Market Structure

Market Structure• The selling environment in which a firm

produces and sells its product is called a market structure.

• Defined by three characteristics:

– The number of firms in the market

– The ease of entry and exit of firms

– The degree of product differentiation

Introduction

• Perfect competition, with an infinite number of firms, and monopoly, with a single firm, are polar opposites.

• Monopolistic competition and oligopoly lie between these two extremes.

Perfect Competition A perfectly competitive market has

the following characteristics: There are many buyers and sellers in the

market. The goods offered by the various sellers

are largely the same. Firms can freely enter or exit the market.

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.

Thus, each buyer and seller is a price taker.

Perfect Competition

Profit-Maximizing Level of Output• The goal of the firm is to maximize

profits.

• Profit is the difference between total revenue and total cost.

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

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

QT R /

TC TR

0

Tot

al c

ost,

rev

enue

$385350315280245210175140105

7035

Quantity1 2 3 4 5 6 7 8 9

Profit Determination Using Total Cost and Revenue Curves

Maximum profit =$81

$130

Loss

Loss

Profit

Profit =$45

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Profit Maximization Using Total Revenue and Total Cost• Profit is maximized where the vertical

distance between total revenue and total cost is greatest.

• At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.

Profit-Maximizing Level of Output• Marginal revenue (MR) – the change

in total revenue associated with a change in quantity.

• Marginal cost (MC) – the change in total cost associated with a change in quantity.

• A firm maximizes profit when MC = MR.

How to Maximize Profit

• If marginal revenue does not equal marginal cost, a firm can increase profit by changing output.

• The supplier will continue to produce as long as marginal cost is less than marginal revenue.

How to Maximize Profit

• The supplier will cut back on production if marginal cost is greater than marginal revenue.

• Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.

Again! MR=MC

• Profit is maximized when MR=MC.– If the cost of producing one more unit is

less than the revenue it generates, then a profit is available for the firm that increases production by one unit.

– If the cost of producing one more unit is more than the revenue it generates, then increasing production reduces profit.

Profit Maximization: Using MR and MC curves

Profit Maximization: The Numbers

Q P TR TC TR-TC MR MC ATC

0 $1 $0 $1.00 -$1.00 $1

1 $1 $1 $2.00 -$1.00 $1 $1.00 $2.00

2 $1 $2 $2.80 -$0.80 $1 $0.80 $1.40

3 $1 $3 $3.50 -$0.50 $1 $0.70 $1.17

4 $1 $4 $4.00 $0.00 $1 $0.50 $1.00

5 $1 $5 $4.50 $0.50 $1 $0.50 $0.90

6 $1 $6 $5.20 $0.80 $1 $0.70 $0.87

7 $1 $7 $6.00 $1.00 $1 $0.80 $0.86

8 $1 $8 $6.86 $1.14 $1 $0.86 $0.86

9 $1 $9 $7.86 $1.14 $1 $1.00 $0.87

10 $1 $10 $9.36 $0.64 $1 $1.50 $0.94

11 $1 $11 $12.00 -$1.00 $1 $2.64 $1.09

MR=MCMR=MC

The Marginal Cost Curve Is the Supply Curve• The marginal cost curve is the firm's

supply curve above the point where price exceeds average variable cost.

• The MC curve tells the competitive firm how much it should produce at a given price.

The Interaction of Firms and Markets

FirmFirm MarketMarketPricePriceAndAnd

CostsCostsPricePrice

qqFF QQMM

aa

bb

cc

dd

AA

BB

qq11qq22qq33qq44 QQ11 QQ22

MCMC

P=MRP=MR00

ATCATC

P=MRP=MR11AVCAVC

SS11

SS22

DD00

$10$10

ATCATC=$7=$7

10 units10 units

The Marginal-Cost Curve and the Firm’s Supply Decision...

Quantity0

Costsand

RevenueMC

ATC

AVC

Q1

P1

P2

Q2

This section of the firm’s MC curve is also the firm’s supply curve (long-run).

Determining Profit and Loss• Find output where MC = MR.

– The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits.

• Find profit per unit where MC = MR.– Drop a line down from where MC equals MR,

and then to the ATC curve.– This is the profit per unit.– Extend a line back to the vertical axis to

identify total profit.

Determining Profit and Loss• The firm makes a profit when the ATC

curve is below the MR curve.• The firm incurs a loss when the ATC curve

is above the MR curve.

Determining Profit and Loss From a Graph• Zero profit or loss where MC=MR.

– Firms can earn zero profit or even a loss where MC = MR.

– Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs.

(a) Profit case (b) Zero profit case (c) Loss case

Determining Profits Graphically

Quantity Quantity Quantity

Price65 60 55 50 45 40 35 30 25 20 15 10

5 0

65 60 55 50 45 40 35 30 25 20 15 10

5 01 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12

D

MC

A P = MR

B ATCAVC

E

Profit

C

MC

ATC

AVC

MC

ATC

AVC

Loss

65 60 55 50 45 40 35 30 25 20 15 10

5 0 1 2 3 4 5 6 7 8 910 12

P = MRP = MR

Price Price

© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-Hill

Loss MinimizationAverage cost of a unit of outputAverage cost of a unit of output

Revenue Revenue generated by a generated by a unit of outputunit of output

Market Market price price fallsfalls

The Firm’s Short-Run Decision to Shut Down The firm shuts down if the revenue it

gets from producing is less than the variable cost of production.

Shut down if TR < VC

Shut down if TR/Q < VC/Q

Shut down if P < AVC

The Shutdown Point

• If total revenue is more than total variable cost, the firm’s best strategy is to temporarily produce at a loss.

• It is taking less of a loss than it would by shutting down.

MC

P = MR

2 4 6 8 Quantity

Price

60

50

40

30

20

10

0

ATC

AVC

Loss

A$17.80

The Shutdown Decision

The Firm’s Long-Run Decision to Exit or Enter a Market In the long-run, the firm exits if the

revenue it would get from producing is less than its total cost.

Exit if TR < TC

Exit if TR/Q < TC/Q

Exit if P < ATC

The Firm’s Long-Run Decision to Exit or Enter a Market A firm will enter the industry if such an

action would be profitable.

Enter if TR > TC

Enter if TR/Q > TC/Q

Enter if P > ATC