Chapter 5 : Market Structure

This chapter discusses how a particular firm decides to

achieve its profit maximization objective.

A firm‘s decision to achieve this goal is dependent on the

type of market in which it operates.

To this effect we distinguish between four major types of

markets:
- perfectly competitive market,
- monopolistically competitive market,
- oligopolistic market,
- and pure monopoly market
5.2. Perfectly competitive market

is a market structure characterized by a complete absence

of rivalry among the individual firms.

5.2.1 Assumptions of perfectly competitive market

A market is said to be perfectly competitive market if the

following assumptions are satisfied.

1. Large number of sellers and buyers:

 the number of sellers is assumed to be too large; the

share of each seller in the product’s total supply is very
Therefore, no single seller can influence the market price
by changing the quantity supplied.

 Similarly, the number of buyers is so large that the

share of each buyer in the total demand is very small,

and that no single buyer or a group of buyers can

influence the market price by changing individual or group
demand for a product.

Therefore, in such a market structure, sellers and buyers

are not price makers, rather they are price takers;

the price is determined by the market supply and demand

2. Homogeneous product:

buyers do not distinguish between products supplied by the

various firms of an industry.

Product of each firm is regarded as a perfect substitute

for the products of other firms.

Therefore, no firm can gain any competitive advantage over

the other firm.
3. Perfect mobility of factors of production:

factors of production are free to move from one firm to

another throughout the economy.

Labor can move from one job to another and from one
region to another.
Capital, raw materials, and other factors are not
monopolized.

4. Free entry and exit:

there is no restriction or barrier on entry of new firms to

the industry; and no restriction on exit of firms from the
5. Perfect knowledge about market conditions:

all the buyers and sellers have full information

regarding the prevailing and future prices and availability of
the commodity.

6. No government interference:-

government does not interfere in any way with the

functioning of the market.

There are no discriminatory taxes or subsidies, no allocation

of inputs by the procurement, or any kind of direct or
indirect control.
Where there is intervention by the government, it is
intended to correct the market imperfection.

From these assumptions, a single producer under perfectly

competitive market is a price-taker.

That is, at the market price, the firm can supply whatever
quantity it would like to sell.

Once the price of the product is determined in the market,

the producer takes the price (Pm in Graph 5.1. ) as given.

Hence, the demand curve (Df) that the firm faces in this
market situation is a horizontal line drawn at the equilibrium
***5.2.2 Short run equilibrium of the firm

The main objective of a firm is profit maximization.

If the firm incurs a loss, it aims to minimize the loss.
Profit is the difference between Total revenue and Total
cost.

Total Revenue (TR):

it is the total amount of money a firm receives from a given

quantity of its product sold.
It is obtained by multiplying the unit price (P) of the
commodity and the quantity (Q) of that product sold.
TR = P.Q
Average revenue (AR):- is the revenue per unit of item
sold.
AR is calculated by dividing the TR by the quantity of the
product sold.
AR = TR/Q = (P.Q)/Q = P

Therefore, the firm’s demand curve is also the average

revenue (AR) curve.

Marginal Revenue (MR): is the additional amount of

money/ revenue the firm receives by selling one more unit of
the product.

That is, MR is the change in TR resulting from the sale of an

MR is calculated as the ratio of the change in TR to the
change in the sale of the product.

MR = ∆(TR)/∆Q = ∆(P.Q)/∆Q = P(∆Q/∆Q) = P

Since P is a constant, MR = P

Thus, in a perfectly competitive market, a firm’s AR, MR

and P of the product are equal,

i.e., AR = MR = P = Df

Since the purely competitive firm is a price taker, it will

maximize its economic profit only by adjusting its
In the short run, the firm has a fixed plant.

It adjusts its output only through changes in the level of

variable resources.

It adjusts its variable resources to achieve the output level

that maximizes its profit.

There are two ways to determine the level of output,

at which a competitive firm will realize maximum profit or
minimum loss.

One method is to compare TR and TC;

the other is to compare MR and MC.
a) Total Approach (TR–TC approach)

In this approach, a firm maximizes total profits in the short

run,

when the (positive) difference between total revenue (TR)

and total costs (TC) is greatest.

In Graph 5.2. the profit maximizing output level is Qe.

At Qe output level, the vertical distance between the TR

and TC curves (or profit) is maximized.
b) Marginal Approach (MR–MC)

In the short run, the firm will maximize profit or minimize

loss by producing the output at which MR equals MC.

More specifically, the perfectly competitive firm maximizes

its short-run total profits when the following two conditions
are met:

• MR = MC
• Slope of MC > Slope of MR;
(or MC is rising, that is, Slope of MC > 0).
Mathematically,

Π = TR – TC

Π is maximized when dπ/dQ = 0

That is, dπ/dQ = d(TR)/dQ – d(TC)/dQ = 0

MR – MC = 0

MR = MC …First Order Condition (FOC)

The second order condition is that
d2π/dQ2 < 0
d2π/dQ2 = [d2(TR)/d2Q] – [d2(TC)/d2Q] < 0

That is,
d(MR)/dQ – d(MC)/dQ < 0
d(MR)/dQ < d(MC)/dQ

or, d(MC)/dQ > d(MR)/dQ

Where,
d(MR)/dQ = slope of MR
and d(MC)/dQ = slope of MC
Therefore,
Slope of MC > Slope of MR … Second Order Condition
(SOC).

Graphically, the marginal approach is shown in Graph 5.3.

The profit maximizing output is Qe,

where MC = MR
and MC curve is increasing.

At Q*, MC = MR,
but since MC is falling at Q*, it is not equilibrium output.
Profit or Loss

Whether the firm in the short- run gets positive, zero or

negative profit depends on the level of AC at
equilibrium.

Thus, depending on the relationship between price and AC,

the firm in the short-run may earn,
economic profit,
normal profit
or incur loss and decide to shut-down business.
i) Economic/positive profit

If the AC is below the market price at equilibrium, the firm

earns a positive profit equal to:
the area between the AC curve and the price line up
to the profit maximizing output.
Graph 5.4.

ii) Loss

If the AC is above the market price at equilibrium, the

firm earns a negative profit (incurs a loss) equal to:
the area between the AC curve and the price line.
Graph 5.5.
iii) Normal Profit (zero profit) or break- even point

If the AC is equal to the market price at equilibrium, the

firm gets zero profit or normal profit.
Graph 5.6.

iv) Shutdown point

A firm will not stop production simply because its AC

exceeds price (gets loss) in the short-run.

The firm will continue to produce irrespective of the

existing loss as far as the price is sufficient to cover the
This means,

if P > AVC, but P < AC, the firm minimizes total losses by
continuing operation.

But if P < AVC, the firm minimizes total losses by shutting

down.

Thus,
P = AVC is the shutdown point for the firm.
Graph 5.7.
*Example:
Suppose that the firm operates in a perfectly competitive
market.

The market price, P of its product is br 10.

The firm estimates its cost of production with the following
cost function:
TC = 2 + 10Q – 4Q2 + Q3

A) What level of output should the firm produce to

maximize its profit?
B) Determine the level of profit at equilibrium.
C) What minimum price is required by the firm to stay in
the
Solution
Given, P = br10, and TC = 2 + 10Q – 4Q2 + Q3

a) The profit maximizing output is that level of output

which satisfies the following condition:

MC = MR
and MC is rising

In a perfectly competitive market, MR = P (market price).

Hence, P = MR = 10.

or, MR = d(TR)/dQ, TR = P.Q = 10Q

So, MR = d(10Q)/dQ =10(dQ/dQ) =10
 MC = d(TC)/dQ = d(2 + 10Q – 4Q2 + Q3)/dQ = 10 – 8Q +
3Q2

To determine equilibrium output, just equate MC and MR,

and then solve for Q.
MR = MC

10 = 3Q2 – 8Q +10
3Q2 – 8Q = 0
Q (3Q – 8) = 0

Q=0 or Q = 8/3

We obtained two different output levels which satisfy

the first order (necessary) condition of profit
To determine which level of output maximizes profit,
use the second order test at the two output levels.

That is, see which output level satisfies the second order
condition of increasing MC. To see this, first determine the
slope of MC

Slope of MC = d(MC)/dQ = 6Q – 8

At Q = 0, slope of MC is – 8 + 6 (0) = – 8 which implies that

MC is decreasing at Q = 0.

Thus, Q = 0 is not equilibrium output because it does not

satisfy the second order condition.
At Q = 8/3, slope of MC is 6(8/3) – 8 = 8, positive, implying
that MC is increasing at Q = 8/3.

Thus, the equilibrium output level is Q = 8/3

b) To determine the firm’s profit at equilibrium,

calculate the TR the firm gets at this level of output,
and the TC of producing the equilibrium level of
output.

TR = P . Q
= (br 10) . (8/3)
TR = br 80/3
TC at Q = 8/3 can be obtained by substituting 8/3 for Q in
the TC function,
i.e., TC = 2 +10 (8/3) – 4 (8/3)2 + (8/3)3
TC = 19.18
Thus, the equilibrium (maximum) profit is

Π = TR – TC = 26.67 – 19.18
Π = birr 7.49

c) To stay in operation the firm needs the price, P

which equals the minimum AVC.

Thus, to determine the minimum price required to stay in

business, we need to determine the minimum AVC.
AVC is minimum when derivative of AVC is equal to zero.
That is:
d(AVC)/dQ = 0

Given TC = 2+10Q – 4Q2 + Q3 ,

TVC = 10Q – 4Q2 + Q3

AVC = TVC/Q = (10Q – 4Q2 + Q3)/Q

= 10 – 4Q + Q2

d(AVC)/dQ = d(10 – 4Q + Q2)/dQ = 0

– 4 + 2Q = 0
Q=2
i.e., AVC is minimum when output is equal to 2 units.
The minimum AVC is obtained by substituting 2 for Q in
the AVC function

i.e., min AVC = 10 – 4 (2) + (2)2 = 6.

Thus, to stay in the market the firm should get a minimum

price of P = br 6 = min AVC .
5 5.2.3 Short run equilibrium of the industry

The perfectly competitive firm always produces

where P = MR = MC (at P > AVC min.),

 Thus, the firm’s short-run supply curve is given by,

the rising portion of its MC curve above shutdown
point
(Graph 5.7).

 The industry/market supply curve is,

the horizontal summation of the supply curves of
the
individual firms.
An industry is at equilibrium in the short-run when
market is cleared at a given price, i.e., when,
total supply of the industry = total demand for its
product.

The prices at which market is cleared is equilibrium price.

When an industry reaches at its equilibrium,

there is no tendency to expand or to contract the
output.