CHAPTER 5

THEORY OF FIRM &

MARKET STRUCTURE
Learning Outcomes
After going through this chapter, the student should be
able to:
• Define the theory of firm
• Explain the total and marginal approach
• Classify the characteristics of perfect competition,
monopoly, monopolistic competition and oligopoly.
• Explain the short run and long run equilibrium in
perfect competition, monopoly and monopolistic
competition.

2
Introduction
• In the previous chapters, we examined the theory of production
and cost. Now we will apply these theories to the theory of firm
and market structure.
• A firm is an institution that buys or hires factors of production
and organises them to produce and then sell goods and
services. Thus a firm is an independent unit that produces
goods and services and sell them in the market for a price, with
the objective of maximising its profits.
• To enable the firm to maximise its profits, the firm not only
needs to ensure that the price covers the cost of production,
but also minimise it in order to earn more profits.
• A market structure refers to the number and distribution size of
buyers and sellers in the market for a particular good and
services. 3
 Contents
• Profit Maximisation: Total and Marginal Approach
• Perfect Competition
• Characteristics
• Short Run & Long Run Equilibrium
• Monopoly
• Characteristics
• Causes of monopoly
• Short Run & Long Run Equilibrium
• Monopolistic Competition
• Characteristics
• Short Run & Long Run Equilibrium
• Oligopoly
• Characteristics
• Price and output decison
• The kinked demand curve - Sweezy’s Model 4
Profit Maximisation
1. Aggregate Approach
TC
TR/TC

• This approach
maximum
identifies the
biggest difference
b between TR and
TC that will give
a the maximum
profit for the firm.
TR

Q
0 Q0 Q1 Q2 Q3 5
… Profit Maximisation
2. Marginal Approach
Price/Cost/Revenue

• This approach
MC maximises profit
AC
when MC=MR at E.
• At this point, price
P is at P, average cost
C at C and quantity
of output at Q.

E
AR
6
Quantity
Q MR
 Perfect Competition
• Perfect Competition Market is a market structure
characterized by a large number of both buyers and sellers
with the small firms selling identical product, enjoying
freedom in entry or exit and having perfect knowledge of
prices and technology.
• Characteristics:
1. Many buyers and sellers, sellers are small in size
2. Homogenous goods which are perfect substitutes
3. Free entry into and exit from the industry
4. Perfect knowledge of the market
5. Perfect mobility of resources
6. Firms have no power to control over price in the market
(Price Taker with a horizontal demand curve) 7
Short Run Equilibrium (PC)
1. Supernormal profit
• Positive economic
profit
• TR>TC , AR>AC
• TR = 0PAQ
P A • TC = 0CEQ
C • Profit = TR – TC
E
= CPAE
(shaded area)
Q 8
…Short Run Equilibrium (PC)
2. Normal profit

• Zero economic profit

• TR=TC , AR=AC
• TR = 0PEQ
• TC = 0CEQ
P=C
P • Profit = TR – TC
E
=0

9
Q
…Short Run Equilibrium (PC)
3. Subnormal profit
• Negative economic
profit
• TR<TC , AR<AC
A • TR = 0PEQ
C
• TC = 0CAQ
P
C
E • Profit = TR – TC
= PCAE (Loss)
(shaded area)
Q 10
 …Short Run Equilibrium (PC)
4. Shutdown point
• Negative economic
profit, P=AVC
• TR=TVC , AR=AVC
A • TR = 0PEQ
C • TVC = 0PEQ
AVC=P • Profit = TR – TC
E
= PCAE (Loss)
= TFC
• If TR<TVC , firm will shut
Q 11
down.
Long Run Equilibrium (PC)

• PC will only earn zero

LRMC economic profit
LRAC (normal profit) in the
long run due to the
free entry and exit
characteristic.
• Supernormal profit will
P AR=MR attract more firms to
E
enter and subnormal
profit will drive some
firms out of the
industry.
• This will eventually
Q lead to normal profit in
the long run. 12
 Monopoly
• The monopoly produces a product which has no close
substitute and the entry of new firms is prevented by barriers
to entry
• A pure monopoly is a market structure characterized by a
single seller of a product in a particular market
• Characteristics:
• Single seller or producer, control the market supply
• No close substitute, product is unique
• Barriers to entry, difficult to enter the industry
• Advertising is minimal practice as there is no competition
• A monopolist is a price maker as they control the market
supply, and therefore has the power to control the price. 13
 Causes of Monopoly
• Exclusive government franchise and
license
• Patents and copyright – protected rights to
produce
• Resource-based and ownership is of the
entire supply of the resources
• Technological or cost advantages of large-
scale operations
14
Short Run Equilibrium (M)
1. Supernormal profit
• Positive economic
profit
• TR>TC , AR>AC
• TR = 0PAQ
A • TC = 0CBQ
P
B • Profit = TR – TC
C
E = CPAB
(shaded area)
Q 15
…Short Run Equilibrium (M)
2. Normal profit

• Zero economic profit

• TR=TC , AR=AC
• TR = 0PAQ
A P • TC = 0CAQ
P=C
• Profit = TR – TC
E =0

Q 16
…Short Run Equilibrium (M)
3. Subnormal profit
• Negative economic
profit
• TR<TC , AR<AC
A • TR = 0PBQ
C
B
• TC = 0CAQ
P
• Profit = TR – TC
E = PCAB (Loss)
(shaded area)
Q 17
Long Run Equilibrium (M)

• In the long run, a

monopoly will only
get supernormal
profit
• As there is no
A competition, a
P monopolist has the
B power to control its
C price (price maker)

AR=DD

18
 Monopolistic Competition
• Monopolistic competition is a market
structure characterized by a large number
of relatively small firms compete to sell
similar but slightly differentiated product
in a market into which the entry of new
sellers is possible with less perfect
information

19
Characteristics
• Many sellers & buyers
• But not many as perfect competition

• Goods produced have close substitutes

• Product differentiation such as brand names Lux, Palmolive, Dettol
for toiletries products

• Free entry and exit

• Any firm can enter the industry when industry is making profit & exit
the industry if there is a loss

• Product differentiation & engaged in advertising

• Since the goods produced in monopolistic competition are
differentiated & have close substitute, non price competition such as
advertisements is needed

• Have less power to control price in the market 20

• Compared to monopoly, monopolistic have substitute goods
Short Run Equilibrium (MC)
1. Supernormal profit
• Positive economic
profit
• TR>TC , AR>AC
• TR = 0PAQ
A • TC = 0CBQ
P
B • Profit = TR – TC
C
E = CPAB
(shaded area)
Q 21
…Short Run Equilibrium (MC)
2. Normal profit

• Zero economic profit

• TR=TC , AR=AC
• TR = 0PAQ
• TC = 0CAQ
P=C
A P • Profit = TR – TC
=0
E

Q 22
…Short Run Equilibrium (MC)
3. Subnormal profit
• Negative economic
profit
• TR<TC , AR<AC
A
• TR = 0PBQ
C • TC = 0CAQ
P B • Profit = TR – TC
= PCAB (Loss)
E
(shaded area)

Q 23
Long Run Equilibrium (MC)
• In the long run, a
monopolistic competition
LRMC firm will only get normal
profit
LRAC • At equilibrium, LRMC = MR,
and LRAC = AR.
• Due to fairly easy entry and
A
exit, supernormal profit will
P=C attract more firms to enter
and subnormal profit will
E drive some firms out of the
industry.
• This will eventually lead to
Q normal profit in the long
run, similar to perfect
competition.
24
 Oligopoly
• A market structure characterized by a few sellers
dominate the sales of a product and entry of
new sellers is difficult.

• The product can be either differentiated or

standardized and sellers are aware of their
interdependence in pricing and output
determination.

25
Characteristics
1. The number of firms is few and relatively large in
dominating the market
2. Oligopolies may be homogenous or differentiated
3. High barriers to entry
4. Mutual interdependence (collusive)
5. Immense market power
6. Non-price competition
7. Tendency for oligopolies to collude in formal or
informal arrangement to determine the pricing policies
of fix the price by controlling the supply
8. No standard model in price and output behavior 26
Price and Output Decision

Two (2) Assumptions:

• There are only a few firms in this market
1. If any firms lowers its price, other firms will
follow suit (less elastic), DE in the diagram.
2. If any firm increases its price, other firms
will maintain their current pricing policy
(elastic), ED in the diagram.

27
The kinked demand curve
- Sweezy’s Model
• A firm in oligopolistic
market faces elastic
demand above E and
inelastic demand
below E.
D • The demand curve
DED, which is also the
average revenue curve
E
is kinked at E.
P

D
0 Q 28
 The kinked demand curve
- Sweezy’s Model
• The kinked demand
D curve creates a gap in the
marginal revenue curve
which lies between
points A and B.
P E
• As long as the MC shift
A within this gap, and
equilibrium MC=MR rule
B D
0 applies, price will not
Q
change.
• This stability in price is
called price rigidity or 29
stickiness.
 Summary
• A perfectly competitive market is as a market in which there are
many buyers and sellers, selling homogeneous products, and the
producers can easily enter and exit the market.
• A monopolistic market is a market with a single seller and large
number of buyers, selling unique products and difficult to enter and
exit.
• A monopolistic competitive market has a large number of small
sellers selling differentiated but close substitutes products with easy
entry and exit to the market.
• Oligopoly, on the other hand, is a market with only a few firms that
are mutually interdependent, engages in non-price competition and
has price rigidity.
• All these firms will maximise their profit when MC=MR and may
have supernormal, normal and subnormal profit in the short run.
However, in the long run, a perfectly competitive firm and a
monopolistic firm will earn normal profit, whereas the monopolistic
firm will earn supernormal profit. 30
 References

• Vengedasalam, D., and Madhavan, K.

Principles of Economics, 3rd Ed. Oxford,
2013.
• Walstad, W.B. and Bingham, R.C. Economics
Study Guide (to accompany McConnel and
Brue), 12th Ed., McGraw Hill, 1993.

31
 Prepared by:

Dr Nurhani Aba Ibrahim

Senior Economics Lecturer,
Faculty of Business Management,
University Teknologi MARA

and

Dr Ting Siew King

Senior Economics Lecturer,
Faculty of Business Management,
University Teknologi MARA

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