168

Perfect and imperfect

competition 14
OVERVIEW

We have now arrived at a point where it is possible to lay the foundation for how, in a perfectly
competitive market system, the economic problem of what to produce, how to produce and for whom
to produce is solved.
We start the section with an explanation of the requirements of perfect competition. We then take a
closer look at how a firm will behave in this perfect competitive world.

TOPIC OUTCOME

After you have worked through this learning unit, you should be able to:

• explain and illustrate the output decision of a firm under perfect competition
• explain and illustrate the profit position of a firm under perfect competition

14.1 Requirements of perfect competition

After you have worked through this section of the learning unit, you should be able to:

• identify the requirements of perfect competition

The following are the requirements which must exist in a market for it to be considered perfectly
competitive:
 There must be a large number of buyers (consumers) in the market.
 There must be a large number of sellers (suppliers) in the market.
 There should be no collusion between sellers.
 All goods sold in the market must be homogeneous.
 Buyers and sellers must have complete freedom of entry and exit into and out of the market.
 All buyers and sellers must have perfect knowledge of market conditions.
 There must be no government intervention.
 All factors of production must be perfectly mobile.

While it will be difficult to find a market that meets all of the above requirements, most markets have
elements of a perfectly competitive market.
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Select all the elements of perfect competition you think the South African telecommunications
market (Cell C, Vodacom, Telkom, MTN etc.) has?
o Large number of buyers
o Large number of sellers
o No collusion between sellers
o Homogeneous goods
o Complete freedom to enter and exit
o Perfect knowledge of market conditions
o No government intervention
o Perfectly mobile factors of production
From the following discussion, you will see that there are many buyers, a fairly homogenous
product and no collusion.

It is estimated that there are 59 million cell phones in use in South Africa, which means that there
are definitely a huge number of buyers in the market. The reason for the requirement of having
many buyers is to ensure that a buyer or a group of buyers cannot manipulate the market price. For
perfect competition to exist, buyers must be price takers.

Collusion occurs when rival firms cooperate to their advantage. This usually involves price fixing
between rival firms. There is currently no evidence of this having occurred in the
telecommunications market. A requirement for a perfect market is then also that there must be
many suppliers to ensure that a supplier or group of suppliers cannot manipulate the market price
through their actions. In a perfect competitive market, sellers have small market shares and are
also price takers.

While the quality of service may differ between the operators, they provide a fairly homogeneous
good to the market. What happens here is that suppliers try to differentiate their product through
advertising and offering contracts that are different from those of their competitors. This gives
them some control over the price they can charge. In perfect competition, there is no product
differentiation in that the product is perfectly homogeneous. The product of one supplier cannot be
distinguished for another supplier in that the product has the same characteristics and quality.

Which elements of perfect competition do you think the following market for tomatoes has?
 170

o Large number of buyers

o Large number of sellers
o No collusion between sellers
o Homogeneous goods
o Complete freedom to enter and exit
o Perfect knowledge of market conditions
o No government intervention
o Perfectly mobile factors of production
What one finds in this market is that there are probably many buyers and many sellers and that the
product that is sold is homogeneous.

Complete freedom of entry and exit requires that it must be possible for firms and buyers to
easily enter and exit a market. There are no barriers to entry in the form of legal, financial,
technological, physical or other restrictions that inhibit the free movement of buyers, sellers and
producers. This means that new firms can enter the market to compete with existing firms.

Perfect knowledge of market conditions requires that buyers are aware of the price charged by
sellers and that sellers are aware of the price charge by other sellers. This ensures that a seller
cannot charge a buyer a higher price than the other sellers, and sellers will not sell at a price lower
than other sellers. This requirement of perfect knowledge also extends to issues such as use of
technology, different production techniques and availability and the cost of factors of productions.
Under perfect competition, all firms have access to the same information.

Perfect mobility of the factors of production implies that land, labour and capital can be moved
according to changing market conditions. This ensures that the factors of production are allocated
in the most efficient manner.

Perfect completion also requires that there is no government intervention in the market. It is left
to the forces of demand and supply to sort out the economic problem of what to produce, how to
produce and for whom to produce.

Given the requirements of perfect competition, which of the following markets do you think
satisfies all the requirements?
o The stock exchange
o The market for electricity
o The foreign exchange market
o The maize market
o None of the above.
None of the above would be the safest choice here because in the real world, there is no market
that can fulfil all the requirements of perfect competition.

While some markets are closer to perfect competition than others, there is no market in the real world
that satisfies all the requirements. For instance, while the stock exchange market and the foreign
exchange market closely resembles perfection competition there are however restrictions on entering
and information might be costly to acquire and can be complex to understand.
In South Africa, the market for electricity is dominated by only one supplier and therefore violates the
principle of many sellers. To enter the maize market as a supplier might also be difficult.
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At this stage, you are probably asking why one needs to study perfect competition if it is only a
theoretical ideal. We can still learn a lot about how a firm operates and what motivates an
entrepreneur’s decisions. Once we understand the basic principles underlying the theory of the firm
under perfect competition, we can start to explore how a firm operates in a more complex environment.

ACTIVITY 1

Indicate whether the following statements relating to perfect competition is true or false:

T F

1.1 Under perfect competition, buyers are price takers, while suppliers are price
makers.

1.2 Under perfect competition, a producer is a price taker since it cannot influence
the market price and has to take the market price as given.

1.3 Perfect competition can only exist if the goods sold in the market by different
sellers are identical or homogeneous.

1.4 Perfect competition is characterised by a large degree of government

intervention.

1.5 Perfect competition represents a standard or norm against which the functioning
of all other markets can be compared.

14.2 The demand curve of the perfectly competitive firm

After you have worked through this section of the learning unit, you should be able to:

• derive the demand curve for a perfectly competitive firm

Let's assume that the market for fried chicken pieces is a perfectly competitive market. There are many
buyers and sellers in this market, the suppliers produce a homogeneous good, there is no collusion
between the sellers and buyers, and firms are free to enter and exit the market as they wish. In addition,
we also assume there is perfect knowledge about market conditions, there is no government
intervention in the market, and the factors of production in the market are perfectly mobile.
In this market, suppliers of fried chicken pieces are price takers. A price taker is a firm that has no
control over the price at which it is able to sell its product. But how do firms know which price they are
supposed to "take" or charge?
In a perfectly competitive market, the price of a product is determined by the forces of market demand
and market supply; and the price is set at such a level that the quantity demanded is equal to the
quantity supplied. In terms of the demand and supply curves, this occurs where the market demand and
the market supply curves intersect. Do you remember how the market equilibrium price is determined?
If not, refer back to the unit on market equilibrium.
 172

Market for fried chicken pieces

Let's take a closer look at what it means for an individual firm to be a price taker.
As an example, we will use Funky Chicken, which is a supplier of fried chicken pieces in the market
for fried chicken pieces.
The market for fried chicken, which is represented in diagram A, consists of the market demand and
market supply of fried chicken pieces. Given this market demand and market supply, the equilibrium
price is established at R4 and the equilibrium quantity at 100 000 fried chicken pieces.

Diagram A Diagram B
In diagram B, the position of the individual supplier of fried chicken pieces, Funky Chicken, is
represented. Since Funky Chicken is a price taker, it has to take the price of R4 as given and sell its
fried chicken pieces at R4. By extending the market price of R4 to diagram B as a horizontal line, the
demand curve facing the individual firms is derived. This demand curve is perfectly elastic and
indicates that Funky Chicken can sell any quantity at a price of R4. Remember that Funky Chicken has
a small market share since there are many sellers in the market.
Why can it not sell chicken pieces for R5? It is selling the same product as other suppliers, and since
buyers know that they can obtain a piece of fried chicken for R4, nobody would be prepared to buy it
for R5. Why not sell a piece of fried chicken for R3? Because Funky Chicken knows that it can sell all
its fried chicken pieces for R4, and because it wishes to maximise its profits, it would be irrational for
the business to sell it for R3 if it can obtain R4 for a piece of fried chicken.

Change in the market and the individual demand curve

After you have worked through this section of the learning unit, you should be able to:

• demonstrate how a change in the market influences the demand curve for a firm
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We have now learnt that the perfectly competitive firm is a price taker. So what implications would a
change in the market have for the individual firm?

Assume that the income of households increase. How do you think the market for fried
chicken would react to this increase in income?
The market demand for fried chicken pieces would increase and the equilibrium price
would rise.
The market supply of fried chicken pieces would decrease and the equilibrium price would
rise.
It would increase the demand for fried chicken pieces and the equilibrium price would rise.

If the equilibrium price for fried chicken pieces in the market increases from R4 to R6, at
what price would Funky Chicken sell its fried chicken?
o R4
o R6
It would sell at the market equilibrium price, which is R6, because Funky Chicken is a
price taker.

Graphically, the impact of an increase in the market demand on the individual demand by Funky
Chicken can be represented as follows:

In the market for fried chicken pieces, the market demand curve shifts to the right and the equilibrium
price increases from R4 to R6. The impact on the individual demand for Funky Chicken can now sell
any quantity at R6.

ACTIVITY 2

2.1 Indicate whether the following statements relating to the quantities of Spar Cold-drinks
is true or false:
T F

a. By changing its quantity supplied, Spar Cold-drinks can influence the market
equilibrium price of cold drinks.

b. Customers are able to purchase cold drinks at the market equilibrium price from
any supplier of cold drinks.
 174

T F

c. If Spar Cold-drinks charges a higher price than the price determined by the
market, the quantity demanded for the firm’s cold drinks will fall to zero.

d. Spar Cold-drinks can only sell 50 cold drinks at the equilibrium price.

e. Selling cold drinks at a price lower than the market equilibrium price would not
be beneficial for Spar Cold-drinks since the business can sell any quantity at the
equilibrium price.

2.2 Use the diagram to complete the following paragraph by choosing the correct option in brackets:

An increase in the number of suppliers will cause a (rightward; leftward) shift of the (market
supply; market demand) curve. This will cause the market equilibrium price to (decrease;
increase) and the individual demand curve facing the firm will shift (upwards; downwards).

14.3 Total revenue, average revenue and marginal revenue of the perfectly
competitive firm
After you have worked through this section of the learning unit, you should be able to:

• distinguish between total revenue, average revenue and marginal revenue of the perfectly
competitive firm

Total revenue is the income brought into the firm from selling its products. It is calculated by
multiplying the price of the product by the quantity of output sold:
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 = 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑 × 𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒
𝑻𝑻𝑻𝑻 = 𝑷𝑷 × 𝑸𝑸

If the price of a product is R100 and the firms sells 20 units, the total revenue of the firm is R100 x 20
= R2 000.
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If the market price for a fried chicken piece is R4, what is the total revenue of Funky Chicken if it
sells ______?
o 1 piece of fried chicken
o 4 pieces of fried chicken
o 10 pieces of fried chicken

For one piece of fried chicken, it is R4 x R1 = R4, for four pieces it is R4 x 4 = R16 and for ten
pieces it is R4 x 10 = R40. As its sells more, its total revenue increases.

Average revenue is the revenue generated per unit sold and is calculated by dividing the total
revenue by the quantity sold.
𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓
𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 =
𝒒𝒒𝒒𝒒𝒒𝒒𝒏𝒏𝒏𝒏𝒏𝒏𝒏𝒏𝒏𝒏
𝑻𝑻𝑻𝑻
𝑨𝑨𝑨𝑨 =
𝑸𝑸

If the total revenue of a firm is R5 000 and the quantity sold is 1 000, then the average revenue per unit
is R5 000 ÷ 1 000 = R5.

What is the average revenue of Funky Chicken if its total revenue is _____?
R12 and the number of units sold is 3
R20 and number of units sold is 5
If total revenue is R12 and the number of units sold is three, then the average revenue is R12 ÷ 3 =
R4; and if total revenue is R20 and the number of units sold five, it is R4. You will see later that
for a firm under perfect competition, its average revenue is equal to the price.

Marginal revenue (MR) is the increase in total revenue that results from the sale of one
additional unit of output. Marginal revenue is calculated by dividing the change in total revenue by
the change in quantity.
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓
𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴𝑴 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 =
𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 𝒊𝒊𝒊𝒊 𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒𝒒
∆𝑻𝑻𝑻𝑻
𝑴𝑴𝑴𝑴 =
∆𝑸𝑸

If a firm sells one additional unit for R100, the marginal revenue of the firm is R100.

Given the following information for Funky Chicken, calculate the marginal revenue for the 4th and
5th unit.
The total revenue for three units is R12, and the total revenue for four units is R16.
By increasing its sales from four to five units, the total revenue for Funky chicken increases from
R16 to R20.
By selling the 4th unit, the marginal revenue is R4 and by selling the 5th unit, the marginal
revenue is R4. As you will shortly see, for a firm under perfect competition, the marginal revenue
is equal to the price.
 176
The following table indicates the total revenue, average revenue and marginal revenue for Funky
Chicken:
Total revenue, average revenue and marginal revenue

Total Marginal Average

Price
Quantity revenue revenue revenue
P
Q TR MR AR
(rand)
(rand) (rand) (rand)
R4 - --- ---
1 R4 4 4 4
2 R4 8 4 4
3 R4 12 4 4
4 R4 16 4 4
5 R4 20 4 4

The market price for a fried chicken piece is R4 and this is indicated in column 2. Note that the market
price does not change as the quantity changes, since the firm under perfect competition is a price taker.
The total revenue is equal to the price (column 2) times the quantity (column 1) and is indicated in
column 3. The marginal revenue is the revenue from selling an additional unit and is provided in
column 4. Since the quantity is given for intervals of one, the marginal revenue for the fourth unit can
be calculated as follows: total revenue for four units minus total revenue for three units = R16 – R12 =
R4.
The interesting thing to note about the marginal revenue is that it is a constant R4 and equal to the price
of R4. In other words, the marginal revenue does not change as the firm produces more output and is
equal to the price. Think of it in this way: If the price at which a firm can sell its product is given, then
the marginal revenue (the additional revenue the firm obtains by selling an additional unit) is also equal
to the price that the firm can obtain for that additional unit. Funky Chicken is a price taker and is too
small to influence the market price by supplying more. So, every time Funky Chicken sells one more
fried chicken piece, its revenue increases by exactly the same amount as the market price of R4.
Average revenue, which is indicated in column 5, is calculated by dividing the total revenue (column 3)
by the quantity (column 1). It is also constant and equal to the market price of R4.
From the above table, we can see that price (P) = marginal revenue (MR) = average revenue (AR). The
demand curve facing the individual firm under perfect competition is therefore also the marginal
revenue curve and the average revenue curve.
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Total revenue is indicated by the area under the individual demand curve (P x Q).
Now do the following activity to see if you understand the difference between total revenue, marginal
revenue and average revenue:

ACTIVITY 3

3.1 Study the following diagram of the market for cold drinks and individual demand facing Spar
Cold-drinks in the market for cold drinks and then answer the following questions:

a. Use the data in the diagram to complete the following table.

Quantity Price Total revenue Marginal Average

Q P TR revenue revenue
(rand) (rand) MR AR
(rand) (rand)
1
2
3
4
5
6
 178
b. If the market equilibrium price increases to R12, then marginal revenue for each output
level will be ______.
c. If the market equilibrium price increases to R12, then average revenue for each output level
will be ____.
3.2 Do you agree or disagree with the following statement?
For Spar Cold-drinks, the price (P) = marginal revenue (MR) = average revenue (AR). The
demand curve facing Spar Cold-drinks under perfect competition is therefore also the marginal
revenue curve and the average revenue curve.
a. Agree
b. Disagree

14.4 Profit maximisation of the individual firm

After you have worked through this section of the learning unit, you should be able to:

• identify, describe and illustrate with the aid of diagrams the profit maximisation position of a
firm

The goal of all firms is to maximise their profit. Under perfect competition, a firm cannot determine the
price of the good or service it sells because it is a price taker. However, what it can decide on is the
quantity of the good or service it will provide; and if it wishes to maximise its profits, it should set its
quantity at such a level that it maximises its profit.
The profit maximisation position of the firm can be understood in terms of total revenue (TR) and total
costs (TC), but can also be determined using marginal revenue (MR) and marginal cost (MC).
We will make use of the marginal revenue (MR) and marginal cost (MC) approach to determine the
profit maximisation position of a firm under perfect competition.

You are given the following information:

The marginal cost of producing an additional fried chicken piece is R3,20.
The marginal revenue of this additional fried chicken piece is R4.
Should Funky Chicken produce this additional fried chicken piece?
o Yes, because it contributes to its profits.
o No, because it decreases its profit.

The additional cost is only R3,20, while the additional revenue is R4. By producing this additional
fried chicken piece, Funky Chicken adds 80 cents to its profits.

According to the marginal revenue marginal cost approach, a firm under perfect competition should
continue to increase its production as long as the marginal revenue exceeds the marginal cost. In other
words, as long as the revenue of an additional unit is greater than the additional cost to produce that
unit, profits are growing and it is worth producing the additional unit.

You are given the following information:

The marginal cost of producing an additional fried chicken piece is R6.
The market price of a fried chicken piece is R4.
Should Funky Chicken produce the additional unit?
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o No, because the marginal cost is greater than the marginal revenue.
o Yes, because the marginal cost is less than the marginal revenue.
o I cannot say, because the marginal revenue is unknown.

The marginal cost is indeed greater than the marginal revenue since the marginal revenue is R4.
Remember that P = MR. In this case, producing the additional unit will cost more than what it can
be sold for and profits therefore decline. Funky Chicken should therefore not produce the
additional unit.

As a general rule, we can now state the following:

 If marginal revenue is greater than marginal cost (MR > MC), the firm should increase
production.
 If marginal revenue is equal to marginal cost (MR = MC), profit maximisation is reached.
 If marginal revenue is less than marginal cost (MR < MC), the firm should decrease
production.

In order to determine the profit maximisation position, we need to add the cost of production data.
The following table indicates the cost and revenue data for Funky Chicken:
Table: Cost and revenue data for Funky Chicken

Quantity Marginal
Total cost Total revenue Marginal cost
(units of fried revenue
TC TR MC
chicken MR
(rand) (rand) (rand)
pieces) (rand)
0 62 0 --- ---
10 90 40 2,80 4,00
20 110 80 2,00 4,00
30 126 120 1,60 4,00
40 144 160 1,80 4,00
50 166 200 2,20 4,00
60 192 240 2,60 4,00
70 224 280 3,20 4,00
80 264 320 4,00 4,00
90 324 360 6,00 4,00
100 404 400 8,00 4,00

Column 1 indicates the quantity of fried chicken pieces. The total cost to produce these quantities is
provided in column 2, while the total revenue from selling these quantities is provided in column 3.
Column 4 indicates the marginal cost and column 5 the marginal revenue.
 180

Study the above table and answer the following questions:

Which one of the following correctly describes what is happening to marginal cost as more is
produced?
o Marginal cost is constant.
o Marginal cost eventually increases at an increasing rate.
o Marginal cost eventually increases at a decreasing rate.
o Marginal cost decreases.
What we see is that marginal cost eventually increases at an increasing rate (1,6; 1,8; 2,2; 2,6; …).
This is due to the law of increasing costs.
Which one of the following correctly describes what is happening to marginal revenue as more is
produced?
o Marginal revenue is constant.
o Marginal revenue eventually increases at an increasing rate.
o Marginal revenue eventually increases at a decreasing rate.
o Marginal revenue decreases.
What we see is that marginal revenue is constant.

To determine at which output level Funky Chicken maximises its profits, we can use the rule that profit
maximisation occurs where marginal revenue equals marginal cost (MR = MC).
According to the data for Funky Chicken, this occurs at an output level of 80. This is also the point
where the difference between total revenue and total cost is the greatest, as indicated in the following
table:
Revenue and cost

Quantity Marginal cost Marginal

Total cost Total revenue Profit
(units of fried MC revenue
TC TR TR-TC
chicken) (rand) MR
(rand) (rand) (rand)
Q (rand)
0 62 0 --- --- -62
10 90 40 2,80 4,00 -50
20 110 80 2,00 4,00 -30
30 126 120 1,60 4,00 -6
40 144 160 1,80 4,00 16
50 166 200 2,20 4,00 34
60 192 240 2,60 4,00 48
70 226 280 3,40 4,00 54
80 264 320 4,00 4,00 56
90 324 360 6,00 4,00 36
100 404 400 8,00 4,00 -4
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We can now represent the profit maximisation position of Funky Chicken graphically. For this purpose,
we will only use the quantity, marginal revenue and marginal cost data as indicated in the table below.

Marginal cost and revenue for Funky Chicken The firm maximises profits at point E where
Quantity (units Marginal marginal revenue is equal to marginal cost. The
Marginal cost output level at this point is 80.
of fried revenue
MC
chicken) MR
(rand)
Q (rand)
10 2,80 4,00
20 2,00 4,00
30 1,60 4,00
40 1,80 4,00
50 2,20 4,00
60 2,60 4,00
70 3,40 4,00
80 4,00 4,00
90 6,00 4,00
100 8,00 4,00

Consider an output level of 60 in the following diagram:

What is the marginal revenue at this output level?

What is the marginal cost at this output level?
Should the firm increase or decrease its production?
At an output level of 60, the marginal revenue is R4,00 and the marginal cost is R2,60. Since
marginal revenue is greater that marginal cost, Funky Chicken should increase its production
because the additional units produced add to the firm's profits.
 182

Consider an output level of 90 in the following diagram:

What is the marginal revenue at this output level?

What is the marginal cost at this output level?
Should the firm increase or decrease its production?
At an output level of 90, the marginal revenue is R4,00 and the marginal cost is R6,00. In this case,
the profits from Funky Chicken decrease since it costs R6,00 to produce the additional unit.
However, the revenue from it is only R4,00, and there is a loss of R2,00. By decreasing its
production, Funky Chicken can increase its profits.

Levels of output to the right of 80, where MR = MC, indicate that marginal revenue is less than
marginal cost, and it is in the interest of the firm to decrease its production in order to increase its
profits.

To summarise, we can conclude the following:

The firm maximises profits if it produces the quantity where the marginal revenue (MR) is equal to the
marginal cost (MC).
If MR = MC, then there is profit maximisation.
If MR > MC, then profits increase.
The reason for this is straightforward. For as long as the marginal revenue is greater than the marginal
cost, the marginal revenue contributes towards total profits. By producing and selling an additional
unit, the producer gains more than it costs to produce the additional unit, and its profits increase.

If MR < MC, then profits decrease.

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When marginal revenue is less than marginal cost, total profits will decline. It is costing the firm more
to produce the additional unit than it obtains from selling the additional unit. It is therefore not in the
interest of the firm to produce the extra unit because this decreases its profits.
Now do the following activity to see if you understand the profit maximisation position of the
individual firm:

ACTIVITY 4

Each graph indicates the output which the ice cream factory is currently producing. Based on the
following graphs, what should the firm do to its output in each instance if it wishes to maximise its
profits?
4.1

a. Expand output
b. Leave output unchanged
c. Reduce output
4.2

a. Expand output
b. Leave output unchanged
c. Reduce output
 184
4.3

a. Expand output
b. Leave output unchanged
c. Reduce output

14.5 Profit position of the firm

After you have worked through this section of the learning unit, you should be able to:

• distinguish between normal profit, economic profit and a loss

To determine whether a firm is making a normal profit, an economic profit or a loss we need to add the
average cost (AC) curve to the individual firm's marginal cost (MC) and marginal revenue (MR)
curves.
If you do not remember the characteristics of the average cost (AC) curve refer to the topic "Cost of
production".

Normal profit
Normal profit is the best return that the firm's self-owned, self-employed resources could earn
elsewhere. It can be regarded as the minimum payment required by the owner of the firm to stay in the
particular business. Normal profit includes the cost of the owner's time and capital. Thus, if an
economist talks about the cost of doing business, he or she would include the normal profits that must
be paid to the owners to keep them in the particular business.
Consider the diagram below where the average cost curve has been added to the marginal revenue and
marginal cost curves. Average cost consists of average fixed cost and average variable cost and the
average cost curve (AC) is U-shaped. The marginal cost curve (MC) is upward sloping and the
marginal and average revenue curves (AR = MR) are the same and horizontal.
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Given a market price of P, profit is maximised where MR = MC = P. This occurs at a quantity of Q. At

Q, the firm's average revenue (AR) per unit of production is P, which is also equal to the average cost
per unit (AC). Since AR = AC, the firm only earns a normal profit, since all its costs, including the
opportunity cost of self-owned, self-employed resources, are fully covered. Point E is usually called the
break-even point which is the point where the firm is able to cover its costs and earns only a
normal profit.
As long as average revenue is equal to average cost, the firm is earning a normal profit.

If AR = AC, then a normal profit is earned.

Alternatively, you can find the firm's profit position by subtracting the firm's total cost from its total
revenue. The firm's total revenue is equal to the price of the product P, multiplied by the quantity
produced (and sold) Q. This is equal to the area 0-P-E-Q in the above diagram. The total cost of the
firm is equal to the average cost, which is equal to P, multiplied by the quantity Q, and is also
represented by the area 0-P-E-Q (the same as for total revenue). Therefore, total revenue equals total
cost and the producer is only making a normal profit.

Economic profit
Economic profit is equal to the total revenue that exceeds the total cost. Economic profit is the extra
profit the owner receives above the minimum payment required (the normal profit) by the owner of the
firm to stay in the particular business. Economic profit is sometimes called excess profit, abnormal
profit, super-normal profit or pure profit.

Given a market price of P, profit is maximised where MC = MR = P. This occurs at a quantity of Q. At

Q, the firm's average revenue (AR) per unit of production is P. The average cost per unit of
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production is C. At an output level of Q, the firm is making an economic profit per unit of production
of P – C. The total profit is given by the area C-P-E-M, which is equal to the profit per unit of output P
– C multiplied by the quantity produced Q.
As long as average revenue is greater than average cost, the firm is earning an economic profit.

If AR > AC, then an economic profit is earned.

Alternatively, the area representing total profit can be obtained by subtracting the firm's total cost from
its total revenue. The firm's total revenue is equal to the price of the product P multiplied by the
quantity produced (and sold) Q. This is equal to the area 0-P-E-Q. The total cost of the firm is equal to
the average cost C, multiplied by the quantity Q, and is represented by the area 0-C-M-Q. The
difference between these two areas is the economic profit and is represented by the area C-P-E-M.

Economic loss
As long as the price is equal to or higher than average cost per unit, the firm makes a profit. But what
happens if, for some reason, the price falls below the average cost per unit or the average cost increases
and total revenue is less than total cost? In this case, the firm makes an economic loss.

Given a market price of P, MR = MC at point E. This occurs at a quantity of Q. At Q, the firm's

average revenue (AR) per unit of production is P, which is lower than the average cost per
unit C. Since AR < AC, the firm therefore makes an economic loss per unit of output, equal to the
difference between C and P. The total economic loss is indicated by the area P-C-M-E.

If AR < AC, then an economic loss occurs.

Alternatively, the area representing a total loss can be obtained by subtracting the firm's total cost from
its total revenue. The firm's total revenue is equal to the price of the product P multiplied by the
quantity produced (and sold) Q. This is equal to the area 0-P-E-Q. The total cost of the firm is equal to
the average cost C, multiplied by the quantity Q, and is represented by the area 0-C-M-Q. The
difference between these two areas is the economic loss indicated by the area P-C-M-E.
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Now do the following activity to see if you understand the profit maximisation position of the
individual firm:

ACTIVITY 5

5.1 Indicate whether the following statements relating to average and marginal variables
is true or false:
T F

a. Whenever marginal revenue (MR) is greater than marginal cost (MC), the firm
is making a total profit.

b. If a firm's average revenue (AR) is greater than its average cost (AC), it is
earning a normal profit.

c. If a perfectly competitive firm is earning a normal profit only, it follows that

its average cost, marginal cost, average revenue and marginal revenue are all
equal at the equilibrium quantity and also equal to the market price.

d. If a perfectly competitive firm is making an economic loss, it implies that its

average cost (AC) is greater than the market price.

5.2 Study the following diagram and answer the questions:

a. At what point does the firm maximise profits?

b. What is the output level at the profit maximisation point?
c. What is the total revenue at the profit maximisation point?
d. What is the total cost at the profit maximisation point?
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e. Is average cost greater, the same or smaller than average revenue at point B?
f. Is the firm making an economic profit, a normal profit or an economic loss?
5.3 Study the following diagram and answer the questions:

a. At what point does the firm maximise profits?

b. What is the output level at the profit maximisation point?
c. What is the total revenue at the profit maximisation point?
d. What is the total cost at the profit maximisation point?
e. Is average cost greater, the same or smaller than average revenue at point A?
f. Is the firm making an economic profit, a normal profit or an economic loss?

14.6 The shutdown point

After you have worked through this section of the learning unit, you should be able to:

• identify and describe the shutdown point with the aid of a diagram

When should a firm considering shutting down its production? The first warning lights for a firm to
consider shutting down its production is when the total revenue (TR) the firm receives for its product is
less than the total cost of production (TC).
However, making a loss is not a sufficient enough reason for a firm to shut down its production in the
short run. To understand why it might be in the interest of a firm to continue production even if it
makes a loss, we need to revisit the difference between fixed and variable costs.
Fixed costs and variable costs

Fixed costs (FC) Variable costs (VC)

 The costs that remain constant
 The costs that change with the level of
irrespective of the level of output that is
output. They represent the cost of the
produced. Even if the level of production
variable inputs. As more of a good or
of a firm is zero, it must still pay its fixed
service is produced, the variable costs
costs.
increase.
 As the firm increases production, the
 Include payments for raw materials,
fixed costs do not increase but remain the
power, labour services, water, etc.
same.
 Are also called direct costs, prime costs
 Examples of fixed costs are the cost
or avoidable costs.
associated with the maintenance of a
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building, factory or equipment and the  These are the costs that the firm can
rent that must be paid even if it shuts avoid if it shuts down its operations.
down its operations.  In the long run, all inputs are variable, a
 Fixed costs are also known as sunk, firm can build another factory or sell the
unavoidable, overhead or indirect costs. one it has.

Fixed cost is only fixed in the short run. In the long run a firm can cancel the rental agreement for the
factory.
The following example of two firms that produce cold drinks in a perfectly competitive market
illustrates why it is in the interest of a firm to continue its production even if it makes a loss:
Given that the price of a cold drink is R5 and that each firm produces a 1 000 cold drinks, their total
revenue (TR) – that is, the price times the quantity (P x Q) – is R5 000. Both firms face the same fixed
cost of R2 000.
Their variable costs, however, differ. In the case of firm 1, the variable cost (VC) is R4 000, while for
firm 2, it is R5 500. The reason for the difference in the variable costs might be that firm 1 is more
efficient in using its resources than firm 2. The total cost of production (TC) for firm 1 to produce 1
000 cold drinks is therefore R2 000 (the fixed cost) + R4 000 (the variable cost) = R6 000; and for firm
2, it is R2 000 (fixed cost) + R5 500 (variable cost) = R7 500. In both cases, the total revenue is smaller
than the total cost, and both firms make a loss. The total loss for firm 1 is R5 000 – R6 000 = -R1 000,
while for firm 2, it is R5 000 – R7 500 = -R2 500.

The shutdown point

Firm 1 Firm 2
Total revenue (TR) R5 000 R5 000
Fixed cost (FC) R2 000 R2 000
Variable cost (VC) + R4 000 + R5 500
Total cost (TC) - R6 000 R6 000 - R7 500 R7 500
Total loss if it stays in
-R1 000 -R2 500
business
Total loss if it shuts
R2 000 R2 000
down

Should both firms shut down their production? Not necessarily. Let's see why.

Looking at firm 1, how much would it lose if it shuts down its production?
o R1 000
o R2 500
o R2 000
By shutting down its production, it would lose its revenue of R5 000, but it would also avoid the
variable cost of R4 000. However, it must still pay its fixed cost of R2 000. By shutting down its
operations, it would therefore lose R2 000. The choice for firm 1 is either to continue with its
production and lose R1 000 or shut down and lose R2 000. Which choice do you think the firm
should make?
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Looking at firm 2, how much would it lose if it shut down its production?
o R1 000
o R2 500
o R2 000
By shutting down its production, it would lose its revenue of R5 000, but it would also avoid its
variable cost of R5 500. However, it must still pay its fixed cost of R2 000. The choice for firm 2
is therefore to continue its production and lose R2 500 or shut down its business and lose R2 000.
What choice do you think the firm should make?

In the case of firm 1, it should keep on producing since it would only lose R1 000 as opposed to
R2 000, while firm 2 should shut down its business because by doing so it would only lose R2 000. If it
decides to keep the business open, it would lose R2 500. In this case, we say that firms are minimising
their losses.
There is another way of explaining the shutdown rule, that is, by comparing the price of the product
(P), which is also the average revenue (AR), with the average variable cost of production (AVC).
Remember:
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄
𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨 𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗𝒗 𝒄𝒄𝒄𝒄𝒄𝒄𝒄𝒄 =
𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸𝑸 𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑𝒑

In the above example, the average variable cost to produce 1 000 cold drinks for firm 1 is R4 000 ÷
1 000 = R4 per cold drink, while for firm 2 it is R5 500 ÷ 1 000 = R5,50.
As long as the price (and average revenue) is greater than the average variable cost, it is in the interest
of the firm to continue production. This is the case for firm 1 where the average revenue is R5 and the
average variable cost is R5.

P = AR > AVC keep on producing

If the price is lower than the average variable cost, the firm should shut down its business. This is the
case for firm 1, where the average revenue is R5 and the average variable cost is R5,50.

P = AR < AVC to shut down production

The following diagram provides a summary of the shutdown rule for the firm:
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In terms of a diagram, it can be represented graphically as follows:

The shutdown point for the firm is where P = AR = AVC. At a point below the shutdown point, the
average revenue is smaller than the average variable cost and the firm should shut down its production.
Do the following activity to see if you understand the shutdown point:

ACTIVITY 6

Indicate whether the firm should continue production or shut down.

6.1 Its average revenue is R12, while its average variable cost is R15.
a. Continue
b. Shut down
6.2 Its average revenue is R10, its average cost is R12 and its average variable cost is R8.
a. Continue
b. Shut down
6.3 Its total revenue is less than its total variable cost.
a. Continue
b. Shut down
6.4 The price is greater than the average variable cost.
a. Continue
b. Shut down
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6.5 Use the diagram to complete the following sentence:

The breakeven point is represented by point _____ and the shutdown point by point ______ .

14.7 The supply curve of the firm and market supply

After you have worked through this section of the learning unit, you should be able to:
• derive the supply curve for an individual firm under perfect completion

An individual firm under perfect competition is a price taker and changes in the market will influence
its behaviour through changes in the price of the goods or services. In reaction to a change in the
market price, the firm will change the quantity it produces.
Let's consider the case where an increase in the income of households leads to an increase in the market
demand for fried chicken pieces. This impact is shown in diagram A, where the market demand curve
shifts to the right, causing the equilibrium price to increase to R5. The impact on Funky Chicken is
indicated in diagram B. Since Funky Chicken is a price taker, its individual demand curve shifts
upwards to R5. At this new price of R5, the marginal revenue is greater than the marginal cost at an
output level of 80. It is therefore in the interest of Funky Chicken to increase its output until marginal
revenue is equal to marginal cost. This occurs at an output level of 100.

Diagram A: Market Diagram B: Individual firms

What we can conclude from this is that an increase in the price leads to an increase in the quantity
supplied. We have now provided an explanation for why the supply curve is upward sloping – in other
words, why it is that an increase in price leads to an increase in the quantity supplied, and vice versa.
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One can also view this from another angle and argue that owing to the law of increasing marginal cost,
a firm will only be willing to supply a higher quantity if it can obtain a higher price.

We have also identified the shutdown point as point B – the point where the average revenue (AR) is
equal to the average variable cost (AVC). At a price lower than P2, the firm will not be willing to
supply goods and services. The part of the marginal cost curve that lies below point B is therefore not
part of the supply curve of the firm. For instance, a point such as A, where the price is P1 and the
average revenue (AR) is smaller than the average variable cost (AVC), is not part of the firm's supply
curve.
The part of the marginal cost curve that lies above the shutdown point, point B, however, is part of the
firm's supply curve. As the price rises from P2, the firm supplies a higher quantity. Note that even if it
makes a loss, that is, between points B and C, it is still in the firm’s interest to supply the good since it
is minimising its losses.
By adding all the different supply curves of firms together, one can obtain the market supply curve.

ACTIVITY 7

7.1 Study the graph below and answer the questions that follow:

a. Which point is not part of the firm's supply curve?

b. Which point is the shutdown point?
c. Does the firm make an economic loss at point C?
d. At which point on the supply curve does the firm make a normal profit?
e. At which point on the supply curve does the firm make an economic profit?
f. The supply curve runs from point ______ onwards.
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14.8 Long-run equilibrium of the individual firm

After you have worked through this section of the learning unit, you should be able to:

• describe the long-run equilibrium position

We have learnt that, in the short run, firms will be restricted in some way by the presence of fixed
costs. However, in the long run, all factors of production and costs become variables, and firms are able
to enter and exit the market. If firms in the market are making economic profits, this will attract new
entrants into the market, whereas if firms are making economic losses, this will lead to firms exiting the
market.
What condition of perfect competition allows firms to enter and exit?
o Many buyers and sellers
o Homogeneous goods
o Complete freedom of entry and exit
This is due to complete freedom of entry and exit.

When existing firms are making an economic profit, it will attract new firms wishing to enter the
market. As more firms enter the market, the market supply increases and the equilibrium price
decreases. This process will continue until firms are only making a normal profit.
This can be illustrated by the following diagrams:
The market is represented in diagram A, while the individual firm is represented in diagram B.
At a market price of P1, the firm is making an economic profit as the average revenue is greater than the
average cost. This is indicated by point A. The economic profit attracts firms to enter the market, and
the market supply curve thus shifts to the right, and the market equilibrium price decreases to P2. As the
market equilibrium price decreases, the firm's economic profit declines, as indicated by point B. This
process of an increase in the number of new entrants, an increase in the market supply and a decrease in
market equilibrium price continues until point C is reached, where only normal profits are earned.
Thus, in the perfectly competitive market, long-run equilibrium will only be achieved once all firms are
earning normal profits.

Diagram A Diagram B
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ACTIVITY 8

Indicate whether the following statement relating to a competitive market is true or false:

T F

8.1 If all the firms in a perfectly competitive industry earn economic profits, new
firms will be attracted to the market. The supply of the goods will increase,
thus lowering the price. Eventually, all the firms will be earning normal profit
only.

8.2 Complete the paragraph by selecting the correct options in the brackets.
If individual firms make an economic loss it will result in (new firms entering; existing firms
exiting). The market supply thus (increases; decreases) and the market supply curve shifts
(leftwards; rightwards) and the market price (increases; decreases). This change in the market
price causes the marginal revenue curve of the individual firm to (shift downwards; shift
upwards) causing the (economic profit; normal profit; economic loss) of the firm to decline. This
process continues until only (an economic profit; a normal profit; an economic loss) is made by
the firm.

Summary: Efficiency in perfectly competitive markets

When profit-maximising firms in perfectly competitive markets combine with utility-maximising
consumers, something remarkable happens: the resulting quantities of outputs of goods and services
demonstrate both technical and allocative efficiency.
Technical efficiency means producing without waste, so that the choice is on the production possibility
curve. In the long run, in a perfectly competitive market, because of the process of entry and exit, the
price in the market is equal to the minimum of the long-run average cost curve. In other words, goods
are being produced and sold at the lowest possible average cost. Those firms that are inefficient will not
be able to profitably produce goods at this price and will be forced to leave the market.

Allocative efficiency means that among the points on the production possibility frontier, the point that
is chosen is socially preferred – at least in a particular and specific sense. In a perfectly competitive
market, price will be equal to the marginal cost of production. Think about the price that is paid for a
good as a measure of the social benefit received for that good; after all, willingness to pay conveys
what the good is worth to a buyer. Then think about the marginal cost of producing the good as
 196
representing not only the cost for the firm, but also more broadly as the social cost of producing that
good. When perfectly competitive firms follow the rule that profits are maximised by producing at the
quantity where price is equal to marginal cost, they are thus ensuring that the social benefits received
from producing a good are in line with the social costs of production.

To explore what is meant by allocative efficiency, it is useful to work through an example. Begin by
assuming that the market for wholesale flowers is perfectly competitive – hence P = MC. Now,
consider what it would mean if firms in that market were to produce a smaller quantity of flowers. At a
smaller quantity, marginal costs would not yet have increased as much, so that price would exceed
marginal cost; that is, P > MC. In that situation, the benefit to society as a whole of producing
additional goods, as measured by the willingness of consumers to pay for marginal units of a good,
would be higher than the cost of the inputs of labour and physical capital needed to produce the
marginal good. In other words, the gains to society as a whole from producing additional marginal units
would be greater than the costs.
Conversely, consider what it would mean if, compared to the level of output at the allocative efficient
choice when P = MC, firms were to produce a greater quantity of flowers. At a greater quantity, the
marginal costs of production would have increased so that P < MC. In that case, the marginal costs of
producing additional flowers would be greater than the benefit to society as measured by what people
would be willing to pay. For society as a whole, since the costs outstrip the benefits, it would make
sense to produce a smaller quantity of such goods.
When perfectly competitive firms maximise their profits by producing the quantity where P = MC, they
also ensure that the benefit to consumers of what they are buying, as measured by the price they are
willing to pay, is equal to the costs to society of producing the marginal units, as measured by the
marginal costs the firm must pay – and thus that allocative efficiency holds.
The statement that a perfectly competitive market in the long run will feature both technical and
allocative efficiency needs to be taken with a pinch of salt. Remember, economists use the concept of
"efficiency" in a particular and specific sense, not as a synonym for "desirable in every way". For one
thing, consumers' ability to pay reflects the income distribution in a particular society. Thus, a homeless
person may not have the ability to pay for housing because he or she has insufficient income. Although
the market could be efficient, it does not imply that it is equitable.
Perfect competition, in the long run, is a hypothetical benchmark. For market structures such as
monopoly, monopolistic competition and oligopoly, which are more frequently observed in the real
world than perfect competition, firms will not always produce at the minimum of average cost; nor will
they always set the price equal to marginal cost. Thus, these other competitive situations will not
produce productive and allocative efficiency.
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Moreover, real-world markets include many issues that are assumed away in the model of perfect
competition, including pollution, the invention of new technology, poverty, which may result in some
people being unable to pay for basic necessities of life, government programmes like national defence
or education, discrimination in labour markets, and buyers and sellers who must deal with imperfect
and unclear information.
However, the theoretical efficiency of perfect competition does provide a useful benchmark for
comparing the issues that arise from these real-world problems.

14.9 Imperfect competition

OVERVIEW

The perfectly competitive market introduced in the previous section lies at one end of a spectrum of
market models. At the other end is the monopoly model. It assumes a market in which there is no
competition, a market in which only a single firm operates. Two models that fall between the extremes
of perfect competition and monopoly are monopolistic competition and oligopoly.
In this section we will take closer look at the characteristics of a monopoly, monopolistic competition
and oligopoly.

TOPIC OUTCOME

After you have worked through this section of the learning unit, you should be able to:

• identify the characteristics of a monopoly, monopolistic competition and oligopoly

• describe the sources of monopoly power
Monopoly
Monopoly is at the opposite end of the spectrum of market models from perfect competition.
A monopoly firm has no rivals. It is the only firm in its industry. There are no close substitutes for the
good or service a monopoly produces. Not only does a monopoly firm have the market to itself, but it
also need not worry about other firms entering. In the case of monopoly, entry by potential rivals is
prohibitively difficult.
A monopoly does not take the market price as given; it determines its own price. It selects from its
demand curve the price that corresponds to the quantity the firm has chosen to produce in order to earn
the maximum profit possible. The entry of new firms, which eliminates profit in the long run in a
competitive market, cannot occur in the monopoly model.
A firm that sets or picks price based on its output decision is called a price setter. A firm that acts as a
price setter possesses monopoly power.
As was the case when we discussed perfect competition in the previous section, the assumptions of the
monopoly model are rather strong. In assuming there is one firm in a market, we assume there are no
other firms producing goods or services that could be considered part of the same market as that of the
monopoly firm. In assuming blocked entry, we assume, for reasons we will discuss below, that no other
firm can enter that market. Such conditions are rare in the real world. As always with models, we make
the assumptions that define monopoly in order to simplify our analysis, not to describe the real world.
The result is a model that gives us important insights into the nature of the choices of firms and their
impact on the economy.
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Sources of Monopoly Power

Why are some markets dominated by single firms? What are the sources of monopoly power?
Economists have identified a number of conditions that, individually or in combination, can lead to
domination of a market by a single firm and create barriers that prevent the entry of new firms.
Barriers to entry are characteristics of a particular market that block new firms from entering it. They
include economies of scale, special advantages of location, high sunk costs, a dominant position in the
ownership of some of the inputs required to produce the good, and government restrictions. These
barriers may be interrelated, making entry that much more formidable. Although these barriers might
allow one firm to gain and hold monopoly control over a market, there are often forces at work that can
erode this control.

Economies of Scale
Scale economies and diseconomies define the shape of a firm’s long-run average cost (LRAC) curve as
it increases its output. If long-run average cost declines as the level of production increases, a firm is
said to experience economies of scale.
A firm that confronts economies of scale over the entire range of outputs demanded in its industry is
a natural monopoly. Utilities that distribute electricity, water, and natural gas to some markets are
examples. In a natural monopoly, the LRAC of any one firm intersects the market demand curve where
long-run average costs are falling or are at a minimum. If this is the case, one firm in the industry will
expand to exploit the economies of scale available to it. Because this firm will have lower unit costs
than its rivals, it can drive them out of the market and gain monopoly control over the industry.

Location
Sometimes monopoly power is the result of location. For example, sellers in markets isolated by
distance from their nearest rivals have a degree of monopoly power. The local movie theater in a small
town has a monopoly in showing first-run movies. Doctors, dentists, and mechanics in isolated towns
may also be monopolists.

Sunk Costs
The greater the cost of establishing a new business in an industry, the more difficult it is to enter that
industry. That cost will, in turn, be greater if the outlays required to start a business are unlikely to be
recovered if the business should fail.
Suppose, for example, that entry into a particular industry requires extensive advertising to make
consumers aware of the new brand. Should the effort fail, there is no way to recover the expenditures
for such advertising. An expenditure that has already been made and that cannot be recovered is called
a sunk cost.

Restricted Ownership of Raw Materials and Inputs

In very few cases the source of monopoly power is the ownership of strategic inputs. If a particular firm
owns all of an input required for the production of a particular good or service, then it could emerge as
the only producer of that good or service.

Government Restrictions
Another important basis for monopoly power consists of special privileges granted to some business
firms by government agencies. State and local governments have commonly assigned exclusive
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franchises—rights to conduct business in a specific market—to taxi and bus companies, to cable
television companies, and to providers of telephone services, electricity, natural gas, and water,
although the trend in recent years has been to encourage competition for many of these services.
Governments might also regulate entry into an industry or a profession through licensing and
certification requirements. Governments also provide patent protection to inventors of new products or
production methods in order to encourage innovation; these patents may afford their holders a degree of
monopoly power during the 17-year life of the patent.
Patents can take on extra importance when network effects are present. Network effects arise in
situations where products become more useful the larger the number of users of the product. For
example, one advantage of using the Windows computer operating system is that so many other people
use it. That has advantages in terms of sharing files and other information.

Monopolistic competition
The model of monopolistic competition assumes a large number of firms. It also assumes easy entry
and exit. This model differs from the model of perfect competition in one key respect: it assumes that
the goods and services produced by firms are differentiated. This differentiation may occur by virtue of
advertising, convenience of location, product quality, reputation of the seller, or other factors. Product
differentiation gives firms producing a particular product some degree of price-setting or monopoly
power. However, because of the availability of close substitutes, the price-setting power of
monopolistically competitive firms is quite limited. Monopolistic competition is a model characterized
by many firms producing similar but differentiated products in a market with easy entry and exit.
Restaurants are a monopolistically competitive sector; in most areas there are many firms, each is
different, and entry and exit are very easy. Each restaurant has many close substitutes—these may
include other restaurants, fast-food outlets, and the deli and frozen-food sections at local supermarkets.
Other industries that engage in monopolistic competition include retail stores, barber and beauty shops,
auto-repair shops, service stations, banks, and law and accounting firms.

Oligopoly
In an oligopoly, the fourth and final market structure that we will study, the market is dominated by a
few firms, each of which recognizes that its own actions will produce a response from its rivals and that
those responses will affect it.
The firms that dominate an oligopoly recognize that they are interdependent: What one firm does
affects each of the others. This interdependence stands in sharp contrast to the models of perfect
competition and monopolistic competition, where we assume that each firm is so small that it assumes
the rest of the market will, in effect, ignore what it does. A perfectly competitive firm responds to the
market, not to the actions of any other firm. A monopolistically competitive firm responds to its own
demand, not to the actions of specific rivals. These presumptions greatly simplify the analysis of
perfect competition and monopolistic competition. We do not have that luxury in oligopoly, where the
interdependence of firms is the defining characteristic of the market.
Some oligopoly industries make standardized products: steel, aluminum, wire, and industrial tools.
Others make differentiated products: cigarettes, automobiles, computers, ready-to-eat breakfast cereal,
and soft drinks.
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ACTIVITY 9

Complete the following table by adding the appropriate characteristics:

Perfect Monopoly Monopolistic Oligopoly

competition competition
Freedom of
entry
Other
competitors
Characteristics
of product
Price setting
Interdependence
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ANSWERS TO THE
ACTIVITIES

Activity 1
1.1 The statement is false.
Both buyers and sellers are price takers.
1.2 The statement is true.
Producers are price takers and cannot influence the market price, and they have to take it as
given.
1.3 The statement is true.
There must be no product differentiation, and the product should be identical or homogeneous.
Consumers should be indifferent between the products of different firms in a perfectly
competitive market – they should not prefer the product of one firm above another.
1.4 The statement is false.
There is no government intervention in perfect competition.
1.5 The statement is true.
In reality, there are no such thing as a perfectly competitive market. However, the idea of a
competitive market serves as benchmark against what other markets can be compared.

Activity 2
2.1
a. The statement is false.
Spar Cold-drinks is a price taker and is too small to influence the market equilibrium price of
cold drinks.
b. The statement is true.
Buyers of cold drinks know what the market price is and they can obtain the product from any of
the many suppliers in the market.
c. The statement is true.
If Spar Cold-drinks sells the product for more than the market equilibrium price, buyers will not
buy from the business and the quantity demanded will therefore fall to zero.
d. The statement is false.
Spar Cold-drinks can sell any quantity at the market price.
e. The statement is true.
Spar Cold-drinks can sell any quantity at the market equilibrium price and has no incentive to sell
it at a lower price.
2.6 An increase in the number suppliers will cause a rightward shift of the market supply curve.
This will cause the market equilibrium price to decrease and the individual demand curve facing
the firm will shift downwards.
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Activity 3

3.1 a.

Quantity Price Total revenue Marginal Average

Q P TR revenue revenue
(rand) (rand) MR AR
(rand) (rand)
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10

b. R12. By selling an additional unit, their total revenue increases by R12.

c. R12. The price is R12, and their average revenue is also R12.
3.2 You should agree, because for Spar Cold-drinks the price (P) = marginal revenue (MR) = average
revenue (AR). The demand curve facing Spar Cold-drinks under perfect competition is therefore
also the marginal revenue curve and the average revenue curve.
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Activity 4

4.1 Expand output. Since marginal revenue is greater than marginal cost, the firm can increase its
profits by producing more.

4.2 Leave output unchanged. Since marginal revenue is equal to marginal cost, the firm is
maximising profits. If it expands production, its profits will decrease.

4.3 Reduce output. Since marginal revenue is smaller than marginal cost, the firm should reduce its
output in order to increase its profits.
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Activity 5
5.1
a. The statement is false.
When marginal revenue is greater than marginal cost, the firm is making a profit on this
additional unit. It does not mean that the firm is making a total profit. For the firm to make a total
profit, its average revenue must be greater than its average cost.
b. The statement is false.
If a firm's average revenue (AR) is greater than its average cost (AC), it is earning an economic
profit.
c. The statement is true.

At point E, AC = MC = AR = MR = P.
d.. The statement is true.

At a point such as M, average cost (AC) is greater than the market price P.
5.2
a. At point B. Profit is maximised where marginal revenue (MR) is equal to marginal cost
(MC). This occurs at point B where MR = MC = R10.
b. It is 100. Profit is maximised at point B, and the output level at point B is 100.
c. It is R1 000. Total revenue is price times quantity = P x Q = R10 x 100 = R1 000.
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d. It is R1 000. Total cost is average cost times quantity = AC x Q = R10 x 100 = R1 000.

e. It is the same. At point B, average cost (AC) = average revenue (AR) = R10.
f. It is making a normal profit because average revenue (AR) = average cost (AC) or total
revenue (TR) = total cost (TC). The firm will make an economic profit if average revenue
(AR) > average cost (AC) or total revenue (TR) > total cost (TC).

5.3
a. At Point A. Profit is maximised where marginal revenue (MR) is equal to marginal cost
(MC). This occurs at point A where MR = MC = R10.
b. It is 100. Profit is maximised at point A, and the output level at point A is 100.
c. It is R1 000. Total revenue is price times quantity = P x Q = R10 x 100 = R1 000.
d. It is R1 200. Total cost is average cost times quantity = AC x Q = R12 x 100 = R1 200.
 206

e. It is greater. Average cost (AC) > average revenue (AR). At point B, average cost (AC) is
R12, while average revenue is R10.
f. It is making an economic loss since average revenue (AR) < average cost (AC) or total
revenue (TR) < total cost (TC). The firm will make an economic profit if average revenue
(AR) > average cost (AC) or total revenue (TR) > total cost (TC).
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Activity 6

6.1 Shut down. Since its average revenue is smaller than its average variable cost, it should shut
down.

6.2 Continue. Since its average revenue is greater than its average variable cost, it should continue
with production. The firm has some revenue left to pay some of the fixed costs.

6.3 It should shut down. If total revenue (area 0-P1-A-Q) is less than total variable cost (area 0-P2-A-
Q), it implies that average revenue is less than average cost.
 208
6.4 Continue. The price is equal to average revenue, and if average revenue is greater than average
variable cost, the firm should continue with production.

6.5 The breakeven point is represented by point A and the shutdown point by point B.

Activity 7

7.1
a. Point A is not part of the supply curve since average revenue (AR) is smaller than average
variable cost (AVC).
b. Point B is the shutdown point since at this point average revenue (AR) is equal to average
variable cost (AVC).
c. It does. At point C, average revenue (AR) is less than average cost (AC) and the firm makes an
economic loss.
d. At point D, average revenue (AR) is equal to average cost (AC) and the firm makes a normal
profit.
e. At point E, average revenue (AR) is greater than average cost (AC) and the firm makes an
economic profit.
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f. The supply curve runs from point B onwards.

Activity 8

8.1 The statement is true. Economic profits attract new entrants and the market supply increases,
which decreases the price; and as the price decreases, economic profits decline.
8.2 If individual firms make an economic loss, it will result in existing firms exiting. The market
supply thus decreases and the market supply curve shifts leftwards and the market price
increases. This change in the market price causes the marginal revenue curve of the individual
firm to shift upwards causing the economic loss of the firm to decline. This process continues
until only a normal profit is made by the firm.
The above is illustrated in the following diagram:
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Activity 9

Perfect Monopoly Monopolistic Oligopoly

competition competition
Freedom of Easy Barriers to Easy Difficult
entry entry
Other Many None Less than Few
competitors perfect
competition
Characteristics Homogenous Unique Differentiated Differentiated and
of product unique
Price setting Price taker Price setter Limited price Limited price setting
setting
Interdependence None None None Between firms
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CHECKLIST

Well Satis- Must

factory redo
Concepts and relationships
I am able to
describe perfect competition
list the conditions necessary for perfect competition to exist
define a price taker and price maker
define total revenue, average revenue and marginal revenue and
identify the relationship between them
define the equilibrium position of the firm under perfect competition
describe the marginal revue marginal cost approach and how it relates
to the production decision of the firm
define normal profit, economic profit and an economic loss
identify the break-even point
identify the shut-down point
explain why the supply curve for a firm is upward sloping
describe the long run equilibrium of an individual firm
identify the characteristics of a monopoly, monopolistic competition
and oligopoly
identify the essential difference between monopolistic competition
and monopoly
identify the essential difference between monopolistic competition
and perfect competition
identify the sources of monopoly power
Diagrams
I am able to
(i) show on a diagram
(ii) explain with or without the aid of a diagram
the demand curve for a perfectly competitive firm
how a change in the market influence the demand curve for a
perfectly competitive firm
the relationship between total revenue, average revenue and marginal
revenue
the break-even point and the shut-down point
the profit maximisation positon of a firm
 212

Well Satis- Must

factory redo
distinguish between normal profit, economic profit and an economic
loss
the supply curve of the firm
the impact of new firms entering the market
Calculations
I am able to
calculate total, marginal, and average revenue under perfect
competition
calculate, with given prices and quantities, the profit and/or loss
position of the firm in the short run