CHAPTER FIVE

MARKET STRUCTURES AND DETERMINATION OF PRICE

AND OUTPUT

MICROECONOMICS-I
Wednesday, Nove
mber 13, 2024 Lecture notes333
 The Firm, its objective and market structure
2

 The objective of a consumer is

maximization of utility; likewise the firms
produce goods and service and sell the
product to consumers.
 Consumer demand for goods and
services determines the revenue side of
a business operation.
 Production theory has been used to
derive the cost conditions faced by firms.
 Brought together, revenue and cost
determines the behavior of a profit
 Contd…
3

 The most important factor that determines firm’s

choice of price and output is the market
structure.
 The term market structure refers to the
organizational features of an industry that
influence firm’s behavior in its choice of
price and output.
 Economists have found it useful to classify
markets in to two broad general types.
1. perfectly competitive market structure
2. Imperfect Market structures include : monopoly,
monopolistic competition and oligopoly
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 Contd…
4
 This Classification is mainly based on
 the numbers of firms in the industry,
 the nature of products and
 the nature of entrance of new firms.
 In this unit, we investigate how price and output
are determined in perfectly competitive markets
in the short as well as long run periods.
 Perfect competition is a market structure
characterized by
 a complete absence of rivalry among the individual
firms, because there are so many firms in the
industry
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 Perfectly Competitive Market Structure
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 A perfectly competitive firm has the following
characteristics:
 Large number of sellers and buyers:

 under perfect competition the number of sellers is

assumed to be too large that the share of each seller in
the total supply of a product is very small.
 Therefore, no single seller can influence the market price
by changing the quantity supply.
 Similarly, the number of buyers is so large that the share of each
buyer in the total demand is very small and that no single buyer
or a group of buyers can influence the market price by changing
their individual or group demand for a product.
 Therefore, in such a market structure, sellers and buyers are not
price makers rather they are price takers i.e. the price is
determined by the interaction of the market supply and demand
forces.
 Market equilibrium; and demand curve of a firm in
perfect market
6

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 Contd…
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 Homogeneous product: -
 homogeneity of the product implies that buyers do

not distinguish between products supplied by the

various firms of an industry.
 Product of each firm is regarded as a perfect

substitute for the products of other firms. Therefore

no firm can gain any competitive advantage over the
other firm.
 Perfect mobility of factors of production: -

 factors of production are free to move from one firm

to another throughout the economy.

 This means that labor can move from one job to

another and from one region to another. Capital, raw

materials, and other factors are not monopolized.
 Contd…
8

 Free entry and exit :-

 there is no restriction or market barrier on entry of
new firms to the industry, and no restriction on
exit of firms from the industry.
 A firm may enter the industry or quit it on its
accord. A firm can enter or exit an industry/market
with no cost.
 Perfect knowledge/ information: -
 There is perfect knowledge about the market
conditions. All the buyers and sellers have full
information regarding the prevailing and future
prices and availability of the commodity.
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 Contd…
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 No government interference: -
 government does not interfere in any way
with the functioning of the market.
 There are no discriminator taxes or
subsidies, no licensing, no allocation of
inputs by the procurement, or any kind of
direct or indirect control.
 That is, the government follows the free
enterprise policy. Where there is
intervention by the government, it is
intended to correct the market
imperfection. 11/13/2024
 Demand curve, Price, Average revenue (AR)
and Marginal revenue (MR) of a firm
10

 We have seen that a perfectly competitive

firm faces a horizontal demand curve for its
product. This has a number of implications;
 A perfectly competitive firm can’t affect the
market price by changing its output. A firm is
simply a price - taker not price – maker, it
simply accept the market price.
 A firm has no market power, all firms have
equal market power, i.e, is zero.
 Price, AR and MR of a firm are always equal in
prefect market; P = MR = AR.
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 Contd…
11

 AR = TR/Q = (P*Q) /Q = P,
 MR = dTR/dQ = d(PQ)/dQ = P* dQ/dQ =
P; P = AR =MR
 From this we can conclude that the
demand curve of individual firm under
perfect is also the AR and the MR curves.
Given P is a market price
 Contd…
12

 A horizontal demand curve also shows,

the price elasticity of demand for a
competitive firm is perfectly elastic; Ed
= ∞.
 The response is so high that for slight
change in price , TR of the firm will
become zero.( its total sale becomes
zero).

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 Short – Run Equilibrium of a Firm
13

A) Equilibrium of a firm - A profit maximizing

firm is in equilibrium at the level of MC equal to
MR (the marginal approach). And short – run
equilibrium is based on the following assumptions
 Capital is fixed and labor is variable

 Price of inputs are given

 Price of the commodity is fixed, and

 The firm is faced with short run cost curves.

 There are two approaches of profit maximization;

 Total Approach and

 Marginal Approach.
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 Total Cost and Revenue Approach:
14

According to this approach profit is

maximized when the vertical difference
between total revenue (TR) and total cost
(TC) is the largest. symbolically;
∏= TR - TC and TR = P x Q ;
Where
 ∏ = profit TR = Total revenue, TC = Total cost,
 P = price of output, Q = quantity of output.
 It can be shown graphically by assuming
linear total revenue function as follows;
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 Contd…
15
 The marginal Approach
Marginal Cost (MC) and Marginal Revenue (MR
16
 According to this approach, given other things being
constant, such as prices. That is , any rational firm a
produces an output level where at least its MR is
equal to its MC.
 At equilibrium, a firm could maximize profit or
minimizes its loss or earn zero profit by producing
that level of output where the following conditions are
fulfilled;
 The first order condition (F.O.C); MR = MC.
MR = MC; but, MR = dTR/dQ and MC = dTC/dQ;
Hence, dTR/dQ = dTC/dQ
 The second order condition (S.O.C); dMR/dQ <
dMC/dQ . MC should be increasing at a higher rate
than MR.
 Graphically
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Price of a commodity is fixed by

the market forces in a perfectly
competitive market, the firms
have horizontal demand curve
as shown.
As shown by the line Pe = MR
and also P = MR = AR - all are
equal in perfect market.
At point E the equilibrium
condition is satisfied; MR =MC;
it also implies that; Pe = MR
=MC= AR , at point E.
Qe is the equilibrium level of
output – it is a best or most
 Total Profit (π) , Equilibrium of a Firm , Price
and AC
18

 In the short run, equilibrium of a firm doesn’t

necessarily tell us the level of profit the firm is earning.
 The equilibrium condition, MR = MC, only tell us how
much has to produce or it is the determination of the
best possible level of output level given the
circumstances (prices and cost function) a firm faced.
 MC of a firm doesn’t help to know the total profit.
 In the short run, total profit of a firm depends on AC of
production relative to market price of the product.
 Accordingly, the total profit (π) of the firm could be
positive, zero or negative at equilibrium based on the
AC of the firm relative to price.

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 Contd…
19

 Observe the following relationship between P

& AC of a competitive firm
 π = TR – TC = (AR).Q - Q*AC

[Because
TR=Q*(TR/Q)=Q*AR,TC=Q*(TC/Q)=Q*AC]
 Since under perfect market P = AR, then

π = P*Q – Q*AC = Q* (P – AC)

Thus; if
 P > AC , then π > 0 ,
 P = AC , then π = 0 and
 P < AC ,then π < 0
 Case 1 – when market price greater than AC ( P > AC , π > 0)

20
 The firm equilibrium at point E where the
condition is satisfied (MR = MC) with P > AC;
thus, π > 0; the firm will earn positive profit.
π = TR – TC = (AR).Q - Q*AC , since under
perfect market P = AR, then
π = P*Q – Q*AC = Q(P – AC), thus , π > 0 if P
> AC
 Output level Qe is, therefore, profit maximizer,
or called equilibrium output level.
 At this output, the firm is at equilibrium and is
making positive profit. Firm’s maximum total
profit is shown by the area of a rectangle, PeERA.
 Graphically
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Pric
e SMC
SAC

Pe E
P=MR

A R

0
Q Output(Q)
e
 Case 2 – when P = AC ; π = 0 ( break –even point)
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 In the short run, a firm may not always earn
abnormal/positive profit.
 If the firm is at equilibrium with its short run
average cost (SAC) is equal to price. The
equilibrium condition is MR = MC which
satisfied at point E with output, Qe.
 The SAC curve is also tangent to P = MR line,
at this point, where P = SAC.
 Thus, the firm makes normal profit/zero profit.
 Note that at point E : P = MR = SMC = SAC
= AR and π = 0
 Graphically
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Pric SAC
e SMC

Pe E
P=MR

0
Q Output(Q)
e
 Case 3 - when P < SAC and π < 0
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 If AC is above the price or if a firm at

equilibrium where P < AC the firm incurs
losses in the short run (π < 0). It is
shown graphically as follows.
 Given Pe is market price; at point E,
equilibrium condition is satisfied ;
Pe = MC = MR ;
 But AC > Pe , thus, the firm is at
equilibrium with negative profit or π <
0.
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 The total loss the firm is shown by the
 Graphically
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SAC
Pric
e SMC

E E
’Pe
R P=MR

0
Q Output(Q)
e
 Shut –down or close – down points
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 In case a firm is making loss it must cover its short

run average variable cost (SAVC). A firm unable to
cover its minimum AVC will have to close down.
 The MC/MR intersects AVC at its minimum level as
shown in the figure below.
 Given Mkt price is Pe ; at point E, MC = MR = Pe
and Pe = AVC , hence, the firm is at shut- down.
 Note also that at point E, MR = AVC and Loss =
TFC amount. Loss = TR –
(FC +VC) = TR – TFC –TVC; Since TR = TVC,
Then; Loss = - TFC amount
 Graphically
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SAC
Pric AVC
e SMC

E E
’Pe
R P=MR

0
Q Output(Q)
e
 Derivation of supply curve of a firm
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 The supply curve of a competitive firm is

derived on the basis of its equilibrium output
and from the MC curve.
 As such the supply curve of a perfectly
competitive firm is derived from its MC curve
that lies above point where it intersects with
AVC curve.
 The equilibrium output determined by the
intersection of MR and MC curves, is the
optimum supply by a profit maximizing (or
cost minimizing) firm.
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 Contd…
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 Contd…
30

 According to the figure, at point M, MC = AVC =

Price, P1 and Q1 is the minimum supply of the firm.
A firm can’t produce below the point where MC =
AVC or below point M.
 As the price increases above P1, firm will increases
its output moving along its MC curve. When price
increases to P2, the equilibrium point moves along
its MC curve from M to R and
 when price is P3 equilibrium is at point K ; and
output increases to Q2 then to Q3 and so on, the
supply curve is derive by plotting this information or
simply taking MC curve above point M.
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 Equilibrium of an industry/ market
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 The industry/market supply curve is a horizontal
summation of the supply curves of the individual
firms.
 If all firms have identical supply curve the industry
supply curve can be obtained simply by
multiplying the individual supply at various prices
by the number of firms.
 In short run, however, the individual supply curves
may not be identical, if so, the market supply
curve can be obtained by summing horizontally
the individual supply curves.
 An industry is in equilibrium in the short-run when
market is cleared at a given price i.e.
 Contd…
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Pric
Supply
e

Pe E

demand

0 Q Output(Q)
e
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 Contd…
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 In short run equilibrium of the industry,

 some individual firms may make pure
profit,
 some normal profits and
 some may make even losses depending on
their cost and revenue conditions,
 As we will discuss in the next sub-topic,
this situation will however not continue
in the long-run.

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 Long – Run Equilibriums of the Firm and Industry
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The short-run, by definition is a period in which:

 Firms cost and revenue curves are given

 Firms cannot change their size, their capital is

fixed
 Existing firms cannot leave the industry, and

 New firms cannot enter the industry.

In contrast, long run is a period in which these

constraints are relaxed.
 It permits change in technology and
employment of both, labor and capital.
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 Equilibrium of a firm [LR]
35

 To show the long run equilibrium, let us

begin with a short-run situation.
 Suppose that short run price is given at OP1
and the short-run average and marginal cost
as SAC1 and SMC1 [panel (A) & panel (B)].
 Given the price OP1, the firms are in
equilibrium at point E1.
 It may be noticed that the firms are making
abnormal profit. Abnormal profit brings about
two major changes in the industry.
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 Contd…
36

 First,
 existing firms get incentive to increase the
scale of their production. This phenomenon
is shown by SAC1 and SMC1.
 Second,
 attracted by the abnormal profit, new firms
enter the industry. For these reasons, the
industry supply curve SS1, shifts out ward
to SS2 (panel A).
 The shift in supply curve brings down the
market price to OP2 which is the long-run
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equilibrium price. Thus, equilibrium price is
 Graphically
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Given the new equilibrium market prices OP2, firms

attain their equilibrium in the long run where AR =
MR = LMC = LAC = SMC = SAC.
 Equilibrium of the Industry [LR]
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 An important condition for the industry

to be in equilibrium is that it produces
the level of output at which the quantity
demanded equals to the quantity
supplied of a product.
 This is achieved at which all firms are in
equilibrium producing at the minimum
point of their LAC curve and making just
normal profits.
 Under these condition there is no further
entry or exit of firms in 11/13/2024
the industry,
 Graphically
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