AF1605 Introduction to Economics

Topic 5: Market Structure

Part I: Perfect Competition

Lecturer: Chau Tak Wai

School of Accounting and Finance

v Characteristics of a perfectly competitive industry

v Short run profit maximizing decision and market outcomes

v Long run profit maximizing decision and market outcomes

v Allocative efficiency

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v For a basic theory of a firm’s decision, we assume that the objective of a
firm is to maximize economic profit defined as total revenue minus
total economic cost (max π = TR – TC).

v Total approach to profit maximization:

v The firm produces at an output level where π = TR – TC is
maximized.

v Marginal approach to profit maximization:

v The firm produces at an output level where MR equals MC (stop
when MR(Q)<MC(Q)).

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v Marginal cost (MC)
v The extra cost a firm has to pay by increasing its output by one unit.
v The MC curve is usually upward sloping eventually. (Refer to Topic 4)

v Marginal revenue (MR)

v The additional revenue a firm receives by increasing its output by
one unit. (TR(Q) – TR(Q-1) or more generally Δ𝑇𝑅/Δ𝑄.)
v The shape of the MR curve depends on the type of market structure
to which the firm belongs to.

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v Three major types of market structure introduced in this class:
v Perfect competition
v Monopoly
v Oligopoly

v Factors that determine the type of market structure:

v Number of sellers
v Degree of product differentiation
v Barrier to entry

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Characteristics of perfect competition:

v Identical products
v The products sold by different firms are perfect substitutes.
v Many sellers and buyers
v Each participant is insignificant relative to the whole market.
v No Entry Barrier
v There is no restriction on entry into or exit from the market.
v Perfect Information
v Buyers and sellers are well informed about prices as well as the quality of
the good.

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v This is an ideal case on the extreme of many sellers with severe
competition.
v It is hard to find perfect examples that fully satisfy all the conditions.
v Closer examples: stalls in wet food markets, Taobao stalls.

v One may partially apply the models with certain characteristics:

-If the entry barrier is low, what would you expect on the long run profit of
each firm? When will firms stop entering the market?

v This is also the basis of the simple demand-supply analysis.

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v One important implication: Firms in a perfectly competitive industry are price
takers: they will only follow the market price.
v Why?

v Each firm is too small relative to the whole industry and so they have no
power to control or affect other sellers and the whole market.
v Buyers have perfect information on the prices charged by all other sellers.

v The demand curve for each competitive firm is perfectly elastic (horizontal)
at the market price.
v When the price is higher than the prevailing market price, no consumer will
buy from this firm, so the quantity demanded for goods from this firm is zero.
v If a firm charges a price lower than the prevailing market price, in theory, all
consumers would like to buy from this firm, which is a very large amount for
this small firm. Thus, the quantity demanded is very large.
v So, the firm can have a usual amount of quantity demanded only when the
price is at the prevailing market price.. 8
v Note: Market and Firm level diagrams are different and should be drawn
separately.

=d

Market A Firm
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v Recall: Profit = Total Revenue – Total Cost

v As output increases, both total revenue and total cost increase.

v Since price is constant, total revenue increases at a constant rate.

v Because of diminishing marginal returns (short run) or diseconomies of scale

(long run), total cost eventually increases in an increasing rate and
increasing faster than that of total revenue.
Recall: In short run, when MP is increasing
(decreasing), MC is decreasing (increasing)
v Profit maximization occurs at the output level where the gap between total
revenue and total cost is the largest.

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v Marginal analysis compares MR with MC.

v If MR > MC, the extra revenue from selling one more unit exceeds the
extra cost incurred to produce it.
v Economic profit increases if output increases.

v If MR < MC, the extra revenue from selling one more unit is less than the
extra cost incurred to produce it.
v Economic profit decreases if output increases.

v Profit maximization occurs at the output level (Q*) where

Continuous: MR(Q*) = MC(Q*).
Discrete: Stop at Q* if MC starts to rise above MR at Q*+1.

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v Marginal cost (MC) curve of a firm:
v Positive and eventually upward sloping.

v Marginal revenue (MR) curve of a firm:

v At the firm level, since a perfectly competitive firm is a price taker, it will
always sell at the market price (P*).
v Market price is determined by the demand and supply at the market
level.
v Since price does not change when the firm increases its output and sales
by one unit, marginal revenue MR at the Qth unit = P*xQ – P*x(Q-1) = P*.
v Therefore, MR is constant and equals market price. (MR = P)
v A perfectly competitive firm’s MR curve is a horizontal line at the market
price, coincide with the demand curve. 13
 Market A Firm

(Q) (q) (q)

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v Profit maximization condition:
Continuous: MR(Q*) = MC(Q*) and MC is increasing.
Discrete: Stop at Q* if MC starts to rise above MB at Q*+1.

✓
✗

MR = P TC increases
faster than TR
Price Taker: MR(Q) = P
Profit Maximizer: MR(Q*) = MC(Q*)
=> P = MC(Q*)
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§ Suppose a firm is considering the 5th unit of output where the marginal
cost is $8 and average total cost is $9. Currently the market price is at
$10. Which of the following is true? (Assume continuous adjustment)

§ A. The firm should produce more than 5 units since MR > MC.
§ B. The firm should produce less than 5 units since MC < ATC.
§ C. The firm should produce 5 units since the firm is earning a positive
profit.
§ D. The firm should produce zero unit since it is earning a negative profit.

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v A perfectly competitive firm’s supply curve
shows how the firm’s profit-maximizing output
varies as the price varies, other things remaining
the same.

v Recall that the profit maximizing condition for a

PC firm: P = MC(Q*), meaning that for each given
P, the firm will produce at Q* where the MC at
this Q* just equals P.

v When the market price equals $12 per unit, the

firm maximizes profit by producing 11 units per day.
v When the market price equals $8 per unit, the firm
maximizes profit by producing 10 units per day.
v When the market price equals $3 per unit, the firm
maximizes profit by producing 7 units per day.

v The firm’s supply curve traces the marginal cost

curve (with some qualifications). 17
v In the short run, the firm has at least one fixed factor.

v For example, the firm has fixed plant size.

v Since the plant size is fixed (cannot be reduced to zero), existing firms
cannot exit from the market.

v New firms which do not have the plant cannot enter into the market to
produce.

v In short run, there is no firm entry or exit.

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v A firm may incur an economic loss (negative profit) when it is producing at
the non-zero profit-maximizing output level.

v In the short run, while the firm cannot exit from the market, and it has an
option to temporarily shut down (producing zero output) or to produce
some output.

v If the firm shuts down temporarily, profit = -TFC.

v If the firm produces some output, profit = TR – TC = TR – TFC - TVC.

v If TR > TVC (or P > AVC), the firm’s profit is higher to produce some outputs
than to shut down.
v If TR < TVC (or P < AVC), the firm’s profit is higher to shut down than to
produce some output.
v The point where P = AVC is the shut down point.

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 At the shut down point,
(1) AVC curve is at its minimum;
(2) TR is just enough to cover TVC, the
paid TFC becomes the loss.

Note: Profit = TR – TC = P*Q – TC = (P – ATC)* Q

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v Recall that the competitive firm’s supply curve
traces the marginal cost curve since P = MC(Q*).
v In the short run, with the restriction of no exit but
able to shut down, a competitive firm will choose
to produce nothing (shut down) if P < AVC.
v A competitive firm produce a positive amount
according to P = MC(Q*) if P ≥ AVC(Q*).
v In this example, when the market price drops
below $3 per unit, the firm shuts down and does
not produce.
v Note: P > AVC(Q*) => MC(Q*) > AVC(Q*)
v The firm’s short-run supply curve is the same as
the (short-run) MC curve when the MC curve is
above the AVC curve, and output drops to zero if
the price is below the shut down point.
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v At the profit maximizing output level, P > ATC and the firm is making
positive economic profit (blue area = (P – ATC) × Q).

Note: The market supply curve is the horizontal summation of all firm’s supply curve.
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v At the profit maximizing output level, P < ATC (implying a negative profit
or a loss) but the firm still produces as long as P > AVC.

LOSS

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v At the profit maximizing output level, P = ATC and the firm is making zero
economic profit.

Question: Does zero profit mean the firm owner cannot even get an income for his
own living? 24
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§ Which of the following is FALSE for a perfectly competitive firm?

§ A. It will produce at a quantity where P = MC if not shut down

temporarily.
§ B. It cannot have a choice to incur zero cost in the short run.
§ C. It will shut down whenever its total revenue cannot cover its total
cost when producing at any positive output levels.
§ D. It will shut down whenever its total revenue cannot cover its total
variable cost when producing at any positive output levels.

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v In the long run, all input factors are variable.

v What will change in the long run?

v 1. We use long run cost curves instead of short run cost curves.
-Cost can be lower as the firms can adjust all factors to lower the cost.

v 2. New firms can enter into or existing firms can exit from the industry
in response to economic profit or loss.
-So when will firms enter and when will firms exit?

v If the profit of a typical firm is positive, entrepreneurs can earn more in

this market than in another business, and so they will enter the market.
v If the profit of a typical firm is negative, entrepreneurs can earn less in
this market than in another businesses, and so they will exit the market.

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v When existing firms are earning positive economic profit (P > LAC):
v New firms enter the market.
v Market supply curve shifts rightward.
v Market price will drop.
v Profit of existing firms will decrease.
v If profit is still positive, more firms will enter.
v The process continues until firm’s profit becomes zero, with P = LAC.

v When existing firms are earning a negative economic profit (economic

loss) (P < LAC):
v Some existing firms exit the market.
v Market supply curve shifts leftward.
v Market price will increase.
v Loss of existing firms will decrease.
v If profit is still negative, more existing firms will exit.
v The process continues until firm’s profit becomes zero, with P = LAC.

v In the long run, perfectly competitive firms earn zero economic profit. 30
 S MC
ATC
Economic profit
= $104,000/yr

Price ($/bushel)
Price ($/bushel)

2.00 2.00 Price

1.20

65 130
Quantity (millions of Quantity (1000s of
bushels/year) bushels/year)

v Market price of $2/bushel produces economic profits

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 S MC
S’
ATC
Economic profit
= $50,400/yr

Price ($/bushel)
Price ($/bushel)

2.00 2.00

1.50 1.50 Price

1.08

65 95 120 130
Quantity (millions of Quantity (1000s of
bushels/year) bushels/year)

v Economic profits attract firms, reducing prices and profits

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 MC
ATC

Price ($/bushel)
Price ($/bushel)

1.00 1.00 Price

115 90
Quantity (millions of Quantity (1000s of
bushels/year) bushels/year)

v Entry of firms continues until all firms earn a normal profit

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v In the long run equilibrium, perfectly competitive firms produce at the
output level where LAC is at its minimum.
v Why?

v Explanation:
(1) P = MR(Q) due to price taking of perfectly competitive firms.
(2) MR(Q*) = MC(Q*) due to maximizing profits by competitive firms.
(3) P = LAC(Q*) because firms earn zero profit.

v Therefore, P = MR = MC = ATC implies MC = LAC.

v MC equals LAC implies LAC is at minimum.

v This also implies that a perfectly competitive firm in the long run produces at
its optimal scale (utilize all economies of scale and stop before turning to
diseconomies of scale). 34
v The treatment here assumes all firms are identical.
v What if there is a new technology that can lower the marginal cost (MC
curve shifts down) and can be adopted by any firms in the industry?

v Some firms may first adopt it, lowering the cost, and enjoy some short-
run profit.
v In the long run, more and more firms would adopt this technology and
produce at a lower marginal cost.
v Supply of these firms will increase, raising the market supply.
v Equilibrium market price will fall.
v Those which refuse to adopt this technology will suffer an economic loss
in the long run.
v They will be driven out of the market due to competition.
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1. What is the long run equilibrium price if there is an increase in
demand but no change in cost curves of each identical perfectly
competitive firms?
§ A. increase
§ B. decrease
§ C. no change
§ D. uncertain

2. If the marginal cost and average total cost of each competitive

firm increases by $2 at all quantities, what is the resulting increase
in market equilibrium price in the long run?
§ A. $0
§ B. $1
§ C. $2
§ D. somewhere between $0 and $2.
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v Consumers earn consumer surplus from consumption.

v Producers earn producer surplus from production.

v Social surplus is the sum of consumer surplus and producer surplus.

v We can achieve allocative efficiency if the market produces at the

output level where social surplus is maximized.

v We can demonstrate that the output level of a perfectly competitive

market can achieve allocative efficiency.

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v Recall: Consumer surplus is the
marginal benefit from a good or
service in excess of the price
paid for it for a particular unit,
summed over the quantity
consumed (Q).
$
𝐶𝑆 = )(𝑀𝐵! − 𝑃)
!"#

v Consumer surplus (the green

triangle) equals the area below
the demand curve minus total
expenditure.

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v Recall: Producer surplus is the price
of a good in excess of the marginal
cost of producing it at a particular
unit, summed over the quantity
produced (Q).
$
𝑃𝑆 = )(𝑃 − 𝑀𝐶! )
!"#

v Producer surplus (the blue triangle)

equals total revenue minus the area
below the supply curve.

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v From above, in perfect competition, supply curve is also the marginal
cost curve for firms/society.

v From earlier discussion, demand curve is also the marginal benefit

curve for consumers/society.

v Because the market supply and market demand curves intersect at the
equilibrium price, that price equals both marginal cost (to the firm)
and marginal benefit (to the consumer). (P = MB(Q*) = MC(Q*))

v Since social surplus (sum of consumer surplus and producer surplus) is

simply TB - TC, the condition for maximizing social surplus under the
marginal approach is achieved by having MB(Q*)=MC(Q*).

v The output level in perfect competition is allocative efficient.

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v Social surplus is maximized and allocative efficiency is achieved at the output
level where MB = MC = P.

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Two contrasting cases of Consumer Surplus

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v Social surplus is not maximized and allocative efficiency is not achieved at the output
level below or above the optimal level of output.

v Deadweight loss is the decrease in social surplus that results from an inefficient level of
production (underproduction or overproduction).

v It is an implicit loss due to an unrealized net benefit due to not producing certain units
or over-producing certain units.

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§ Determine in each of the following cases whether there is a deadweight
loss, assuming that it is in a perfectly competitive market with no other
market failures. For each case, draw the corresponding demand and
supply diagram and label the area of deadweight loss (if any) (assume
continuous case).

§ 1. An effective price floor.

§ 2. An effective price ceiling.

§ 3. A quota (a legal restriction on maximum quantity transaction)
§ 4. A per-unit tax.

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v Characteristics of a perfectly competitive industry

v Short run profit maximizing decision and market outcomes

v Long run profit maximizing decision and market outcomes

v Allocative efficiency

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