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Market structure – identifies how a market is made up in terms of: The number of firms in the industry The nature of the product produced The degree of monopoly power each firm has The degree to which the firm can influence

price Profit levels Firms’ behaviour – pricing strategies, non-price

competition, output levels The extent of barriers to entry The impact on efficiency

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Economists group industries into four distinct market structures based on their characteristics. The four market models are: Pure competition Monopolistic competition Oligopoly Pure monopoly

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Pure competition is one of four market structures in which thousands of firms each produce a tiny fraction of market supply in their respective industries.

Examples: farm commodities (wheat, soybean, strawberries, milo), the stock market, and the foreign exchange market

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Very large numbers – a large number of independently acting sellers who offer their products in large markets.

Standardized product – firms produce a product that is identical or homogenous.

Price taker – the firm cannot change the market price, but can only accept it as “given” and adjust to it.

Free entry and exit – no barriers to entry exist.

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Advantages: optimal allocation of resources competition encourages efficiency consumers charged a lower price responsive to consumer wishes: Change in demand,

leads extra supply Disadvantages: insufficient profits for investment lack of product variety lack of competition over product design and

specification unequal distribution of goods & income externalities e.g. Pollution

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The demand schedule and demand curve faced by the individual firm in a purely competitive industry is perfectly elastic at the market price.

Recall that the firm is a price taker and cannot influence the market price.

However, the industry as a whole, which determines the market demand curve, can affect price by changing industry output.

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INDUSTRY (ORMARKET) DEMAND

AND SUPPLY

INDIVIDUALFIRM DEMAND

Price

P

Q Quantity Quantity

PriceS

D

D

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MARKET DEMAND AND SUPPLY FIRM DEMANDPrice

P1

Q1 Q2 Quantity Quantity

PriceS1

D

D1

S2

If market supply increases, the market price falls. Since each firm isa price taker, it has no choice but to charge the lower price for its product.

P2 D2

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Average revenue (AR) is total revenue from the sale of a product divided by the quantity of the product sold. AR = TR ÷ Q

Total revenue (TR) is the total number of dollars received by a firm from the sale of a product. TR = P x Q

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Marginal revenue (MR) is the change in total revenue that results from selling 1 more unit of output. MR = (change in TR) ÷ (change in Q) MR is constant at the market determined

price—each additional unit of output produced adds the same amount to total revenue.

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Graphically, total revenue is a straight line that slopes upward to the right.

The demand, marginal revenue, and average revenue curves are horizontal at the market price P. All three curves coincide.

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TR

D = AR = MR$4

Price

Quantity1 2 3 4

$8

$12

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Because the purely competitive firm is a price taker, it can maximize its economic profit (or minimize its economic loss) only by adjusting its output.

In the short run, the firm can adjust its variable resources (but not its fixed resources) to achieve the output level that maximizes profit.

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In deciding how much to produce, the firm will compare the marginal revenue and marginal cost of each successive unit of output.

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As long as producing is preferable to shutting down, the firm should produce any unit of output whose marginal revenue exceeds its marginal cost.

If the marginal cost of a unit of output exceeds its marginal revenue, the firm should not produce that unit.

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A method of determining the total output at which economic profit is at a maximum (or losses at a minimum) is known as the MR = MC rule. This rule only applies if producing is

preferable to shutting down. In pure competition only, we can restate

this rule as P = MC. A firm will adjust output until marginal

revenue is equal to marginal cost.

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Profit MaximizationIf price exceeds ATC at the MR = MC output (q*), the firm will realize an economic profit equal to q*(P – ATC).

Loss MinimizationIf price exceeds the minimum AVC but is less than ATC, the MR = MC output will permit the firm to minimize losses equal to q*(P – ATC).

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MC

MR

P

Q

ATC

AVCP*

ATC

q*

ECONOMICPROFIT

Using the MR = MC rule, output is q*. Since price is greaterthan ATC at q*, the firm is earning an economic profit.

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The price is less than ATC at q* so the firm is making a loss.Since price is greater than the minimum AVC at q*, the firm continuesto operateat a loss.

MC

MR

P

Q

ATC

AVC

P*

ATC

q*

AVC

LOSS

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Shutdown If price falls below the minimum AVC,

the competitive firm will minimize its losses in the short run by shutting down.

A firm shuts down if the total revenue that it would get from producing is less than the variable costs of production.

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P1

P2

P4P3

Break-even(normal profit)

point

Shutdown point (if P is below)

MC

quantity

ATC

AVC

Price

MR1

MR2

MR3

MR4

MR5P5

Q2 Q3Q4 Q5

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Generalized Depiction Price P1 is below the firm’s minimum AVC;

the firm will not operation and quantity supplied will be zero.

Price P2 is just equal to the minimum AVC. The firm will produce at a loss equal to its fixed cost.

Between price P2 and P4, the firm will minimize its losses by producing and supplying the MR = MC quantity.

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Generalized Depiction At price P4, the firm will just break even

and earns a normal profit. At price P5, the firm will realize an

economic profit by producing to the point where MR (=P) = MC.

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The competitive firm’s short-run supply curve tells us the amount of output the firm will supply at each price in a series of prices. It is the portion of the MC curve above the

shutdown point. It slopes upward because of the law of

diminishing returns.

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Equilibrium price is determined by the intersection of total, or market, supply and total demand. The individual supply curve of each of the

identical firms in an industry are summed horizontally to get the total supply curve.

The market supply together with market demand will determine the equilibrium price in a competitive industry.

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The long-run assumptions in a competitive industry are: The only adjustment is the entry or exit of

firms. All firms in the industry have identical cost

curves. The industry is a constant cost industry.