AF1605 Introduction to Economics

Topic 5: Market Structure

Part I: Perfect Competition

Lecturer: Chau Tak Wai

School of Accounting and Finance

v Characteristics of a perfectly competitive industry

v Short run profit maximizing decision and market outcomes

v Long run profit maximizing decision and market outcomes

v Allocative efficiency

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v Three major types of market structure introduced in this class:
v Perfect competition
v Monopoly
v Oligopoly

v Factors that determine the type of market structure:

v Number of sellers
v Degree of product differentiation
v Barrier to entry

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Characteristics of perfect competition:

v Identical products
v The products sold by different firms are perfect substitutes.
v Many sellers and buyers
v Each participant is insignificant relative to the whole market and cannot
affect the market price.
v No Entry Barrier
v There is no restriction on entry into or exit from the market.
v Perfect Information
v Buyers and sellers are well informed about prices as well as the quality of
the good from the sellers.

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v This is an ideal case on the extreme of many sellers with severe
competition.
v It is hard to find perfect examples that fully satisfy all the conditions.
v Closer examples: stalls in wet food markets, Taobao stores.

v One may partially apply the models with certain characteristics:

-If the entry barrier is low, what would you expect on the long run profit of
each firm?
-When will firms stop entering the market?

v This is also the basis of the simple demand-supply analysis.

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v One important implication: Firms in a perfectly competitive industry are price
takers: they will only follow the market price.
v Why?

v Each firm is too small relative to the whole industry and so they have no power to
control or affect other sellers and the whole market.
v Buyers have perfect information on the prices charged by all other sellers.

v The demand curve for each competitive firm is perfectly elastic (horizontal) at the
market price.
v When the price is higher than the prevailing market price, no consumer will buy
from this firm, so the quantity demanded for goods from this firm is zero.
v If a firm charges a price lower than the prevailing market price, in theory, all
consumers would like to buy from this firm, which is a very large amount for this
small firm. Thus, the quantity demanded is very large (infinite).
v So, the firm can have a usual amount of quantity demanded only when the price is
at the prevailing market price.

v Note: the shape of market demand curve is different from the shape of firm
demand curve. 6
v For a basic theory of a firm’s decision, we assume that the objective of a
firm is to maximize economic profit defined as total revenue minus
total economic cost (max π = TR – TC).

v Total approach to profit maximization:

v The firm produces at an output level where π = TR – TC is
maximized.

v Marginal approach to profit maximization:

v The firm produces at an output level where MR equals MC (for
continuous case).
v For discrete case, the firm produces when MR(Q)≥MC(Q) and then
stop when MR(Q)<MC(Q).
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v Recall: Profit = Total Revenue – Total Cost

v As output increases, both total revenue and total cost increase.

v Since price is constant, total revenue increases at a constant rate.

v Because of diminishing marginal returns (short run) or diseconomies of scale

(long run), total cost increases in an increasing rate eventually and
increasing faster than that of total revenue.
Recall: In short run, when MP is increasing
(decreasing), MC is decreasing (increasing)
v Profit maximization occurs at the output level where the gap between total
revenue and total cost is the largest.

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v Marginal cost (MC)
v The extra cost a firm has to pay by increasing its output by one unit.
v The MC curve is usually upward sloping eventually. (Refer to Topic 4)

v Marginal revenue (MR)

v The additional revenue a firm receives by increasing its output by
one unit. (TR(Q) – TR(Q-1) or more generally Δ𝑇𝑅/Δ𝑄.)
v The shape of the MR curve depends on the type of market structure
to which the firm belongs to.

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v Marginal analysis compares MR with MC.

v If MR > MC, the extra revenue from selling one more unit exceeds the
extra cost incurred to produce it.
v Economic profit increases if output increases.

v If MR < MC, the extra revenue from selling one more unit is less than the
extra cost incurred to produce it.
v Economic profit decreases if output increases.

v Profit maximization occurs at the output level (Q*) where

Continuous: MR(Q*) = MC(Q*).
Discrete: Stop at Q* if MC starts to rise above MR at (Q*+1).

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v Marginal cost (MC) curve of a firm:
v Positive and eventually upward sloping.

v Marginal revenue (MR) curve of a firm:

v At the firm level, since a perfectly competitive firm is a price taker, it will
always sell at the market price (P*).
v Market price is determined by the demand and supply at the market
level.
v Since price does not change when the firm increases its output and sales
by one unit, marginal revenue MR at the Qth unit = P*Q – P*(Q-1) = P*.
v Therefore, MR is constant and equals market price. (MR = P)
v A perfectly competitive firm’s MR curve is a horizontal line at the market
price, coincide with the demand curve. 12
 Market A Firm

(Q) (q) (q)

Both the demand curve for a competitive firm’s output, and the marginal
revenue curve for a competitive firm are the same horizontal line at the market
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price.
v Profit maximization condition:
Continuous: MR(Q*) = MC(Q*) and MC is increasing.
Discrete: Stop at Q* if MC starts to rise above MB at Q*+1.

✓
✗

MR = P TC increases
faster than TR
Price Taker: MR(Q) = P
Profit Maximizer: MR(Q*) = MC(Q*)
=> P = MC(Q*)
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§ Suppose a firm is considering the 50th unit of output where the marginal
cost is $8 and average total cost is $9. Currently the market price is at
$10. Which of the following is true? (Assume continuous adjustment)

§ A. The firm should produce more than 50 units since MR > MC.
§ B. The firm should produce less than 50 units since MC < ATC.
§ C. The firm should produce exactly 50 units since the firm is earning a
positive profit.
§ D. The firm should produce zero unit since it is earning a negative profit.

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v A perfectly competitive firm’s supply curve
shows how the firm’s profit-maximizing output
varies as the price varies, other things remaining
the same.

v Recall that the profit maximizing condition for a

PC firm: P = MC(Q*), meaning that for each given
P, the firm will produce at Q* where the MC at
this Q* just equals P.

v When the market price equals $12 per unit, the

firm maximizes profit by producing 11 units per day.
v When the market price equals $8 per unit, the firm
maximizes profit by producing 10 units per day.
v When the market price equals $3 per unit, the firm
maximizes profit by producing 7 units per day.

v The firm’s supply curve traces the marginal cost

curve (with some qualifications). 16
v In the short run, the firm has at least one fixed factor.

v For example, the firm has fixed plant size.

v Since the plant size is fixed (cannot be reduced to zero), existing firms
cannot exit from the market.

v New firms which do not have the plant cannot enter into the market to
produce.

v In short run, there is no firm entry or exit.

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v In the short run, while the firm cannot exit from the market, and it has an
option to temporarily shut down (producing zero output) or to produce
some output.

v A firm may incur an economic loss (negative profit) when it is producing at

the non-zero profit-maximizing output level.

v If the firm shuts down temporarily, profit = -TFC.

v If the firm produces some output, profit = TR – TC = TR – TFC - TVC.

v If TR > TVC (or P > AVC), the firm’s profit is higher to produce some outputs
(at Q where MR=MC) than to shut down.
v If TR < TVC (or P < AVC), the firm’s profit is higher to shut down than to
produce some output.
v The point where P = AVC is the shut down point.

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v Recall that the competitive firm’s supply curve
traces the marginal cost curve since P = MC(Q*).
v In the short run, with the restriction of no exit but
able to shut down, a competitive firm will choose
to produce nothing (shut down) if P < AVC.
v A competitive firm produce a positive amount
according to P = MC(Q*) if P ≥ AVC(Q*).
v In this example, when the market price drops
below $3 per unit, the firm shuts down and does
not produce.
v Note: P > AVC(Q*) => MC(Q*) > AVC(Q*)
v The firm’s short-run supply curve is the same as
the (short-run) MC curve when the MC curve is
above the AVC curve, and output drops to zero if
the price is below the shut down point.
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v At the profit maximizing output level, P > ATC and the firm is making
positive economic profit (blue area = (P – ATC) × Q).

Note: The market supply curve is the horizontal summation of all firm’s supply curve.
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v At the profit maximizing output level, P < ATC (implying a negative profit
or a loss) but the firm still produces as long as P > AVC.

LOSS

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v At the profit maximizing output level, P = ATC and the firm is making zero
economic profit.

Question: Does zero profit mean the firm owner cannot even get an income for his
own living? 22
§ Which of the following is FALSE for a perfectly competitive firm in the
short run?

§ A. It will produce at a quantity where P = MC if not shut down

temporarily.
§ B. It cannot have a choice to incur zero cost in the short run.
§ C. It will shut down whenever its total revenue cannot cover its total
cost when producing at any positive output levels.
§ D. It will shut down whenever its total revenue cannot cover its total
variable cost when producing at any positive output levels.

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v In the long run, all input factors are variable.

v What will change in the long run?

v 1. We use long run cost curves instead of short run cost curves.
-Cost can be lower as the firms can adjust all factors to lower the cost.

v 2. New firms can enter into or existing firms can exit from the industry
in response to economic profit or loss.
-So when will firms enter and when will firms exit?

v If the profit of a typical firm is positive, entrepreneurs can earn more in

this market than in another business, and so they will enter the market.
v If the profit of a typical firm is negative, entrepreneurs can earn less in
this market than in another businesses, and so they will exit the market.

v An assumption: All existing and new firms are identical. They all have
the same cost curves. They have the same profit level under the same
price. 26
v When a typical firm is earning positive economic profit (P > LAC):
v New firms enter the market to earn a positive profit.
v Market supply curve shifts rightward.
v Market price will drop.
v Profit of existing firms will decrease.
v If profit is still positive, more firms will enter.
v The process continues until firm’s profit becomes zero, with P = LAC.

v When a typical firm is earning a negative economic profit (economic

loss) (P < LAC):
v Some existing firms exit the market to avoid the loss.
v Market supply curve shifts leftward.
v Market price will increase.
v Loss of existing firms will decrease.
v If profit is still negative, more existing firms will exit.
v The process continues until firm’s profit becomes zero, with P = LAC.

v In the long run, perfectly competitive firms earn zero economic profit. 27
 S Recall: profit = (P - ATC)*Q MC
ATC
Economic profit
= $104,000/yr

Price ($/bushel)
Price ($/bushel)

2.00 2.00 Price

1.20

65 130
Quantity (millions of Quantity (1000s of
bushels/year) bushels/year)

v Market price of $2/bushel produces economic profits.

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 S MC
S’
ATC
Economic profit
= $50,400/yr

Price ($/bushel)
Price ($/bushel)

2.00 2.00

1.50 1.50 Price

1.08

65 95 120 130
Quantity (millions of Quantity (1000s of
bushels/year) bushels/year)

v Economic profits attract firms, reducing prices and profits.

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 MC
ATC

Price ($/bushel)
Price ($/bushel)

1.00 1.00 Price

115 90
Quantity (millions of Quantity (1000s of
bushels/year) bushels/year)

v Entry of firms continues until all firms earn a zero economic profit.

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v In the long run equilibrium, perfectly competitive firms produce at
the output level where LAC is at its minimum.
v Why?
v Explanation:
(1) P = MR(Q) due to price taking of perfectly competitive firms.
(2) MR(Q*) = MC(Q*) due to maximizing profits by competitive
firms.
(3) P = LAC(Q*) because firms earn zero profit due to free entry and
exit.
v Therefore, P = MR = MC = ATC implies MC = LAC.
v MC equals LAC implies LAC is at its minimum.
v An implication: the long run equilibrium price is solely determined
by the minimum point of the long-run AC curve of a typical firm.
v This also implies that a perfectly competitive firm in the long run
produces at its optimal scale (utilize all economies of scale and stop
before turning to diseconomies of scale). 31
v What if there is a new technology that can lower the marginal cost and
average cost (MC and AC curves shifts down) and can be adopted by any
firms in the industry? (Here, assume all firms are identical.)

v Some firms may first adopt it, lowering the cost, and enjoy some short-
run profit.
v In the long run, more and more firms would adopt this new technology
and produce at a lower marginal cost and average cost.
v Supply of this kind of firms will increase, raising the market supply.
v Equilibrium market price will fall (to the lower minimum AC).
v Those which cannot adopt this technology will suffer an economic loss in
the long run, as the price falls below their minimum point of AC.
v They will be driven out of the market due to competition.
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1. What is the long run equilibrium price if there is an increase in
demand but no change in cost curves of each identical perfectly
competitive firms?
§ A. increase
§ B. decrease
§ C. no change
§ D. uncertain

2. If the marginal cost and average total cost of each competitive

firm increases by $2 at all quantities, what is the resulting increase
in market equilibrium price in the long run?
§ A. $0
§ B. $1
§ C. $2
§ D. somewhere between $0 and $2.
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v Consumers earn consumer surplus from consumption.

v Producers earn producer surplus from production.

v Social surplus is the sum of consumer surplus and producer surplus.

v We can achieve allocative efficiency if the market produces at the

output level where social surplus is maximized.

v We can demonstrate that the output level of a perfectly competitive

market can achieve allocative efficiency.

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v Recall: Consumer surplus is the
marginal benefit from a good or
service in excess of the price
paid for it for a particular unit,
summed over the quantity
consumed (Q).
$
𝐶𝑆 = )(𝑀𝐵! − 𝑃)
!"#

v In the continuous case on the

right, the consumer surplus is
represented by the green
triangle, which is the area
between the demand curve and
the market price line.
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v Recall: Producer surplus is the price
of a good in excess of the marginal
cost of producing it at a particular
unit, summed over the quantity
produced (Q).
$
𝑃𝑆 = )(𝑃 − 𝑀𝐶! )
!"#

v In the continuous case on the right,

the producer surplus is represented
by the blue triangle, which equals to
the area between the supply curve
and the market price line.

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v From above, in perfect competition, supply curve is also the marginal
cost curve for firms/society.

v From earlier discussion, demand curve is also the marginal benefit

curve for consumers/society.

v Because the market supply and market demand curves intersect at the
equilibrium price, that price equals both marginal cost (to the firm)
and marginal benefit (to the consumer) at the market quantity
transacted. (P = MB(Q*) = MC(Q*))

v Since social surplus (sum of consumer surplus and producer surplus) is

simply TB - TC, the condition for maximizing social surplus under the
marginal approach is achieved by having MB(Q*)=MC(Q*).

v The output level in perfect competition is allocative efficient.

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v Social surplus is maximized, and allocative efficiency is achieved at the output
level where MB = MC = P.

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v Social surplus is not maximized, and allocative efficiency is not achieved at the
output level below or above the optimal level of output.
v Deadweight loss is the decrease in social surplus that results from an inefficient
level of production (underproduction or overproduction).
v It is an implicit loss due to an unrealized net benefit due to not producing certain
units or cancelling out of the benefit due to over-producing certain units.
v It is the sum of unrealized surplus (MB-MC) for all units not produced, or the sum
of marginal loss (MC-MB) for all units over-produced.

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§ Let us have an example in discrete case.
§ The market equilibrium price is $35 and
the market equilibrium quantity is 200
units. Price ($) Quantity Quantity
§ The allocative efficient quantity is also demanded supplied
200 units.
50 50 350
§ If for some reasons, 300 units are
produced, what is the deadweight loss? 45 100 300
40 150 250
§ Note that the 201-250 units are worth
$30 per unit to consumers and 251-300 35 200 200
units are worth $25 per unit to
consumers. 30 250 150

§ Similarly, the 201-250 units cost $40 per 25 300 100

unit to producers, and 251-300 units
cost $45 per unit to producers.
§ As a result, if 300 units are produced,
the deadweight loss is $(40-30)x50 +
$(45-25)x50 = $1500.
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Two contrasting cases of Consumer Surplus

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§ Determine in each of the following cases whether there is a deadweight
loss, assuming that it is in a perfectly competitive market with no other
market failures. For each case, draw the corresponding demand and
supply diagram and label the area of deadweight loss (if any) (assume
continuous case).

§ 1. An effective price floor.

§ 2. An effective price ceiling.

§ 3. A quota
§ 4. A per-unit tax.

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§ Given the situation in the following market (continuous case).

§ When there is a quota of 500 thousand units allowed to be sold in the

market, which area represents the deadweight loss?
§ A. C
§ B. E
§ C. C+E
§ D. B+C+D+E
§ E. none of the above 43
v Characteristics of a perfectly competitive industry

v Short run profit maximizing decision and market outcomes

v Long run profit maximizing decision and market outcomes

v Allocative efficiency

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