Market Structure and

Perfect Competitive Firm

Hall and Lieberman, 3rd edition,

Thomson South-Western, Chapter 8
 Overview
What you will learn from this lecture
– Market structure
– 3 Requirements for perfect competition
– Demand curve for a competitive firm
– Supply curve for a competitive firm
– How is the profit is maximized? At which
output level?
– How is profit or loss is measured using
graphs?

2
Part I Market Structure
Sellers want to sell at the highest
possible price
– Buyers seek lowest possible price
– All trade is voluntary
– different goods and services are sold in
vastly different ways
Economists think about market
structure
– Characteristics of a market that influence
behavior of buyers and sellers when they
come together to trade
3
Types of Market
For any particular market, we ask
– How many buyers and sellers are there in the
market?
– Is each seller offering a standardized
product, more or less indistinguishable from
that offered by other sellers?
– Are there any barriers to entry or exit, or can
outsiders easily enter and leave this market?
Four basic types of market
– Perfect competition
– Monopoly
– Monopolistic competition
– Oligopoly
4
Part II. The Three Requirements of Perfect
Competition
Large numbers of buyers and sellers
– Each buys or sells only a tiny fraction of the
total quantity in the market
Sellers offer a standardized product
Sellers can easily enter into or exit
from market
– Significant barriers to entry and exit can
completely change the environment in
which trading takes place

Examples?

5
i. A Large Number of Buyers and Sellers
In perfect competition, there
must be many buyers and
sellers
– How many?
Number must be so large that no
individual decision maker can
significantly affect price of the
product by changing quantity it
buys or sells

6
ii. Selling Standardized Products
Buyers do not perceive
significant differences between
products of one seller and
another
– For instance, buyers of wheat do
not prefer one farmer’s wheat over
another

7
iii. Easy Entry into and Exit from the Market
Easy Entry
– no significant barriers to discourage
new entrants
– any firm wishing to enter can do
business on the same terms as firms
that are already there
Easy exit
– A firm suffering a long-run loss must
be able to sell off its plant and
equipment and leave the industry for
good, without obstacles
8
iii. Easy Entry into and Exit from the Market
In many markets there are
significant barriers to entry
– Legal barriers
– Existing sellers have an important
advantage that new entrants can not
duplicate
Brand loyalty
– Cost advantage of existing firms from
significant economies of scale

9
The U.S. Market is characterized by entry and exit
Example: Job creation and destruction in manufacturing

Annual averages
– 10% of jobs disappear forever
– 9% of jobs appear for the first time
– Shutdowns responsible for 23% of
job destruction
– Start-ups responsible for 16% of
job creation

Haltiwanger, Davis and Schuh, Job Creation and

Job Destruction. MIT Press. 1996.
Is Perfect Competition Realistic?
Assumptions are rather restrictive
In reality, one or more of assumptions will
be violated in vast majority of markets
– Yet economists use perfect competition
more often than any other market
structure
Why?
– Model of perfect competition is powerful
– Many markets come reasonably close to
be perfect competitive
Perfect competition can approximate
conditions and yield accurate-enough
predictions in a wide variety of markets

11
Even if conditions for perfectly competitive
markets are not satisfied…

Assumptions are close

enough for predictions of
– Firm entry or exit
– Price increase or decrease
– Increase or decrease in
industry quantity
– Increase or decrease in firm
quantity

12
Part III. The Perfectly Competitive Firm
What is occurring in a
competitive market is quite
different from the view we get
when looking at a perfect
competitive firm.
– entirely different picture
In learning about competitive
firm, must also discuss
competitive market in which it
operates

13
 Figure 1: The Competitive Industry and Firm
1. The intersection of the market supply 3. The typical firm can sell all it
and the market demand curve… wants at the market price…

Price per Market Price per Firm

Ounce Ounce
S

$400 $400
Demand
Curve Facing
D the Firm

Ounces of Gold per Day Ounces of Gold per Day

2. determine the equilibrium 4. so it faces a horizontal
market price demand curve
14
Goals and Constraints
Perfectly competitive firm faces a
cost constraint when producing
any given level of output
– Firm’s production technology
– Prices it must pay for its inputs
Cost function for a perfectly
competitive firm is standard

15
The Demand Curve Facing a
Perfectly Competitive Firm
Demand curve is horizontal, or infinitely
price elastic
Why?
– Output is standardized
– No matter how much a firm decides to
produce, it cannot make a noticeable
difference in market quantity supplied
So cannot affect market price
– Firm is a price taker
Treats the price of its output as given and
beyond its control
Its only decision is how much output to
produce and sell

16
Cost and Revenue
MR at each quantity is the
same as the market price
– MR = Price
– marginal revenue curve and
demand curve facing firm are
the same
– A horizontal line at the market
price

17
Profit Maximization: The Total Revenue
and Total Cost Approach
Firm’s profit per unit
– ( Revenue per unit ) – ( cost per unit )
profit per unit = P – ATC
Total Profit = TR – TC=Q(P-ATC)
TR and TC approach
– Pick out the output level where there
is biggest difference between TR and
TC
– Most direct way of viewing firm’s
search for the profit-maximizing
output level

18
 Figure 2a: Profit Maximization: find
greatest TR - TC
Dollars
TR TC
$2,800
Maximum Profit
per Day = $700
2,100

550 Slope = 400

1 2 3 4 5 6 7 8 9 10
Ounces of Gold per Day

19
Profit Maximization: The Marginal Revenue
and Marginal Cost Approach
Profit-maximizing output is
found where MC curve crosses
MR curve from below
– Or where P =MC
Firm should continue to increase
output as long as p=MR>MC
Requires no new concepts or
techniques

20
 Figure 2b: Profit Maximization
Find MR =MC from below
Dollars

MC

$400 D = MR

1 2 3 4 5 6 7 8 9 10
Ounces of Gold per Day
21
Measuring Total Profit Graphically
How to measure profit or loss?
1. Find the optimal output level Q*
from profit maximization
– P =MC or using TR & TC method
2. At Q* , find the ATC, unit cost for
producing that amount of outputs
3. Pointing out the difference
between P and ATC along the
vertical axis
4. The area (P-ATC) X Q* is
– Profit if P>ATC
– Loss if P<ATC

22
 Figure 3a: Measuring Profit if P > ATC
Economic Profit
Dollars
ATC

Profit per Ounce ($100) MC

d = MR
$400
300

Ounces of
1 2 3 4 5 6 7 8 Gold per Day

23
 Figure 3b: Measuring Loss if P < ATC
Economic Loss
Dollars

MC
Loss per Ounce ($100)
ATC
$300
200 d = MR

Ounces of
1 2 3 4 5 6 7 8 Gold per Day

24
The Firm’s Short-Run Supply Curve
A competitive firm is a price taker
– Then decides how much output it will
produce at that price
– Whenever the market price is set at a
new level, the best output level will be
determined by firms, using the MR and
MC approach
– Exception
If the firm is suffering a loss large enough to
justify shutting down, it will not produce
along its MC curve
– Zero output produced instead

25
 Figure 4: Short-Run Supply Under Perfect
Competition
(a) (b)

Dollars Price per

ATC Bushel
MC Firm's Supply
Curve
$3.50 d1=MR1 $3.50

2.50 d2=MR2 2.50

2.00 AVC d3=MR3 2.00

1.00 d4=MR4 1.00

0.50 d5=MR5 0.50

Bushels Bushels
1,000 4,000 7,000 per Year 2,0004,000 7,000 per Year
2,000 5,000 5,000
26
The Shutdown Price and Supply Curve

Shutdown price is the price at which a

firm is indifferent between producing
and shutting down
Supply curve has two parts
– Whenever P>AVC, supply curve coincides
with MC curve
– Whenever P<AVC, firm will shut down
A vertical line segment at zero units of output
Figure 4: For all prices below $1—the
shutdown price—output is zero and the
supply curve coincides with vertical axis

27
The (Short-Run) Market Supply Curve

The shut run market supply curve is

obtained from the aggregation of
individual firm’s supply curve
– summing quantities of output supplied
by all firms in market at each price
As we move along the market supply
curve, we are assuming that two
things are constant
– Fixed inputs of each firm
– Number of firms in market

28
 Figure 5: Deriving The Market Supply Curve
3.The total supplied by all firms at different
1. At each price . . . prices is the market supply curve.

Firm Market
Price per Price per
Bushel Firm's Supply Curve Bushel Market Supply
Curve
$3.50 $3.50

2.50 2.50
2.00 2.00

1.00 1.00
0.50 0.50

2,000 4,000 7,000 Bushels 400,000 700,000 Bushels

5,000 per Year 200,000 500,000 per Year
2. the typical firm supplies the
profit-maximizing quantity.
29
 Summary
– 3 Requirements for perfect competition
many sellers and buyers
standardized products
free entry and exit
– Demand curve for a competitive firm is
perfect elastic (horizontal line)
MR = P
– Supply curve for a competitive firm is discrete
is MC when P> AVC
is zero when P<AVC
– 2 approaches to maximize profit by choosing
output level
Maximized difference between TR and TC
MR = MC
– Profit can be measured using graphs

30