1. Theory of the Firm: Market Structures
(1) Perfect Competition

2. 1. Perfect competition (perfectly competitive markets) 2. Monopoly
Market structure describes the characteristics of market organization that influence the behavior of firms within an industry
There are four market structures that we will study in detail
1. Perfect competition (perfectly competitive markets)
2. Monopoly
3. Monopolistic Competition
4. Oligopoly

3. We will assume that for all Firms………
firm’s behavior (choice of output) is guided by its goal of
profit maximization
Yet, firms may not always make a profit; in some cases, they are making a loss and until they decide to shut down, they are interested in producing the quantity that will make the loss as small as possible
 Loss minimization involves determining the level of output that the firm should produce to make loss as small as possible

4. Reminder: Profit π π = TR − TC
But costs include both explicit costs and implicit costs (i.e. economic costs using the notion of opportunity cost and therefore including “normal profit”)
The firms’ profit maximization rule is to produce the level of output where TR – TC is as large as possible (in case of loss, to produce the output where difference between TR and TC is small as possible)

5. Revenues
Revenues are the payments firms receive for selling goods over a period of time = sales
Three fundamental revenue concepts:
Total Revenue – obtained by multiplying the price at which a good is sold (P) by the number of units of the good sold (Q) TR = P x Q
Marginal Revenue – is the additional revenue arising from the sale of an additional unit of output MR = △ TR /△ Q = gradient of TR curve
Average Revenue – is revenue per unit of output sold AR = TR / Q =P

6. Mathematically… MR is the slope of the TR curve
AR is always equal to the P of the product!
The definitions of the revenues given above apply to all firms and group of firms (market structure, industries) BUT the analysis of the of revenues is not the same for all firms because this depends on whether or not the firm has any control over the price at which it sells its product…

7. 1. Model of Perfect Competition
this model does not exist in reality but it will be used as the benchmark to analyze the other models and in helping design different policies and interventions

8. (continued)
Although perfectly competitive markets are rarely observed in the real world as the assumptions are hardly ever fully met, some industries are close to the model
Eg Some agricultural commodities e.g. wheat, corn, livestock
Silver and gold
Nails, pins, clips, eggs, tofu
Money market (financial markets and foreign exchange market)

9. Assumptions of Perfect Competition
The model of perfect competition is based on the following assumptions:
There is a large number of firms (and buyers)
All firms produce identical or homogenous products
There is perfect and complete information
There is perfect mobility
 a) PRICE-TAKERS ie Firms in a perfectly competitive market have no control over price
b) free entry and exit to the industry/market

10. PRICE-TAKERS
The individual firm, being small and having many competitors, can do nothing to influence its price
It must accept Pe and sell whatever output will maximize profits for them
If the firm raises its price above Pe, it will not sell any output because the buyers will buy the homogenous product elsewhere at a cheaper price. On the other hand, since it can sell all it wants at Pe, there is no incentive to lower their price below it as they have nothing to gain
 perfectly (infinitely) elastic demand curve facing the FIRM
(the MARKET demand curve is still downward sloping)

11. The Demand Curve (AR Curve) for Firms in PC Market
Market One firm
The FIRM’s demand curve is perfectly elastic  PED is infinite (perfectly elastic), appearing horizontal at Pe. The demand curve (AR curve) is also the marginal revenue (MR) curve

12. Revenue Curves where the firm has no control over price
As you can see, the price at which the good is sold does not change across different levels of output
This data can be plotted as follow

13. MR and AR of Firms in Perfect Competition
The above finding implies that no matter how much output the firm in the perfectly competitive market sells, P = MR = AR and these are constant at the level of the horizontal demand curve

14. Cost Curves for Firms in Perfect Comp.
The costs curves are the same curves introduced earlier with the law of diminishing returns (in the SR) and returns to scale (in the LR) explaining the U shaped curves
These will be assumed to be the same basic shape whatever the level of competition

15. Combining the Revenue and Cost Curves Together: Profit Maximization in the Short Run
 Handouts (pages 1 and 2) and graphs

16. Suppose firm is producing 5 units……
Suppose firm is producing 5 units…….. Suppose firm is producing 10 units……. 1 2 3 4 5 6 7 8 9 10
$28.00
20.00
16.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
68.00
Price = MR
Quantity Produced
Marginal Cost
$35.00
35.00
Costs 1 2 3 4 5 6 7 8 9 10
Quantity 60 50 40 30 20 C A
P = D = MR A B

17. Further graphical analysis….explain the shaded area

18. ….or same information as a table

19. Suppose the MARKET price moves up or down
Marginal cost
Cost, Price
$70 60 50 40 30 20 10 1
Quantity 2 3 4 5 6 7 8 9

20. As the market price changes from $16$13$12$11$10

21. Suppose price is very low…………..

22. The Shutdown Decision MC 2 4 6 8 Quantity Price 60 50 40 30 20 10 ATC
ATC
Loss
P = MR
AVC A
$17.80

23. Consequently……………
The marginal cost curve tells the competitive firm how much it should produce at a given price.
The profit-maximizing firm should increase output so long as MR≥MC
 The Marginal Cost Curve (above average variable cost) is the firm’s Supply Curve

24. SR and LR equilibria SR equilibrium is where……. MR=MC
 Review Pages 3-5
But in the LONG-RUN
……………………………………………????

25. Movement to the LR equilibrium
Remember the assumption of free entry and exit of firms into/out of the industry
Therefore, in the long run, (all resources are variable) not only can the firm change its scale but it can also decide to sell its resources and business and leave the industry altogether. Similarly, new firms can enter the industry to compete as well
The Long Run for market theory is defined as where new firms can enter the industry/market or where existing firms can quit (exit) the market (not just “shut down”)
(Handout Pages 6 and 7)……………………………….?

26. The mechanism of achieving LR Equilibrium in PC Market

27. The long run outcome …
if firms are earning abnormal (positive) profits in the short run,
this sends a signal and incentives for other firms to enter the business (e.g. the next trend: iPhone and the App business).
The profits lead the process of entry for firms into the market
 the MARKET supply curve shifts right and the price falls
and this reduces the short run profits of the firms
_______________________________________________________________
And in the case of short run losses (e.g. outdated trend: tamagochi, iPod, CDs): if firms are making losses in the short run,
the losses lead to a process of exit of some firms from the market
market supply shifts left and the price rises
and thus remaining firms’ losses are reduced
____________________________________________________________
In both cases:  a long run equilibrium where most firms are earning
zero economic profit (but still earning normal profit)
i.e. where P = minimum ATC or the break even price
Their economic profits and losses are eliminated and they earn just enough revenue to cover economic costs Group III

28. If some firms are making abnormal π……….

29. If some carrot firms are making losses……….

30. EFFICIENCY ANALYSIS……
of the perfectly competitive firm, which profit maximizes, in:
A) the short run
B) the long run

31. Technically (Productively) Efficient level of output…..
Is NOT necessarily where profits are maximized
It is where COSTS are MINIMIZED (Production of the good uses up the least amount of resources possible)
at the minimum point on the AC (or ATC) curve
Does the perfectly competitive firm achieve this?
In the SR: No But in the LR: Yes

32. Allocative Efficiency Analysis of Perfectly Competitive Markets

33. ALLOCATIVE EFFICIENCY= Optimum allocation of scarce resources
(last page of handout)
ALLOCATIVE EFFICIENCY occurs when
MC = Price= MU (or MB)
 more simply expressed as:
MC = Price
Does the perfectly competitive firm achieve this?
Yes …..in both SR and LR because MR =Price

34. Efficiency Analysis of Perfectly Competitive Market in the Short Run
For the short run,, when a firm is earning an economic profit (or minimizing loss), the firm achieves allocative efficiency as P = MC but the firm fails to achieve productive efficiency because ATC is higher than its minimum at the level of output where they produce
Only if the firm happens to produce an output which earns zero economic profit, will it achieve productive efficiency

35. Efficiency Analysis of PC Market in the Long Run
The long run equilibrium position of a firm in the PC Market is shown again as follows
The firm is achieving both allocative and productive efficiency in the LR equilibrium. At the profit max output, Qe, P = MC and ATC is at its minimum
The industry as a whole is also achieving AE as the sum of CS and PS is maximized at the market equilibrium  NO WELFARE LOSS
This finding is essential, as we will see later that Perf. Comp. is the only market structure which achieves AE and PE in the long run
 EFFICIENCY (filling in words)

36. In summary: Allocative Efficiency & Perfect Competition
If consumers are rational and utility maximizing, it can be assumed that they will consume up to the point where:
MB = Price    or MU= P i.e. the Demand curve represents the MB of each unit
If firms are profit-maximizing and in perfect competition, they will produce up to the point where
MC = MR = P i.e. the Supply curve represents the MC of each unit
 MB=P=MC
and ALLOCATIVE EFFICIENCY has been achieved 
Defined simply as where MC=P
e.g. If MB>MC then _________________________ should be produced in order to use society's scarce resources in the most efficient way.

37. Evaluating the Perf. Comp. Market Structure
positive outcomes:
leads to allocative efficiency or the “best” (optimal) allocation of resources for the goods and services society wants
leads to productive efficiency (in the LR) where production is at the lowest possible cost, avoiding waste in the use of resources (minimum point of ATC)
Low prices for consumers from productive efficiency and zero economic profits due to free entry of firms
Competition leads to the closing down of inefficient producers AND
incentivizes firms to find ways to lower costs and improve quality
Responds to shifts in demand and supply determinants

38. Limitations of the model:
Unrealistic assumptions (i.e. many small firms, homeogeneous good, perfect knowledge and mobilty, freedom of entry and exit)
Limited possibilities to take advantage of economies of scale i.e. a firm could lower average costs as it grows and produces more and more. But in Perf. Comp., all firms are small and there are many of them, which prevents them from growing large enough to take advantage of economies of scale
Lack of product diversity--all firms produce the identical homogenous product. However, consumers prefer variety
Maybe less research and development since there are no economic profits in the long run and because all innovations will, theoretically, be copied if they are profitable because no entry barriers lack of Dynamic Efficiency
Waste of resources in the process of long run adjustment i.e. continuous opening and closing of firms can lead to waste of resources (assumes no costs of transaction and adjustment)
PLUS consider: WHO gets the goods?

39. Suppose aim is NOT π maximisation
In reality, firm’s operations can be motivated by other aims
Revenue maximization – with separation of management from ownership, CEOs tend to care more about sales while owners/shareholder care more about profits
Growth maximization – firms can be more interested in the change, the sense of progress (start to end). Growing firm signifies economies of scale, market power, diversification, reduction in risks, etc.
Managerial utility maximization – CEOs maybe interested more in sales, benefits, employment, etc.
Satisficing – not maximising profit, revenue, growth or managerial utility, but reach a satisfactory level in each one
Ethical and environmental concern and corporate social responsibility – image, to avoid regulation and taxes. Rising consumer awareness of corporate behavior and environment

40. REVIEW: Profit Maximization Using Total Revenue and Total Cost
Profit is maximized where the vertical distance between total revenue and total cost is greatest.
At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.

41. Review: Profit Determination Using Total Cost and Revenue CurvesTC TR
Total cost, revenue
$385
350
315
280
245
210
175
140
105 70 35
Quantity 1 2 3 4 5 6 7 8 9
Loss
Maximum profit =$81
$130
Profit =$45
Loss

42. REVIEWThree Steps in Analyzing the Profit Maximization (Loss Minimization) Process
1) compare MR with MC to determine the profit maximization output
The firm should increase output so long as MR>MC (and vice-versa)
the PROFIT-MAXIMISING or equil. level of output is where MC =MR
(second-order condition is that MC cuts MR from below)
2) compare AR (or price) and ATC to determine the amount of profit (or loss) per unit of output
3) find the total profit (total loss) by multiplying the Q produced to the value obtained in (2)

43. Review Determining Profits Graphically
Quantity
Price 65 60 55 50 45 40 35 30 25 20 15 10 5 1 2 3 4 6 7 8 9 12 D MC A
P = MR B
ATC
AVC E
Profit C
Loss
(a) Profit case
(b) Zero profit case
(c) Loss case

44. Recap
Perfectly competitive markets achieve allocative efficiency at the market equilibrium (both SR and LR) where
MB or MU = MC=P
Here, the sum of consumer and producer surplus (social surplus) is at its _____________
Note: the two interest groups: consumers and producers are brought together through MB and MC, respectively
And there is no other allocation of resources where we are able to make some better off without making others worse off

45. In perfect competition….
The demand curve facing the firm is equal to the Price (P) level
In other words, D or MB (marginal benefit) is equal to P
Thus, through substituting P for MB, we can restate the condition of allocative efficiency as P = MC
The interest of consumers (their D and MB) are reflected in the P and the MC is the firm’s supply curve or the reflection of the interest and profit decision-making process of the firms.
note: we assume there are no externalities. If there are, Allocative Efficiency is achieved when MSB = MSC (to be studied in 2017)

46. What would happen if P > MC?
Here, the additional unit of the good is worth more to the consumer than it costs to produce. There is an underallocation of resources to its production and some consumers will be better (without making other worse off) if more of it were produced
Vice versa, what if P < MC ?
The additional unit of the good costs more to produce than it is worth to consumers and there is an overallocation of resources to the good. Consumers will be better off if output were reduced
Resources are allocated efficiently only when P = MC