FOUR TYPES OF MARKETS Perfect CompetitionPerfect Competition --- A market with a very large number of firms, each of which produces the same standardized

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Perfect Competition Perfect Competition ---

A market with a very large number of firms, each of which produces the same standardized product and takes the market price as given.

A price-taking firm.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Monopolistic Competition Monopolistic Competition ------

There are many firms, each sells a differentiated product. Because products sold by different firms are not perfect substitutes, each firm has some control over price. There are no barriers to entering the market.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Oligopoly --- There are just a

few firms in the market, a result of two sorts of barriers to entry:

• economies of scale,

• government may limit number of firms in the market

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Monopoly ---

A single firm serves the entire market. A monopoly occurs when the barriers to entry are very strong, which could result from very large economies of scale or a government limit on the number of firms.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Monopoly ---

EXAMPLESlarge scale economies:

• local phone service,

• electric power generation,

established by government policy:

• drugs covered by patents,

• concessions in National Parks

Characteristics of Different Types of MarketsCharacteristics of Different Types of Markets Perfect Monopolistic Oligopoly

Monopoly Competition Competition

Number very large many few one of firms

Type of standardized differentiated std or diff. uniqueproductControl none slight considerable considerableover price if not

regulatedEntry no barriers no barriers large largeconditions barriers barriersExamples wheat restaurants automobiles local phone soybeans retail stores air travel and electric

clothing breakfast patentedcereal drugs

TOTAL REVENUETOTAL REVENUE

• The money the firm gets from selling its product and is equal to price times quantity sold:Total Revenue = price Total Revenue = price ** quantity quantity

ECONOMIC PROFITECONOMIC PROFIT

Economic Profit = Total revenue - total economic costEconomic Profit = Total revenue - total economic cost

Total economic cost Total economic cost

= explicit costs= explicit costs

( firm’s actual cash payments for inputs )

+ implicit costs + implicit costs

( opportunity costs of non-purchased inputs, such as entrepreneur’s time or money )

ECONOMIC PROFITECONOMIC PROFITECONOMIC PROFITECONOMIC PROFIT

Total revenue - total economic costTotal revenue - total economic cost






Total revenue - total economic costTotal revenue - total economic cost






THE MARGINAL PRINCIPLETHE MARGINAL PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.

Marginal Benefit of Firm’s ActivityMarginal Benefit of Firm’s Activity

Extra revenue earned by selling one more unit of output.

Marginal Revenue

The change in total revenue that results from selling one more unit of output.

For a perfectly-competitive firm, marginal revenue equals market price.

EXAMPLE

Farmer sells 100 bushels of corn @ $200;

Farmer sells 101 bushels of corn @ $202;

Marginal revenue of 101st bushel is $2 (i.e., the same as price).

Applying Marginal Principle to Output DecisionApplying Marginal Principle to Output Decision

The marginal principle suggests that the firm should pick the quantity of output at which marginal revenue equals marginal cost:

Marginal revenue = Marginal cost

Continue to increase output as long as extra revenue from one unit of output exceeds extra cost.

Applying Marginal Principle to Perfect CompetitionApplying Marginal Principle to Perfect Competition

For a perfectly-competitive (price-taking) firm, marginal revenue equals the market price, so the firm should pick quantity of output at which price equals marginal cost:

Price = Marginal Cost

Picking the Profit-Maximizing Output Picking the Profit-Maximizing Output LevelLevel

Output Marginal Revenue = Price Marginal Cost

14 $36 $12

17 $36 $18

20 $36 $24

25 $36 $36

27 $36 $43

COST / PRICECOST / PRICE

OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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PRICE = MR = $36 PRICE = MR = $36

Profit Maximizing OutputProfit Maximizing OutputShort-Run Marginal CostShort-Run Marginal Cost

(SMC)(SMC) ff

ee

Short-Run AverageShort-Run AverageTotal Cost (SATC)Total Cost (SATC)


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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(SMC)(SMC) ff

ee


bbcc

Profit = $250 per hourProfit = $250 per hour

ECONOMIC PROFIT AND ECONOMIC PROFIT AND ACCOUNTING PROFITACCOUNTING PROFIT

Total Profit = [Price - Average cost] ** Quantity

If average cost of producing 25 chairs is $26:

firm’s average profit = $36 - $26 = $10

firm’s total profit = $10 • 25 chairs = $250

firm’s total profit = [$36 - $26] • 25 = $250


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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(SMC)(SMC) ff

ee


bb

ECONOMIC PROFIT AND ACCOUNTING PROFIT

Total Profit = (Price - Average Cost) ** Quantity

If the Price is $24, the firm satisfies marginal principle (price = marginal cost) at point b, with 20 chairs.

At this quantity, the price also equals average cost, so economic profit is zero.

When a firm earns zero economic profit, it earns a normal level of accounting profit.

ECONOMIC PROFIT AND ACCOUNTING PROFITECONOMIC PROFIT AND ACCOUNTING PROFIT

Accounting Profit is equal to total revenue minus explicit costs;

Normal Accounting Profit is the accounting profit when economic profit is zero;

(A firm’s implicit costs are covered).

If firm producing 20 chairs has an explicit cost of $400 and implicit cost of $80, and

Total Revenue = $24 ** 20 = $480;

while economic profit = 0,

Total Revenue - ( explicit costs + implicit costs ) = 0

accounting profit = $80,

Total Revenue - explicit costs = $480 - $400 = $80


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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The Shut-Down DecisionThe Shut-Down DecisionShort-Run Marginal CostShort-Run Marginal Cost

(SMC)(SMC) Short-Run AverageShort-Run AverageTotal Cost (SATC)Total Cost (SATC)

zz

1717

The Shut-Down DecisionThe Shut-Down Decision

If market price of chairs drops to $18, the firm will produce 17 chairs per hour (point z).


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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tt

zz

1717

The Shut-Down DecisionThe Shut-Down DecisionAt an output of 17 chairs per hour, the

average total cost becomes $26 (point t).

Since the average cost exceeds the market price by $8, the firm will lose $136 per hour.

$8 ** 17 = $136


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

55 1010 1515 2020 2525 3030 3535 4040


The Shut-Down DecisionThe Shut-Down DecisionThe Shut-Down DecisionThe Shut-Down DecisionShort-Run Marginal CostShort-Run Marginal Cost


tt

zz

1717

Loss = $136 / HrLoss = $136 / Hr


The firm should continue to operate an unprofitable facility if the benefit of operating the facility exceeds the cost.


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

55 1010 1515 2020 2525 3030 3535 4040




Short-Run AverageShort-Run AverageVariable Cost (SAVC)Variable Cost (SAVC)

tt

zz

1717

Loss = $136 / HrLoss = $136 / Hr


The benefit equals the total revenue generated by the facility.

The firm’s operating cost is the cost incurred by operating -- as opposed to shutting down:

The firm’s variable cost

(cost of labor and material)


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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tt

zz

uu

1717

1414

Loss = $136 / HrLoss = $136 / Hr

The Shut-Down Decision The Shut-Down Decision The benefit = Total Revenue:

Total Revenue = Price ** quantity sold

Total Revenue = $18 ** 17 = $306

The firm’s operating cost = variable cost:

Total variable cost = average variable cost ** quantity

sold

Total variable cost = $14 ** 17 = $238

Since the benefit ($306) is greater than the operating cost ($238), continue to operate


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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tt

zz

uuss

1717

14141212

Loss = $136 / HrLoss = $136 / Hr


OPERATE:

Price > Average variable Cost

SHUTDOWN:

Price < Average Variable CostWhy Operate an Unprofitable Facility ?Why Operate an Unprofitable Facility ?

If Firm Shuts down:

• Although no longer paying for labor, it still pays for idle production facility -- sunk cost.

• Because firm won’t sell any output, it will lose an amount of money equal to fixed cost.

Why Operate an Unprofitable Facility ?Why Operate an Unprofitable Facility ?

With 17 chairs:

Firm’s total cost = $442;

variable cost = $238, fixed cost = $204

If firm shuts down, firm loses $204;

If firm operates, it loses $136:

($8 ** 17 chairs)

$68 left to cover fixed costsThe Shut-Down PriceThe Shut-Down Price

The price at which the firm is indifferent between operating and shutting down: point ‘s’ of the following diagram.

If the total revenue is less than variable cost, the benefit of operating the facility is less than the cost; irrational to continue operating..


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

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ss

Shut-Down PriceShut-Down Price

Short-run Supply Curve of Short-run Supply Curve of The FirmThe Firm

The part of the firm’s marginal cost curve above the shut-down price.


OUTPUTOUTPUT

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

55 1010 1515 2020 2525 3030 3535 4040




ss

Shut-Down PriceShut-Down Price

Firm’s Short-run Supply CurveFirm’s Short-run Supply Curve

The Market Supply CurveThe Market Supply CurveThe short-run market supply curve shows

relationship between market price and quantity supplied by entire industry.

To compute market supply at particular price, use individual supply curves to determine how much output each firm produces, then add quantities to get total supply for industry.

COST / REVENUECOST / REVENUE

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

2020

Market Effects of Change in DemandMarket Effects of Change in Demand(SMC)(SMC)

(SATC)(SATC)

bb

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

$24 $24

1,0001,000

$24 $24 ee


CHAIRS PRODUCED / HOURCHAIRS PRODUCED / HOUR CHAIRS PRODUCED / HOURCHAIRS PRODUCED / HOUR

Short-runShort-runmarketmarketsupplysupply

DemandDemand

Market Effects of Change In Market Effects of Change In DemandDemand

• If market demand shifts to the right and intersects the market supply at $36 instead of $24, each firm produces more output.

• The market price now exceeds the average cost and an economic profit now occurs.


$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

2020

Market Effects of Change in DemandMarket Effects of Change in Demand(SMC)(SMC)

(SATC)(SATC)

bb

$5$5

$10$10

$15$15

$20$20

$25$25

$30$30

$35$35

$40$40

$45$45

$24 $24

1,0001,000

$24 $24 ee


CHAIRS PRODUCED / HOURCHAIRS PRODUCED / HOUR CHAIRS PRODUCED / HOURCHAIRS PRODUCED / HOUR

Short-runShort-runmarketmarketsupplysupply

$36$36

1,2501,250

ff

2525

$36$36

ECONOMICECONOMICPROFITPROFIT

NewNewDemandDemand

OriginalOriginalDemandDemand

Documents

FOUR TYPES OF MARKETS Perfect CompetitionPerfect Competition --- A market with a very large number of firms, each of which produces the same standardized