
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 Chapter-7: Market Structure
The reason is that revenue will be sufficient
to cover variable costs and make a
contribution to payment of the firm’s
fixed cost.
In contrast, shutting down means that firm’s
loss is the entire fixed cost.
In the diagram, when price falls below AVC,
(Ps), the firm minimizes its loss by
shutting down, if price greater, the loss
minimizes by continuing production.
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Chapter-7: Market Structure

MC
ATC
AVC

PΠ

Ps

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 Chapter-7: Market Structure
If price is greater than average variable cost,
but less than average total cost, the firm
earns less than a normal rate of profit but
losses less than if its operations were shut
down.
Finally, for price greater than or equal to
average total cost (i.e. P or greater), the
Π

firm earns at least a normal rate of

profit.

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 Chapter-7: Market Structure
Two qualifications apply to the basic decision
rule:
i). The rule does not necessarily mean that
managers should shutdown operations
every time price drops below average
variable cost.
In many cases, substantial costs are incurred
when production process is shut down and
also when it is restarted.
This costs must taken into account.
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 Chapter-7: Market Structure
ii). The distinction between short run and
long run.
The decision to shut down depends on
whether the firm can make a
contribution to its fixed cost by
continuing to produce.
In the long run there is not fixed cost,
buildings can be sold, equipment can be
auctioned off, purchase contracts can be
expired.
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 Chapter-7: Market Structure
Thus in the long run, if price goes down to
average total cost, the firm will shut
down and go out of business.
The same rule applies to short and long run
and a firm should continue to produce as
long as revenue exceeds variable or
avoidable costs.

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 Chapter-7: Market Structure
A bicycle manufacturer faces a
horizontal demand curve. The firm’s
total costs are given by the equation
TVC= 150Q- 20Q2+Q3, where Q is
quantity
Below what price the firm shut down
operations?

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Chapter-7: Market Structure

Thank you

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