Chapter FIVE

Market STRUCTURE
Introduction:
•What is market structure?
•Types of market structure:
•Perfect competitive
•Pure monopoly
•Monopolistic competition
•Oligopoly
Perfect competitive market
•Definition: Perfect competition is a market structure
characterized by a complete absence of rivalry among
the individual firms
2.1 Nature of Perfect Competitive market
structure:
Assumptions:
a. Large number of sellers and buyers
Thus, no single buyer/seller can affect the market
b. Homogenous products:- this implies that individual firms
are price taker (P=MR=Demand).
c. Both buyers & sellers have perfect information about the
price, quality of a product
d. Free entry and exit of the firm
e. The goal of the firm is profit maximization
f. Perfect mobility of factor of production
g. Absence of government regulation


cost structure: similar to earlier discussion, per unit cost

(AVC&AC) have u –shape due to the law of variable
proportions (in the short run) and the law of returns to scale
(in the long run).

2.2 Demand and revenue functions

* firms are price takers and sell any quantity demanded at the
ongoing market price.
* hence, the demand function that an individual seller faces is
perfectly elastic ( or horizontal line).
Graphically,
 P

_
P price

Q
Figure 2.2: demand curve for firms operating under perfectively
competitive market.

•The same is true for buyers who are price taker.

• they just adopt a market price which is determined
through the interaction of demand & supply.
•Given this demand function, the total revenue (TR) of a
firm is given by the product of the market price and the
quantities of sales, i.e.
•TR= P * Q
•Since P is constant/fixed, TR is linear & a positive function of
quantity of sales.
•To increase TR, sale should rise
 TR

TR= P*Q

Q
Figure 5.3: Total Revenue for a firm facing a perfectively competitive
market
•Marginal and Average revenue:
•MR = ∆TR∕ ∆Q MR measures a change in TR with
respect to change in Q
•MR is the slope of TR.
•Average Revenue (AR):- it is a ratio of TR and quantity
•AR= TR/Q
•Note: under perfectively market: MR= AR=P
5.3 Short Run Equilibrium of the firm
•equilibrium when it produces that level of output
which maximizes its profit, given the market
price.
•Two approaches to determine the level of output
that maximize profit for the firm
• total approach
• marginal approach
• Total approach: the profit maximizing
level of output is that level of output at
which the vertical distance between the
TR and TC curves is maximum. (Provided
that the TR curve lies above the TC curve
at this point).
 TC
TR
TC, TR

Q1 Qe Q2 Out Put, Q

Fig. 5.3: TR=TC Conditions for equilibrium of a firm.

• Qe refers to the profit maximizing level of out put because

the vertical distance between TR & TC is the highest at
this point (i.e. profit is the highest)
• For all out put levels below Q1 and above Q2 profit is
negative because TC is above TR.
 Marginal approach
• In this approach the profit maximizing level
of output is that level of output at which:
– MR=MC and
– MC is increasing • the profit maximizing
out put is Qe, where
MC=MR and MC curve
MC, is increasing
MR • At Q*, MC=MR, but
MC since MC is falling at
this output level, it is
MR
not equilibrium out
put.
• For all output levels
ranging from Q* to Qe
the marginal cost of
Q* Q1 Q producing additional
unit of output is less
Fig. 5.4: MC=MR Condition for equilibrium of than the MR obtained
the firm from selling this
output.
• Hence the firm should
produce additional
Mathematical Derivation of the equilibrium
condition
*Profit () = TR-TC
• TC is a function of output, TC=f (Q)
• TR is also a function of output, TR=f (Q)
• Thus, profit is a function of output, =f (Q)
To determine the profit maximizing output we
find the first derivative of the  function and
equate the result to zero.
d 
dTR dTC
 0
dQ dQ dQ

• = MR – MC = 0
• = MR = MC ………………FOC, necessary
conditions
• The sufficient condition for maximization of II
is that the second derivative of the II function
should be less than zero (or negative) i.e.
d 2 d 2TR d 2TC d 2TR d 2TC
0  2 0 2

dQ 2
2
dQ dQ dQ dQ 2

Thus, slope of MR is less than the slope of MC, implying that MC is

increasing
In general, for a firm under perfect competitive market in the short-
run, profit is maximized when MR=AR=SRMC, provided that SRMC
curve is increasing so that it intersects the MR curve from below at
this point.

The firm may earn positive, normal or negative profit depends on the
level of ATC at equilibrium (see fig. 5.5).
i) When ATC is less than the market price at equilibrium, the firm
earns excess/positive profit (fig. 5.5a).
ii) When ATC is equal to market price, the firm earns just normal/zero
profit
iii) When ATC is greater then market price, the firm earns a
loss/negative profit (fig. 5.5b)
 MC

ATC
MC
ATC Loss
P=MR=AR P=MR=AR
Profit

Qe Q Qe Q
Fig. 5.5b: the firm incurs a loss
Fig. 5.5a: excess/economic profit

* The firm continues to produce irrespective of the existing loss as far as

the price is sufficient to cover the average variable costs. i.e. the firm
keeps on producing until P=min AVC.
* P< min AVC is the shut down point. This means if the market price
falls below the AVC, the TR of the firm is not sufficient to cover at
least the total variable cost, hence the firm should close (shut down)
its factory (business).
Exercise:
Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 and a TR of
$6,000 at equilibrium. Should the firm stop its operation? Why?
Numerical Example:
Suppose that the firm operates in a perfectly competitive
market. The market price of his product is$10. The firm
estimates its cost of production with the following cost function:
TC=10q-4q2+q3
i) What level of out put should the firm produce to maximize its
profit?
ii) Determine the level of profit at equilibrium.
iii) What minimum output is required by the firm to stay in the
market?
2.4 The
short run supply curve of the firm
and the industry
i) The short run supply curve of the firm

Thus, the short run supply curve of a perfectly competitive

firm is that part of MC curve which lies above the minimum
average variable cost (Shut down point)
 AC MC curve
P MC of the
AVC
firm

E3
8 P3=MR3
8
E2
P2=MR2
7 7
E1
6 P1=MR1
6

50 140 200 Q 50 140 200

Fig.5.6 The short run supply curve of a perfectly competitive firm is

obtained by connecting different equilibrium points E1, E2, E3 that
occurs at successive price levels p1, p2 and p3 respectively.

When the market price is $6, the firm supplies 50 units to maximize
its profit. As the price increases to $7, the equilibrium quantity
supplied increases to 140 units and so on.

ii) Short run supply curve of the industry

• Industry refers to the group of firms producing a homogenous

product.
• the industry supply is the total supply or market supply.
• The industry –supply curve is the horizontal summation of the
 5.5 Long-run equilibrium of the
firm
i) Equilibrium of an individual firm
• In the long run, firms are in equilibrium when they have
adjusted their plant size so as to produce at the minimum
point of their long run Ac curve, which is tangent (at this
point) to the demand curve defined by the market price.
• That is, firms just earn normal profit in the long-run
because market price is equal to the minimum long run
AC at this equilibrium point.
• Two reasons why firms earn just normal profit in the long-
run:
• A. Entry of new firms remove excess profits: if the firms
existing in the market are making excess profits (the market price
is greater than their LACs) new firms will be attracted to the
industry seeking for this excess profit.
 As a result of new entry of firms:
i. The individual demand curve shifts downwards
following a fall in market price
i. Market price falls due to a rise in supply by the new firms

ii. The cost curves shift upwards following a rise

in prices of factors of production resulted from
high demand for inputs by the new firms.
These changes (decrease in the market price and upward
shift of the cost curves) will continue until the LAC
becomes tangent to the demand curve defined by the
market price.
At this time, entry of new firms will stop since there is no
positive profit (since P = LAC) which attracts new
firms in to the market.
B. Exit of firms remove losses:
 if the firms are incurring losses in the long
run (P < LAC) they will leave the industry
(shut down).
 This will result in higher market price
(because market supply of the
commodity decreases) and lower costs
(because the market demand for inputs
decreases as the number of firms in the
market decreases).
 These changes will continue until the
remaining firms in the industry cover
their total costs inclusive of the normal
rate of profit.
• In general, long-run equilibrium is attained
when SMC = LMC = SAC = LAC = P = MR
• This implies that at the minimum point of the
LAC the corresponding short run plant is
worked at its optimal capacity so that the
minimum of the LAC and SAC coincide.
Long run shut down decision
 The long-run shut down decision (point) is different
from that of the short run.
 The firm shuts down if its revenue is less than its
avoidable or a variable cost.
 In the long run all costs are variable because the
firm can change the quantity of all inputs.
 Thus, in the long run the firm shuts down when its
revenue falls below the long run total cost (i.e. P<
The long-run supply curves the firm
& industry
A firm’s long- run supply curve is its
LMC curve above the minimum of its
long-run average cost curve. It is
upwards sloping.
The long run supply curve of the
industry is the horizontal sum of the
supply of individual firms just like the
case of short run supply curve of the
industry.
 Long-run equilibrium of the
industry
An industry is in the long-run equilibrium when the price is reached at which all
firms are in equilibrium. At this price all firms are in equilibrium because
LMC=SMC=P=MR and they get only normal profit because LAC=SAC=P.
P Industry P
supply
LMC LAC

SMC
SAC

Pe Pe P=MR

Market
demand

Q Q
Industry Firm’s
equilibrium equilibrium
Fig 5.6: long-run equilibrium of the industry is defined by the price
at which all individual firms are in equilibrium, marking just normal
profit.
 5.2. Common characteristics of monopoly

• 1. Single Seller: It is a market structure in which the

entire supply is controlled by one firm, which implies
that the firm and industry are same.
• 2. No clear substitutes: there are no close
substitutes for the goods produced.
• 3. The monopolist is the price maker: It does not
take a price which is determined by the interaction of
market demand and market supply. In order to expand
its sale, it decreases the price of the commodity.
• 4. Blocked entry: Entry is blocked in such market
structure. The barriers may be legal, financial, and
natural.
• 5. No Collusion and Competition: Because there is
only one firm there is no competition exists and no
collusion among firms also.
Causes for the existence of the
monopoly:
• Exclusive knowledge of technology.
• Exclusive ownership/access to strategic
raw materials needed for production.
• Government Policies: Patent Rights.
• Size of market: The size of the market
may not allow more than a single seller.
• Natural Monopolies: Electricity, Water
etc.,
5.3. Monopolistically competitive market
• This market model can be defined as the market
organization in which there are relatively many
firms selling differentiated products.
• It is the blend of competition and monopoly. The
competitive element arises from the existence of
large number of firms and no barrier to entry or
exit.
• The monopoly element results from differentiated
products, i.e. similar but not identical products.
• A seller of a differentiated product has limited
monopoly power over customers who prefer his
product to others.
• His monopoly is limited because the difference
between his product and others are small enough
that they are close substitutes for one another.
 This market is characterized by:

• (i) Differentiated product: the product produced

and supplied by many sellers in the market is
similar but not identical in the eyes of the buyers
• (ii) Many sellers and buyers: there are many
sellers and buyers of the product, but their number
is not as large as that of the perfectly competitive
market.
• (iii) Easy entry and exit: like the PCM, there is
no barrier on new firms that are willing and able to
produce and supply the product in the market.
• (iv). Existence of non-price competition:
Economic rivals take the form of non-price
competition in terms of product quality,
advertisement, brand name, service to customers,
etc.
 5.4. Oligopoly market
• Few dominant firms: there are few firms although
the exact number of firms is undefined. Each firm
produces a significant portion of the total output.
• Interdependence: since few firms hold a
significant share in the total output of the industry,
each firm is affected by the price and output
decisions of rival firms.
• Entry barrier: there are considerable obstacles
that hinder a new firm from producing and
supplying the product. The barriers may include
economies of scale, legal, control of strategic
inputs, etc.
• Products may be homogenous or
differentiated. If the product is homogeneous, we
have a pure oligopoly.
• Lack of uniformity in the size of firms:
Firms differ considerably in size. Some may
be small, others very large. Such a situation
is asymmetrical.
• Non-price competition: firms try to avoid
price competition due to the fear of price
wars and hence depend on non-price
methods like advertising, after sales services,
warranties, etc. This ensures that firms can
influence demand and build brand
recognition.
THE END!