THEORY OF MARKET STRUCTURE

FIRMS IN COMPETITIVE MARKETS

 Types of Market Structure
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
 - classification based on the degree of
competition

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 Determinants of market structure

 Freedom of entry and exit

 Nature of the product – homogenous (identical),
differentiated?
 Control over supply/output
 Control over price
 Barriers to entry

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 Characteristics of Perfect Competition
1.
1. Many
Many buyers
buyers and
and many
many sellers.
sellers.
2.
2. The
The goods
goods offered
offered for
for sale
sale are
are largely
largely the
the same-
same-
Homogenous
Homogenous products
products
3.
3. Firms
Firms can
can freely
freely enter
enter or
or exit
exit the
the market.
market.
4.
4. Sellers
Sellers are
are price
price takers
takers –– have
have toto accept
accept the
the
market
market price.
price.
5.
5. Perfect
Perfect information
information available
available to
to buyers
buyers and
and
sellers
sellers

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 Examples
 In the real world, it is hard to find examples of industries which fit all the
criteria of ‘perfect knowledge’ and ‘perfect information’. However, some
industries are close.
 Foreign exchange markets. Here currency is all homogeneous. Also,
traders will have access to many different buyers and sellers. There will be
good information about relative prices. When buying currency it is easy to
compare prices
 Agricultural markets. In some cases, there are several farmers selling
identical products to the market, and many buyers. At the market, it is easy
to compare prices. Therefore, agricultural markets often get close to perfect
competition.
 Stock Markets :Several firms selling shares

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 The Revenue of a Competitive Firm
 Total revenue (TR) TR = P x Q

 Average revenue (AR) TR

AR = =P
Q
 Marginal revenue (MR):
The change in TR from ∆TR
MR =
selling one more unit. ∆Q

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 MR = P for a Competitive Firm
 A competitive firm can keep increasing its output
without affecting the market price.
 So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

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 Profit Maximization
 What Q maximizes the firm’s profit?
 To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
 If MR > MC, then increase Q to raise profit.
 If MR < MC, then reduce Q to raise profit.

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 Profit Maximization

Q TR TC Profit MR MC
Profit =
At any Q with MR – MC
MR > MC,
0 $0 $5 –$5
increasing Q $10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

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 MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.

At Qa, MC < MR. Costs

So, increase Q MC
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit. P1 MR

At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q1 Qb

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 MC and the Firm’s Supply Decision
If price rises to P2,
then the profit- Costs
maximizing quantity MC
rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2

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 A Firm With Profits

Costs, P
MC
revenue per unit = P MR
profit per unit = P – ATC profit ATC
cost per unit = ATC

Q
Q
profit-maximizing quantity
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 A Firm With Losses

Costs, P
MC

ATC

cost per unit = ATC

loss loss per unit
revenue per unit = P MR

Q
Q
loss-minimizing quantity
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 Shutdown vs. Exit
 Shutdown:
A short-run decision not to produce anything
because of market conditions.
 Exit:
A long-run decision to leave the market.
 A key difference:
 If shut down in SR, must still pay FC.
 If exit in LR, zero costs.

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 A Firm’s Short-run Decision to Shut Down
 Cost of shutting down: revenue loss = TR
 Benefit of shutting down: cost savings = VC
(firm must still pay FC)
 So, shut down if TR < VC
 Divide both sides by Q: TR/Q < VC/Q
 So, firm’s decision rule is:

Shut down if P < AVC

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 A Firm’s Long-Run Decision to Exit
 Cost of exiting the market: revenue loss = TR
 Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
 So, firm exits if TR < TC
 Divide both sides by Q to write the firm’s
decision rule as:

Exit if P < ATC

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CONCLUSION: The Efficiency of a Competitive
Market
 Profit-maximization: MC = MR
 Perfect competition: P = MR
 So, in the competitive eq’m: P = MC
 Recall, MC is cost of producing the marginal unit.
P is value to buyers of the marginal unit.
 So, the competitive eq’m is efficient, maximizes
total surplus.

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 Summary

 For a firm in a perfectly competitive market,

price = marginal revenue = average revenue.
 If P > AVC, a firm maximizes profit by producing
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.

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