Market structures – Perfect competition

Market Structures Market structure refers to the number and

size of buyers and sellers in the market for a good or service.

A market can be defined as a group of firms willing and able to sell a similar product or service to the same potential buyers.

Classification of market structures 4 broad categories –

1. Perfect competition

2. Monopoly

3. Monopolistic competition

4. Oligopoly

Major features that determine market structure Number of sellers

Product differentiation

Entry and exit conditions

What we analyze in all Market Structures… AR, MR AC, MC The point where MR = MC ( Profit

maximum ) Q* ( Equilibrium Output ) P* ( Equilibrium Price )

Profit Normal Profit : That part of the cost that is

paid to the entrepreneur as a part of his compensation.

Super-normal Profit : The profit that the entrepreneur may get over and above the compensation he gets from the firm, for his contribution.

Perfect competition Features – 1. Large number of buyers and sellers2. Products are perfect substitutes of each other;

homogeneous products3. Free entry and exit from the market4. Perfect knowledge of the market to both buyers

and sellers5. No govt. intervention6. Transport cost are negligible hence don’t affect

pricing.

The Meaning of Competition

As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in

the market have a negligible impact on the market price.

Each buyer and seller takes the market price as given.

The Meaning of Competition

Buyers and sellers in competitive markets are said to be price takers.

Buyers and sellers must accept the price determined by the market.

Revenue of a Competitive Firm

Total revenue for a firm is the selling price times the quantity sold.

TR = (P X Q)

Revenue of a Competitive Firm

Average revenue tells us how much revenue a firm receives for the typical

unit sold.

Revenue of a Competitive Firm

In perfect competition, average revenue equals the price of the

good.

Average revenue=Total revenue

Quantity

=(Price Quantity)

Quantity

=Price

Revenue of a Competitive Firm

Marginal revenue is the change in total revenue from an additional unit sold.

MR =TR/ Q

Revenue of a Competitive Firm

For competitive firms, marginal revenue equals the price of the good.

Total, Average, and Marginal Revenue for a Competitive Firm

Quantity(Q)

Price(P)

Total Revenue(TR=PxQ)

Average Revenue(AR=TR/ Q)

Marginal Revenue(MR= )

1 $6.00 $6.00 $6.002 $6.00 $12.00 $6.00 $6.003 $6.00 $18.00 $6.00 $6.004 $6.00 $24.00 $6.00 $6.005 $6.00 $30.00 $6.00 $6.006 $6.00 $36.00 $6.00 $6.007 $6.00 $42.00 $6.00 $6.008 $6.00 $48.00 $6.00 $6.00

QTR /

Profit Maximization for the Competitive Firm

The goal of a competitive firm is to maximize profit.This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

Short run price and output determination In SR a firm has to decide about the output it

should produce at the market price so that profit is maximum.

Some inputs are fixed=> fixed costs A firm may stay in business to cover these costs

even if it incurs losses in SR Cost functions of firms are different as factors of

production are not homogeneous Hence each firm has different profit levels.

Revenue Concepts Total Revenue (TR) = Price X Quantity Average Revenue ( AR ) = TR / Q = PQ /

Q = P Marginal Revenue = TR

Q

Conditions for Profit Maximization MR = MC ( Necessary condition ) MCC should intersect MRC from below or

MCC should be rising

Price and output determination for a perfectly competitive firm

D

S

Q Q

P P

Industry Firm

P* P*

ACMC

Q* Q*

E

C B

A AR = MR

• Firm has to take the price as given by the market

•At the ruling price firm can sell any amount of its product

•Demand is perfectly elastic

•AR is parallel to X axis

•Equilibrium is at pt. E where demand is equal to supply

• This determines the price P*

• This price is taken by the individual firm

Equilibrium for the firm is where MR =MC and MC curve cuts MR curve from below. I.e. at point A

Profit in the short run is the P*ABC

The firm may incur short run losses also. If the AC curve lies above the AR=MR curve the firm in the short run will incur losses.

Profit

Q

Measuring Profit in the Graph for the Competitive Firm...

Quantity0

Price

P = AR = MR

ATCMC

P

ATC

Profit-maximizing quantity

A Firm with Profits

Loss

Measuring Profit in the Graph for the Competitive Firm...

Quantity0

Price

P = AR = MR

ATCMC

P

QLoss-minimizing quantity

ATC

A Firm with Losses

Long run equilibrium of the firm and industry All factors are variable in the long run Hence all costs are variable Firm can change the plant and adjust the

capacity according to the requirements of production

If profits are supernormal, more firms enter the market and vice versa.

Entry and exit of firms is possible

Long run equilibrium of the firm and industry If the number of firms increase, ( because they

might be attracted towards the supernormal profits ), or the same firms increase their production, the supply curve moves to the right. At the same demand, this results in a decrease in price.

If the number of firms decrease, ( because of losses ), or the same firms decrease production, the supply curve shifts to the left. At the same demand, this results in an increase in price.

Long run equilibrium of the firm and industry Hence, in the long run, supernormal profit is not

possible and all firms have to survive at a Normal profit.

This means that all the firms will stop production at the point where AC is lowest. This is also the price they will sell the goods at.

Hence in the long run, firms have no incentive to expand or contract their production capacity or leave the industry and new firms have no incentive to enter the industry.

MR = MC in long run as well Under perfect competition, since MR =AR, in

equilibrium also MC is equal to AR Price must also equal AC. P > AC => supernormal profits New firms enter the market If there are losses, firms will leave the market. Thus in the long run equality of P and AC

becomes a necessary condition. Thus,

P(AR) =MR =AC = MC in the long run

Long run