EC-103Semester 2

Lectures 4 & 5

Market structure, perfect competition, monopoly and imperfect competition

Firms in competitive markets

An industry is a group of firms which produce similar products.

The total output of an industry is the output of firms within that industry.

A characteristic of an industry is they can have varying numbers of firms making up the output.

Microsoft is the only supplier of ‘Windows’ products.

However, the UK has over 100,000 farms producing agricultural products.

In the next couple of lectures we will be examining why some industries have many producers, some a few and others only one.

Initially we will examine two special benchmark cases, which will help us understand what determines market structure and the behaviour of sellers, perfect competition and monopoly.

Characteristics of a perfectly competitive market

•there are many buyers and sellers in the market therefore actions of any single buyer or seller has no affect on market

prices

• firms take the market price as given as a result have a horizontal demand curve

• the product sold by all firms is the same – homogeneous

• there is perfect customer information

• firms can freely enter or exit the market

The competitive firm’s demand curve

Price

Quantity

P D=AR=MR

For competitive firms, marginal revenue equals price

Objective of a perfectly competitive firm

•The goal of a competitive firm is to maximise profits

•Maximum profits are where the difference between total costs and total revenue is greatest

•Profit maximisation is found where marginal costs equals marginal revenue

Π max where MC = MR

REVISION

Maximizing profits

OutputQ1

E

MC

, MR

MC

MR

0

If MR > MC, an increasein output will increaseprofits.

If MR < MC, a decreasein output will increaseprofits.

So profits are maximized when MR = MC at Q1

(so long as the firmcovers variable costs)

The supply curve under perfect competition (1)

• Above price P3 (point C), the firm makes profit above the opportunity cost of capital in the short run

• At price P3, (point C), the firm makes NORMAL PROFITS

P1

£

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

The supply curve under perfect competition (2)

• Between P1 and P3, (A

and C), the firm makes

short-run losses, but

remains in the market

• Below P1 (the SHUT-

DOWN PRICE), the firm

fails to cover SAVC, and

exits

P1

£

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

The supply curve under perfect competition (3)

– showing how much the firm would produce at each price level.

P1

£

Output

SAVC

SMC

Q1

SATC

P3

A

C

Q3

• So the SMC curve above SAVC represents the firm’s SHORT-RUN SUPPLY CURVE

The firm and the industry in the short run under perfect competition (1)

INDUSTRY

Output

£

Q

P

SRSS

D

Firm

SAC

P

£

Output

SMC

D=MR=AR

q

The firm and the industry in the short run under perfect competition (1)

INDUSTRY

Output

£

Q

P

SRSS

D

Firm

Market price is set at industry level at the intersection of demand and supply– the industry supply curve is the sum of the individual firm’s supply curves

SAC

P

£

Output

SMC

D=MR=AR

q

The firm and the industry in the short run under perfect competition (2)

INDUSTRYFirm

The firm accepts price as given at P

– and chooses output at q where SMC=MR to maximize profits

SAC

P

£

Output

SMC

D=MR=AR

q Output

£

Q

P

SRSS

D

The firm and the industry in the short run under perfect competition (3)

INDUSTRY

Output

£

Q

P

SRSS

D

At this price, profits are shown by the shaded area.These profits attract new entrants into the industry.As more firms join the market, the industry supply curve shiftsto the right, and market price falls.

SRSS1

P1

SAC

Firm

P

£

Output

SMC

D=MR=AR

q Q1

Long-run equilibrium

INDUSTRYFirm

LAC

P*

£

Output

LMC

D=MR=AR

q*

The market settles in long-run equilibrium when the typicalfirm just makes normal profit by setting LMC=MR at the minimum point of LAC. Long-run industry supply is horizontal.If the expansion of the industry pushes up input prices (e.g. wages)then the long-run supply curve will not be horizontal, but upward-sloping.

SRSS

D

Output

£

Q

P* LRSS

A Shift in Demand in the Short Run and Long Run

• An increase in demand raises price and quantity in the short run.

• Firms earn profits because price now exceeds average total cost.

An Increase in Demand in the Short Run and Long Run

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P1

ATC

Long-runsupply

P1

1Q

A

MC

1q

An Increase in Demand in the Short Run and Long Run

Copyright © 2004 South-Western (diagrams)

MarketFirm

(b) Short-Run Response

Quantity (firm)0

Price

MC ATCProfit

P1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S1

P2

Q1

A

Q2

P2

B

q1 q2

If market demand curve shifts from D1 to D2

In the short run the new equilibrium is P2Q2

Individual firms increase output from q1 to q2 (along MC curve) as price increasesThe shaded area shows resulting profits, which attaches more firms to the industry

An Increase in Demand in the Short Run and Long Run

Copyright © 2004 South-Western

P1

Firm

(c) Long-Run Response

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P1

P2

Q1 Q2

Long-runsupply

B

D1

D2

S1

A

S2

Q3

C

q1

This shifts the supply curve from S1 to S2

Industry output increases to Q3, price falls to P1 and the individual output of the firm falls to q1. Increase in market supply is made up of firms entering the market producing output q1

This is the case in a constant cost industry

Why the Long-Run Supply Curve Might Slope Upward

Whilst a constant Long-Run supply curve may exist other cases are possible. For example, when an industry expands its output, the increased demand for inputs (materials, labour etc.) may lead to an increase in their prices.

This shifts up the average cost curve, reducing profits, attracting fewer firms and price settles above P1 resulting in an upward sloping long-run supply curve.

If input costs fall as a result of increased demand, the long-run supply curve may be downward sloping.