Topic 4: Market Structures

Perfect Competition

The Four Market Structures

• Economists have identified four market structures in which firms operate: – perfect competition– monopoly– monopolistic competition– oligopoly

The characteristics of Perfect Competition

–A large number of buyers and sellers–Price takers (price and quantity are

determined by demand and supply)–Selling homogeneous (standardized) product–Free market entry and exit–No advertising

Near perfect competition

• Examples

Gold

Nasi Lemak

Eggs

An Individual Price Taker’s Demand Curve

• Perfectly competitive firms are price takers, selling at the market-determined price.• In other words, the demand is

perfectly elastic (horizontal) at the market price.

• Sellers are provided with current information about market demand and supply conditions as a result of price changes.

A Change In Market Price And A Change In Market Price And The Firm’s Demand CurveThe Firm’s Demand Curve

DD= Price = MR = AR

Profit maximizing Output Decision

Maximize Revenue : Minimize

cost

MR = MC

Based on the table above, which output level should be produced at in order to maximize

the profits?

Short-Run–There are 3 possibilities: •earning profits •generating losses•breaking even

Perfect Competition

Diagrammatic representation

Cost/Revenue

Output/Sales

The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR

P = MR = AR

MC

The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises.

AC

The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values.

Q1

Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply.

At this output the firm is making normal profit. This is a long run equilibrium position.

Perfect CompetitionDiagrammatic representation

Cost/Revenue

Output/Sales

P = MR = AR

MC

AC

Q1

Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method). What would happen?

AC1

MC1

AC1Abnormal profit

Q2

Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again.

P1 = MR1 = AR1

The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area.

Average and Marginal costs could be expected to be lower but price, in the short run, remains the same.

• A firm generating an economic loss faces a tough choice. • Should it: –Continue to produce or –Shut-down its operation?

Evaluating Economic Losses In Evaluating Economic Losses In The Short RunThe Short Run

Cont’

• To make this decision, we need to consider average variable costs (AVC).

Shutdown decision rule

•P < min AVC – Shutdown•P ≥ min AVC – Continue operating

Long-Run Equilibrium

• Since there is no barriers to enter and exit the market (free market entry and exit),

PROFIT

loss LOSS

Entry of new players SS Price TR

Exit players SS Price TR

• In long run‑ equilibrium, perfectly competitive firms make zero economic profits, earning a normal return on the use of their capital.

Economic Profits And Losses Economic Profits And Losses Disappear In The Long RunDisappear In The Long Run

Reference•Chapter 8•Tucker