Theory of the firm: Market Structure Notes

Perfect competition characteristics: 1. There is a large number of firms: each firm has a small output in relation to the size of the market. Firms are independent of each other. Actions of one firm don’t affect the actions of others.2. Homogenous products: Products are relatively similar and identical.3. There is free entry and exit4. There is perfect (complete) information: All firms and consumers have complete information regarding products, prices, resources and methods of production. 5. There is perfect resource mobility: Resources are completely mobile. They can easily and without any costs are transferred from one firm to another or from one industry to another.

Examples: Agricultural commodities like wheat, corn, silver and gold.

The demand curve is perfectly elastic (horizontal line). This is because the individual firm is small and can do nothing to influence this price. The firm is therefore a price-taker.

The demand curve for a good facing the perfectly competitive firm is perfectly elastic (horizontal) at the price determined in the market for that good. This means the firm is a price-taker, as it accepts the price determined in the market.

No matter how much output the perfectly competitive firm sells, P=MR=AR and these are constant at the level of the horizontal demand curve. This follows from the fact that price is constant regardless of the level of output sold.

Perfect competition = short-run profit maximization based on the marginal revenue and marginal cost rule.

Firms interested in maximizing profit (minimizing loss) produces output where MR=MC.

profitQ

=P−ATC

Based on TR-TC = Profit

If the profit-maximizing level of output Q: -If P>ATC, the firm makes supernormal profit (positive economic profit). -If P=ATC, the firm breaks even, making zero economic profit, though it is earning normal profit.-If P<ATC, the firm makes a loss (negative economic profit).

When P>ATC at the level of output where MC=MR, the firm ears positive economic profit (supernormal profit)

The price p=minimum ATC is the firm’s break-even price. At this price the firm is breaking even: it is making zero economic profit, but it is earning normal profit.

When ATC>P>AVC at the level of output where MC=MR, the firm is making a loss but should continue producing because its loss is smaller than its fixed cost. Graphically, this occurs when the demand curve lies below the minimum ATC and above minimum AVC

The price P=minimum AVC is the firm’s shut-down price in the short run. At this price, the firm’s total loss is equal to its fixed cost.

When price falls below the shut-down price, so that P<minimum AVC, the firm should shut down in the short run, and will make a loss equal to its fixed costs.

SUMMARY:

When P>ATC, the firm makes economic profit

When P=minimum ATC, the firm makes zero economic profit but earns normal profit; this P is a break-even price of the firm.

When ATC>P>AVC, the firm produces at a loss, but its loss is less than fixed costs; therefore, it continues to produce.

When P=minimum AVC, the firm’s loss=fixed costs; this P is the firm’s short-run shut-down price.

When P<AVC, i.e. when price falls below the shut-down price, the firm shuts down (stops producing); its loss will then be equal to its fixed costs.

Supernormal profit = (P-ATC) x Q

Loss = (ATC-P) x Q

The short-run supply curve of the perfectly competitive firm is the portion of its marginal cost curve that lies above the point of minimum AVC.

In perfectly competitive long-run equilibrium, firm’s economic profits and losses are eliminated, and revenues are just enough to cover all economic costs so that every firm earns normal profit.

In the long run, a loss-making firm shuts down and exits the market when price falls below minimum ATC.

The short-run shut-down price is P=minimum AVC: the firm shuts down (stops producing) when price falls below minimum AVC.

The long-run shut-down price is P=minimum ATC: the firm shuts down (leaves the industry) when the price falls below the minimum ATC.

Allocative efficiency : MB=MC

Allocative efficiency occurs when firms produce the particular combination of goods and services that consumers mostly prefer. This condition is the following:

Allocative efficiency is achieved when P=MC.

(P=MB)

Productive (also known as technical) efficiency occurs when production takes place at the lowerst possible cost. The condition is the following:

Productive efficiency is achieved when production occurs at minimum ATC>

In the long-run equilibrium under perfect competition, the firm achieves both allocative efficiency (P=MC) and productive efficiency (production at minimum ATC). At the level of the industry, social surplus (consumer surplus plus producer surplus is) is maximum, and MB= MC.

Perfect competition is the only market structure that achieves these two efficiencies.

In the short-run, the perfectly competitive firm achieves allocative efficiency but it is unlikely to achieve productive efficiency.

Evaluation:

Not very realistic.

-Allocative efficiency: leads to the best or ‘optimal’ allocation of resources based on the mix of goods and services that consumers mostly want, achieved through P=MC in long-run equilibrium.

-Productive efficiency: Perfect competition also leads to production at the lowers possible cost, avoiding waste in the use of resources, achieved through production at minimum ATC.

-Low prices for consumers: Consumers benefit from low prices due to productive efficiency and absence of economic profits.

-Competition leads to the closing down of inefficient producers.

-The market responds to consumer tastes.

-The market responds to changes in technology or resource prices: if technology improves, there will be changes in resource prices and the cost curves will shift upward or downward leading to economic profits or losses.

Limitations:

-Unrealistic assumptions

-Limited possibilities to take advantage of economies of scale: economics of scale lead to lower average costs as a firm grows larger and larger. In perfect competition the requirement that firms are many and small prevents them from growing to a size large enough to take advantage of economies of scale.

-Lack of product variety: Not good for consumers who want product variety.

-Waste of resources in the process of long-run adjustment: costs of adjustment for changes in demand, resource prices and technology are not taken into account.

-Limited ability to engage in research and development – due to lack of economic profits.

-Market failures.

Monopoly:

Characteristics:

There is a single seller or dominant firm in the market

There are no close substitutes

There are significant barriers to entry

Barriers to entry:

Economies of scale: downward sloping portion of a firm’s LRATC, permits lower ATCs to be achieved as the firm increases its size. As the slope goes downward the barrier to entry increases.

Branding: Some firms have a unique image and name of a product – brand loyalty.

Legal barriers:Patents: rights given by the government to a firm that has developed a new product or

invention to be its sole produce for a specified period of time. (e.g. Pharmaceutical products).Licenses: granted by governments for particular professions or particular industries (e.g.

operate the radio, dentistry and architecture.)Copyrights: guarantee than author has the sole rights to print, publish and sell copyrighted

works. Public franchises: are granted by the government to a firm to a firm which is to produce or

supply a particular good or service. Tariffs, quotas and other trade restrictions: limit the quantities of a good that can be

imported into a country, thus reducing competition.

Control of essential resources: EXAMPLE: DeBeers mines 50% of the world’s diamonds and purchases about 80% of diamonds sold on open markets

Aggressive tactics: firms cut prices and use tactics to avoid the entry of other firms.

Since the pure monopolist is the entire industry, the demand curve it faces is the industry of market demand curve, which is downward-sloping. This is the most important difference between the monopolist and the perfectly competitive firm, which faces perfectly elastic demand at the price level determined in the market.

Monopolists are price-makers with a significant degree of market power.

The monopolist will not produce any output in the inelastic portion of its demand curve (which is also its average revenue curve).