UNIT 5

THEORY OF FIRM & MARKET STRUCTURE

In the previous units of this course, we have examined theories of production, cost and consumer
behavior. In this chapter, we shall see the behavior of price and output. We will use consumer and
producer behavior as our building blocks. By bringing together revenue and cost, we shall determine the
behavior of a profit maximizing business firm. This behavior determines supply for the entire market
which interacts with demand to establish market price and output. The most important factor that
determines firms’ choice of price and output is market structure. In other words, we shall see theory of
firm and market structure.

5.1. The firm and its objective

A firm is an organization that employs factors of production to produce goods and services for the
market. A firm may be in the form of an individual proprietorship, a partnership or a joint stock
company.
The objective of business firms generally classified as
A) Maximization of profit
b) Maximization of sales revere
c) “ “Firm’s growth rate
d) “ “Managerial utility function
e) “ “firm‘s net worth
f) Satisfactory or standard profit
g) Long-run survival and market share
Since profit maximization is the primary objective of the firm, we shall see it in detail.
Profit is defined as the excess of total revenue over total cost i.e. TT=TR-TC. Profit would be maximum
when TR-TC is maximum; therefore a profit maximizing firm seeks to maximize the difference between
TR & TC.
A firm can use two methods to identify the profit maximizing output level i.e. total approach and
marginal approach.

A) Total approach: -- as it is stated above, in this approach, we use total revenue (TR) and total cost
(TC) curves to determine the profit maximizing output level.

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As it is shown in the figure, there are three different profit region and profit types; these are:
i)The region where the firm gets negative profit / loss/ (i.e. when TR<TC)when the firm produce and
sells less than 5 units and greater than 11 units of output.
ii) The region where the firm earns zero (i.e. when TR=TC) profit; that is when the firm produces and
sells 5 and 11 units of output.
Iii) The region where the firm gets positive profit (i.e. when TR>TC) that is when the firm produces and
sells output between 5 and 11 units of output. Whereas the maximum profit is earned when the firm
produces and sells 9 units of output. Because at this level of output, the difference between total revenue
and total cost will be maximum. This level of output is called optimal output whereas the output level
which makes profit zero is called break even output level.
B) Marginal Approach In this approach we use marginal revenue / MR/and marginal cost /MC/ curves
to determine the profit maximizing level of output.

5.2. Market structure

Market structure refers to the organizational features of an industry that influences the firm’s behavior in
its choice of price and output. According to its behavior and size market structures are classified in to
four. These are:
i) Perfectly competitive market
ii) Monopolistically competitive market
iii) Oligopoly market
iv) Pure monopoly
From among these market structures, we shall discuss about perfectly competitive & pure monopoly
market in the coming section.

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5.2.1. Perfectly competitive market
Perfectly competitive market is characterized by a complete absence of rivalry among the individual
firms as there are so many firms in the industry so that no personal recognition among individual firms
in the market.

5.2.1.1. Basic assumptions (behavior of Perfect competition)

Perfect competition is characterized by the following assumptions:
A) Large number of sellers and buyers
The industry or market includes a large number of firms; so that on the supply side, each firm has small
Share relative to the total market, in that it cannot affect market price by changing its output supplied.
The buyers are also numerous; so that on the demand side, individuals’ influences on the total market is
very small. This means that each buyer purchases a small portion of the total market that he cannot
obtain special consideration of price reduction from the seller.
B) Homogenous product
The product of each seller is identical to the product of every other seller. There is no way in which a
buyer could differentiate among the products of different firms.
The assumption of large number of sellers and of product homogeneity implies that the individual firm
in pure competition is a price taker. Its demand curve is infinitely elastic, indicating that the firm can sell
any amount of output at the prevailing market price. The demined curve of the individual firm is also its
marginal revenue curve.

C) Perfect knowledge or perfect information

Each buyer has full information about price, quality of the product and other characteristics of the
product. Each seller also has full information about price and quality of the product, input price,
technology, future price of the product etc.

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D) Free entry and exit of firms
There is no legal or market barrier on entry of new firms to the industry as a result when normal profit of
the industry increase, new firms enter the industry and if profits decrease firms leave the industry.

5.2.1.2. Short –run equilibrium and supply curve of the firm

The firm is in equilibrium when it realizes maximum profits or minimum losses. It can decide this profit
maximizing output level using Total approach or marginal approach as it is discussed in the preceding
section. When we use the marginal approach, two conditions should fulfill.
The first order condition for maximization of a function is that its first derivative would be equal to zero.
𝑑𝜋 𝑑𝑇𝑅 dTC
i.e.𝑑𝑄 = − =0
𝑑𝑄 dQ
𝑑𝑇𝑅 𝑑𝑇𝐶
i.e. 𝑑𝑄 = => MR = MC (Slopes)
𝑑𝑄

The second order condition for maximum profit requires that the second derivative of the function must
be negative implying that
𝑑2𝜋 𝑑𝑥 2 𝑇𝑅 d 2 TC
i.e. = − <0
𝑑𝑄 2 𝑑𝑄 2 dQ 2

𝑑 2 𝑇𝑅 d 2 TC
i.e. < => 𝑆𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝑅 < 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 𝑀𝐶
𝑑𝑄 2 dQ

As you know, slope of the MR = 0 in perfect competition since it has horizontal demand curve. Thus the
MC to be less than zero it must be rising. That is why the maximum profit is attained when MR=MC
and MC is rising.
In the short-run equilibrium, a firm may not earn profits. In the short-run, it may earn just a normal
profit or even make losses. Whether a firm makes abnormal profits, normal profits or losses, depends on
its cost and revenue conditions. Given the price and cost information the firm should produce at a point
where MR=MC and MC is rising. In the short –run, the firm may have either of the following types of
profits.

i) Abnormal /super normal or positive/ profits, when the price is greater than minimum of SAC at
equilibrium point.

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The firm’s profit is TR-TC=>OP4cq4-Oabq4= P4acb or the shaded region

ii. Normal profit when the price equals minimum SAC at equilibrium point.
When the price P4 fails P3 it becomes equal to SAC minimum; as result profit will be zero ( Normal
profit ) i.e. Π =TR – TC=>P(AR)xQ - ACxQ =>OP3xOq3- OP3xOq3 =>0P3bq3-0P3bq3=0
This means the firm covers all of production costs i.e. fixed and variable costs. This point (the point that
makes TR=TC) is called breakeven point where as the output sold at this breakeven point is break
evenoutput.

iii) What will be the profit, if the price again decrees to P2? At this price, the firm covers only the
variable cost; so it incurs loss with the amount as equal as its fixed cost. At this time, it is advisable for
the firm to continue its production since in cannot save its fixed cost by ceasing / stopping production.
The firm s loss is show in the finger below.

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The optimum output level is q2 since MR=MC and MC is rising at this level of output. At q2,
Π=OP2xOq2-Oc x Oq2 =>OP2aq2-Ocbq2 =p2cba which is loss.

Iv. What could be the profit if the price decreases below P2, i.e. P1 which is below the minimum
SAVC.
At this time, the firm minimizes its loss by ceasing production because for any price less than the
minimum SAVC the loss will be more than the firm’s fixed cost. As a result the firm should close
production just to save its variable cost. As a result the point where the price equals SAVC minimum is
called shut down point and the price is shut down price. Because at any price below OP1, it pays a firm
to close down as it minimizes its loss.

 = TR – TC = OP1x Oq1 – OC x Oq1

= OP1aq1 – Ocbq1, which is loss with the amount as equal as total fixed cost and total variable cost. In
other words, the firm not saves even its variable cost.
Now let as see numerical example on profit determination using marginal approach.
Suppose a firm operating in a perfectly competitive environment is faced with a market price of birr 250
per unit of the product. And the firm’s short-run cost function is as given below

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TC = q3 – 20q2 + 4000q + 6000
If) should the firm produce at this price in the short-run
ii) If the market price is birr 300 per unit, what will total profits or losses be? Should the firm continue to
produce at this price?

The supply curve of an individual firm is derived on the basis of its equilibrium output. The equilibrium
output which is determined by the intersection of MR and MC curves is the optimum supply by a profit
maximizing (cost minimizing) firm. To retain in the business and continue production the firm must
cover its SAVC. For this reason the price must be at least equals with SAVC i.e. P1. It means that when
the price is P4 the firm produces q4 units of output i.e. point c of the MC curve in the figure below.
When price decreases to P3 the equilibrium point shifts to point ‘b’on MC curve and the firm produces
and supplies q3 units of output which is lower than the output at P4. Let the price fails further to P2 so
that the equilibrium output fails to q2 and equilibrium point to ‘a’ on MC curve. But if the price further
decreases to P1, the firm stops production and its supply will be zero. From this we can understand that
the firm’s supply curve is that the segment of the marginal cost curve above the minimum of SAVC.

5.2.1.3. Short run equilibrium and supply curve of the industry

We have already discussed the equilibrium of the firm in the short run. To complete the discussion on
short run price and output determination, we discuss now the short equilibrium and supply curve of the
industry.
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.

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Whereas the supply of the industry in the short run is the sum of short -run supply of the firm in the
industry.

5.2.1.4. Long run equilibrium of the firm

The shortly run by definition , is a period in which firm’s cost and revenue curves are given, firms
cannot change their size as 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. Long run
permits change in technology and employment of both labor and capital .i.e. firms can change their size,
some of the existing firms may leave and new firms may enter the industry. In the long run supply curve
not only shift right word but also becomes more elastic. Thus, a firm is in equilibrium under perfect
competition when marginal cost is equal to price. But for the firm to be in the long run equilibrium,
besides marginal cost being equal to average cost, the price must also be equal to average cost. This is
because, if the price is greater than average cost, the firm will earn more than normal profit. These super
normal profits will attract other firms in to the industry. With the entry of new firms in the industry, the
price of the product will decline as the result of the increase in the supply of the output and the cost will
increase as a result of more competitive for factors of production. The firm will continue entering in to
the industry until the price is equal to average cost so that all firms are earning only normal profit. If the
price is below the average cost the firms in the industry incur losses. To avoid heavy losses, some firms
leave the industry. This decrease the production and forces the price to stay at the average cost, so that
the firm remaining in the industry make normal profit.
It, therefore, follows that for a perfectly competitive firm to be in long run equilibrium, the following
condition must be fulfilled.
1) Price (AR) = LMC=MR
2) Price=average cost

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Hence in the long run, the firm will be in equilibrium if price=AR=LMC =LAC=MR this condition can
be illustrated with the help of graph as follow

At price OP4 , the firm is in equilibrium at point c at output Oq4.The firm earns per unit abnormal profit
of ‘cb’ ,as a result new firms enter the industry and increase production .The increase in production
lowers down the price to OP3.If the price is OP2 which is bellow LAC, the firms will incur losses. In
consequence, to avoid losses, the firms will leave the industry in the long run. This reduce supply in the
market raising the price to OP3 to equal average cost; where the firm makes normal profit andthe LAC is
tangent to the demandcurve( P3=MR3=AR3=DD3). So in the long run firm’s supply will be the output
level in which P= AR= MR= LMC= LAC=SMC = SAC.

5.2.1.5. Long run equilibrium and supply curve of the industry

An important condition for the industry to be in equilibrium is that it produces the level of output at
which the quantity demand and the quantity supplied of its product are equal. This is achieved at which
all firms are in equilibrium producing at the minimum point of LAC curve and maximizing just normal
profits. Under this condition, no further entry or exit of firms in the industry.

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We have earlier derived the short run supply curve of the industry by summing up horizontally the
supply curve of the individual firms. Whereas the shape of the long run supply curve of an industry,
under perfect competition depends on whether factors price remain constant increases or decreases.

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