Market Structure

• Types of market structure:– Perfect Competition– Monopoly– Monopolistic Competition– Oligopoly

• Discussions:– Characteristics of each market– Demand curve (AR) and MR– Profits-maximization rule– Short run and long run output decision

Perfectly competitive marketCharacteristics:• Large number of buyers and sellers in the market. Firms are

price takers because the individual sales volume is relatively small compared to market volume.

• Each firm/ seller or each buyer acts independently, rather than coordinating decisions collectively

• Each firm produces a homogeneous (an identical) product: buyers cannot distinguish the product of one seller from that of another.

• Perfect information about prices– The prices of all sellers are known– A consumer will purchase at the lowest price available in the market– No sale can be made at any higher price.

• Free entry into and exit from market: Equal access to resources

• Absence of promotion strategy and transport cost.

Demand (AR) and MR curve

• Total revenue (TR) = P x Q• Average revenue (AR) = TR / Q = P• Marginal revenue (MR) = ΔTR / ΔQ

P Q TR=P x Q AR= TR/Q MR= ΔTR/ ΔQ

101010

123

102030

101010

101010

Kuantiti (Q)

P, AR, MR

P = AR = MR10

0 1 2 3

Demand at the market and firm level under perfect competition

Firm Market (industry)

RM10

Output

P

D

D S

S

RM10

2000 Output

P

P = AR = MRD

0 1 2

Equilibrium of a Firm

• A firm is in equilibrium when it earns maximum profit or when minimum losses occur.

• Equilibrium output = output level which gives the maximum profit to a firm.

Profit maximization• Total revenue and total cost approach

– Profit = TR – TC– Profit maximization: the highest vertical distance

between TR and TC.

• Marginal revenue and marginal cost approach– Profit maximization: MR = MC

Profit maximization under perfect competition

• Short-run output decision: MR = MC– P > AC firm earns economic profits/abnormal profit– P = AC zero economic profits/ normal profit– P < AC firm suffers economic losses– P < AC but P ≥ AVC loss by operating, but this loss

< FC– P < AVC shut down

• Long-run output decision

Short-run output decision

• P > AC • P = AC

MCAC

P1

P2

Q0Output (Q)

Price & costs

A

B

AR=MR=P=DD

TR = 0QAP1

TC = 0QBP2

Profit = TR – TC = P1ABP2

ACMC

AR=MR=P=DDAP

Q

Price & costs

Output (Q)0

TR = 0PAQ

TC = 0PAQ

Profit =TR –TC = 0

Firm incurs a loss

• P < AC but P > AVC

MCAC

AR=MR=P

Q0

P1

P2 A

B

TR = 0QBP1

TC = 0QAP2

TR < TC, firm incurs a loss = P1BAP2

This firm can reduce cost by using a better technology to obtain normal profit. AC shifts downwards.

MC AC

AVC

output

Harga & kos

output

Harga & kos

0

A

B

E

P

C1

C2

Q

TR = 0PBQ = 0C2EQ + C2EBP

TC = 0C1AQ = 0C2EQ + C2EAC1

The firm incurs a loss, but TR > VC or AR > AVC

P < AC – a loss

AR=MR=P

• MC and short-run supply curve for a competitive firm

AC

AVC

MC

Po

P1

P2

P3

Qo Q1 Q2 Q3

J

K

L

M

MC curve at points JKLM = a firm’s SS curve

Output

Price

Long-run competitive equilibrium• Free entry into and exit from market: if profits were

+ve, entry would occur and P would fall. If profits were –ve, exit would occur and P would rise. Ultimately P = AC, all firms in the market earn zero economic profits/ normal profit. P = MR= MC, P = minimum AC.

LACLMC

SACSMC

AR=MR=P

Q Output

P

0

Harga & kos

Calculation approach:

1. The cost function for a firm is given by

C = 5 + Q2

If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of RM20, what price should the manager of this firm put on the product? What level of output should be produced to maximize profits? How much profits will be earned?

Answer:

- The manager should price the product at RM20

- Profit-maximizing output: MC = P.

MC = 2Q = 20, Q = 10

- Profits = TR – TC = PxQ – (5 + Q2)

= 10(20) – 5 – 100

= RM95

2. Suppose the cost function for a firm is given by C = 100 + Q2. If the firm sells output in a perfectly competitive market and other firms in the industry sell output at a price of RM10, what level of output should the firm produce to maximize profits or minimize losses? What will be the level of profits or losses if the firm makes the optimal decision?

Answer: P = RM10, MC = 2Q.Profit maximizing output: P = MC, 10 = 2Q,

Q = 5 units. Profit = TR – TC =10(5) – 100 – 52

= 50 – 100 – 25 = -RM75 The firm incurs a loss of RM75, which is

less than the loss of RM100 (fixed costs) that would result if the firm shut down its plant in the short run.

3. A vegetable seller faces a horizontal demand curve. Total variable costs are given by TVC=150Q – 20Q2 + Q3. At what price should the firm shut down?

Solution:Shut down point occurs when AVC is at the minimum point. It

also happens when P=MR=MC=AVC. Derive TVC to obtain MC. MC = dTVC/dQ = 150 – 40Q +3Q2

Divide TVC by Q to obtain AVC: AVC = TVC/Q = 150 – 20Q + Q2

To find shut down price, set MC = AVC: 150 – 40Q + 3Q2 = 150 – 20Q + Q2

2Q2 – 20Q = 0, 2Q(Q - 10) = 0 Q = 0 or Q = 10Substitute Q = 10 into the MC equation to obtain PP = MC = 150 – 40(10) + 3(10)2 = 50Shut down price is RM50.