MARKET STRUCTURE

PERFECT COMPETITION
Study Outline:

•PERFECT COMPETITION
 Perfect Competition characteristics
 Short run equilibrium
• Long run equilibrium
After studying this chapter, you will be able to:
 Define perfect competition
 Explain how a firm makes its output decision
 Explain how price and output are determined in
perfect competition
 Explain why firms enter and leave a market
 Predictthe effects of technological change in a
competitive market
 Explain why perfect competition is efficient
 Definition of Perfect Competition

Perfect Competition (P.C) is a market in which there are a large of buyers

and sellers, buying and selling identical products. Without any
restriction on entry and exit and having perfect knowledge of the
market at the same time.

EXAMPLE:
 Characteristics
Characteristic Explanation

• There are large number of sellers and buyers such that each seller supply a
small fraction of the market supply.
Large Number of
1 • Each buyer buys a small fraction of the market demand.
Buyers and Sellers
• Thus, no single seller or buyer can influence the price and affect the
market.

• The individual firm sells a very small share of the total market output and,
therefore, cannot influence market price.
2 Price taker • Each firm takes market price as given – price taker.
• The individual consumer buys too small a share of industry output to have
any impact on market price.
 • The products of all firms are perfect substitutes.
Homogeneous/Identical
• Product quality is relatively similar as well as other
3 product
product characteristics.
• Agricultural products, oil, copper, iron.

• When there are no special costs that make it difficult for

a firm to enter (or exit) an industry.
• Buyers can easily switch from one supplier to another.
4 Free Entry and Exit
• Suppliers can easily enter or exit a market.
• Pharmaceutical companies are not perfectly competitive
because of the large costs of R&D required.
 • Perfectly competitive firms are free to enter and exit an
industry.
• This means that they can freely move from one firm to
5 Perfect Resource Mobility another. Also, workers are free to move between different
firms. Therefore, people can learn skills easily.
• They are not restricted by government rules and
regulations, start-up cost, or other barriers to entry.

• Buyers are completely aware of sellers' prices, such that

one firm cannot sell its good at a higher price than other
firms.
6 Perfect Knowledge
• Each seller also has complete information about the prices
charged by other sellers so they do not inadvertently
charge less than the going market price.
 What Is Perfect Competition?
•The Firm’s Decisions
•A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints
it faces.
•So the firm must decide:
•1. How to produce at minimum cost
•2. What quantity to produce
•3. Whether to enter or exit a market

•We start by looking at the firm’s output decision.

 The Firm’s Output Decision
Economic Profit and Revenue
•A perfectly competitive firm chooses the output that maximizes its economic profit.
•One way to find the profit-maximizing output is to look at the firm’s total revenue and total
cost .
•The goal of each firm is to maximize economic profit, which equals total revenue minus total
cost.
•A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P  Q.
•A firm’s marginal revenue is the change in total revenue that results from a one-unit increase
in the quantity sold.
 Price Determination In P.C
• no individual firm can affect the market
price
• demand curve facing each firm is
perfectly elastic because one firm’s
product is a perfect substitute for the
product of another firm.
 P.C Short Run Equilibrium
(Profit Maximization)
• There are variable inputs and at least one fixed input.
• Profit maximization in the short run can be based on total approach as well as
marginal approach.
 Total Approach

• Data shows on output, total revenue, total cost and total profit for the Nasi Lemak.
• The profit maximized at USD40.
• The profit maximizing price is fixed at USD100 and the profit maximization output is at 4 units.
 Marginal Approach
(Marginal Revenue = Marginal Cost) (MR=MC)

 Firm will achieve equilibrium whenever MR and MC are equal.

 When MR = MC, profit is maximized.
 From the data, MR=MC at USD100, profit is at a maximum USD40.
 Therefore, the profit maximizing price is USD100 and the profit maximizing output is 4KG.
 3 Type's of Short Run Profits

• Supernormal profit (AR>AC) and (TR>TC at MR=MC)

• Subnormal profit (AR<AC) and (TR<TC at MR=MC)

• Normal profit (AR=AC) and (TR=TC at MR=MC)

 Supernormal profit
(AR>AC) and (TR>TC at MR=MC) -
PROFIT
• Firm achieves its equilibrium level at point
C, where MR=MC.
• AR point at point C id higher than the AC
at point D.
• The firm’s profit maximizing price is
attained at A and the profit maximizing
output is at Q.
• The firm is said to be earning supernormal
profit as shown in the shaded area ABCD
because AR exceeds AC.
SAMPLE QUESTION 1
• Calculate profit.
 Subnormal profit
(AR<AC) and (TR<TC at MR=MC) - LOSS

• The profit maximizing output is obtained

at Q and the profit maximizing price is at
A when MR=MC.
• The firm is said to experience subnormal
profit or losses
• Because the AR at point C is less than the
AC at point D.
• The loss is shown in the shaded area
ABCD.
SAMPLE QUESTION 2
• Calculate loss.
 Normal profit
(AR=AC) and (TR=TC at MR=MC) - BREAKEVEN

• MR=MC, the profit maximizing

output and price are achieved at
point A and A respectively.
• The AR=AC gives the condition
of normal profit or zero profit.
SAMPLE QUESTION 3

• Calculate normal profit.

 The Shutdown Decision
P
MC
• The shutdown point is the point
below which the firm will be better
AC
off if it shuts down than it will if it
stays in business
• If P>min of AVC, then the firm AVC
will still produce, but earn a loss
• If P<min of AVC, the firm will PShut P = D = MR=AR
shut down down

• If a firm shuts down, it still has to

Q
pay its fixed costs Qprofit max
SAMPLE QUESTION 4
 Chapter Summary
• The necessary conditions for perfect competition are:
1. Buyers and sellers are price takers
2. The number of firms is large
3. There are no barriers to entry
4. Firms’ products are identical
5. There is complete information
6. Sellers are profit-maximizing entrepreneurial firms
• Competitive firms maximize profit where MR = MC
• Profit is (P – ATC)(Q) at the profit-maximizing level of output
• Perfectly competitive firms shut down if P < AVC
• The supply curve of a competitive firm is its MC curve above minimum
AVC
• The short-run market supply curve is the horizontal sum of the MC curves
above AVC for all the firms in the market
• In the short run, competitive firms can make a profit or loss. In the long
run they make zero profits.
• If there are profits:
• Firms enter the industry
• Supply increases
• Price decreases, eliminating profit
• If there are losses:
• Firms leave the industry
• Supply decreases
• Price increases, eliminating losses
MARKET STRUCTURE

MONOPOLY
 27

Monopoly is a made up of the word

“mono”, which means single and “poly”
which means seller.

Definition Monopoly means existence of a single

of seller in the market producing a product
that has no substitutes and the entry of
other firms is restricted.
Monopoly
EXAMPLE:
 28

Characteristics

Characteristic Explanation

• Exists when there is only one seller of a product.

1 Single firm/seller • The difference between a firm and an industry does not
exist in a monopoly since there is only one seller.

• In a perfect competition, no single firm can influence the

price and this is called a price taker.
Firm is a Price
2 • The monopolist is a price maker since there is only one
(maker)
seller or one producer and is has the power to control the
price in the market.
 29

• In a monopoly, a firm produces a unique product which has no close

substitutes in the market.
Product has no close • For example, in Malaysia the only supplier of electricity is Tenaga
3 substitutes Nasional Berhad (TNB).
• There are no other products that can be the substitutes of electricity in
Malaysia and therefore TNB is the sole producer of electricity in
Malaysia. (SAJ/TM)

• In a pure monopoly, a firm has no competition since there are barriers to

Restriction on the entry of new firms joining the industry.
4 entry and exit of new • The barriers are comprised of various forms such as legal, technology,
firms control over raw material, patent and copyright, licenses, etc.
• Types of barriers will be discussed in detail in the next section.
 30

• The type of products will determine whether there is a need for

advertising.
• It the type of products produced are water supply, electricity,
telecommunications services, etc.
Minimum • There is no need for advertisement since the consumers are
5 advertising well aware of the market and where to obtain such goods and
needed services.
• However, for product such as luxury imported cars, luxury
special furniture, luxury brands of mobile phones, etc.
• There is a need for some advertisement to inform consumers
of the existence of such goods and services in the market.
31
 Demand and
32

Revenue for the Monopolist

A monopolistic firm’s marginal revenue is not its price

 Marginal revenue is always below its price
 Marginal revenue changes as output changes and is not
equal to the price
 Marginal Revenue

• Recall that the marginal revenue (MR) is:

TR
MR 
Q

33
 The Monopolist’s Price and Output
Numerically
• Remember is that marginal revenue is the change in total revenue that
occurs as a firm changes its output.
TR=P x Q
MR = Change in Total Revenue/ change in output

Another way to say it is:

“how much does your Total Revenue changes as you increase output”

34
 Average Revenue

• Whenever MR is greater than AR, AR rises.

• Whenever MR is less than AR, AR falls.
• Average revenue is:

P Q
AR  P
Q 35
Average Revenue > Marginal Revenue

• Note that the AR is the same as price. In fact, the AR

curve is the demand curve.
• With a downward-sloping demand curve, prices fall as
output increases. This means that AR falls.
• MR must always be less than AR.

36
Marginal approach (MR=MC)

• Firm will maximize profit when

……………..
• Total profit maximizing is at ...…
and the profit maximizing
quantity at ……

37
• Firm will maximize profit when
……………..
• This is shown at the intersection point
at ……..
• The profit maximizing is at ...… and
the profit maximizing quantity at ……

38
 39
3 Type's of Short Run Profits
• Supernormal profit (AR>AC) and (TR>TC at MR=MC)

• Subnormal profit (AR<AC) and (TR<TC at MR=MC)

• Normal profit (AR=AC) and (TR=TC at MR=MC)

 Supernormal profit
(AR>AC) and (TR>TC at MR=MC) - PROFIT

• Firm achieves its equilibrium level at

point E*, where MR=MC.
• The firm’s profit maximizing price is
attained at A and the profit
maximizing output is at Q.
• The firm is said to be earning
supernormal profit as shown in the
shaded area ABCD because AR>AC.
40
 41

SAMPLE
QUESTION 1
• Calculate profit.
• 0A – RM10
• 0M – 10 unit
• 0B – RM5
 Subnormal profit
(AR<AC) and (TR<TC at MR=MC) - LOSS

• The profit maximizing output is

obtained at Q and the profit
maximizing price is at B when
MR=MC.
• The firm is said to experience
subnormal profit or losses
• Because the AR<AC.
• The loss is shown in the shaded area
ABCD. 42
 43

SAMPLE
QUESTION 2
• Calculate normal
profit.
• 0A – RM10
• 0M – 10 unit
• 0B – RM15
 Normal profit
(AR=AC) and (TR=TC at MR=MC) - BREAKEVEN

• MR=MC, the profit maximizing

output and price are achieved at
point A and Q respectively.
• The AR=AC gives the condition of
normal profit or zero profit.

44
 45

SAMPLE
QUESTION 3
• Calculate loss.
• 0A – RM10
• 0M – 10 unit
 The Shutdown Decision

• The shutdown point is the point

below which the firm will be better off
if it shuts down than it will if it stays
in business
• If P>min of AVC, then the firm will
still produce, but earn a loss
• If P<min of AVC, the firm will shut
down
• If a firm shuts down, it still has to pay
its fixed costs 46
SAMPLE QUESTION 4

47
 Monopoly Long Run Equilibrium
• Long run is a period, whereby all inputs are
variable because there is ample time for the firm
to make necessary changes to the inputs.
• Long run equilibrium also follow the same rule as
short run equilibrium where marginal revenue is
equal to marginal cost (MR=MC).
• In the long run, a monopolist will earn
supernormal profit because of the barriers to entry
that exist in industries in the monopoly market.
• The reason why a monopolist only earns supernormal
profit is because when there is restriction on entry of new
firms, the monopolist does not have any competitors.
• Therefore, due to no competition, the monopolist can
increase or decrease the price, depending on the cost that
they incur.
• For instance, if the production cost increases, the
monopolist may increase its price in order to avoid
minimum profit or losses.
• This means a monopolist can make all the necessary
changes to cost due to restriction on entry of new firms
into the industry. 48
• As illustrated in Figure the long run equilibrium
of a monopoly is achieved when long run
marginal revenue equates long run marginal
cost (LRMR=LRMC).
• This is shown at point E*. The profit-
maximizing price is obtained at point A and the
profit-maximizing output is achieved at point
Q.
• The shaded area ACDB represents supernormal
profit that is earned by the monopolist in the
49
long run, due to barriers to entry.
 MARKET STRUCTURE

MONOPOLISTIC COMPETITION
 Large number of small
sellers selling different
products with close
Definition of substitute.
Monopolistic
Competition
EXAMPLE:

51
 Characteristics
Characteristic Explanation

• There are large number of sellers.

• The size of each firm is small.
1 Large Number of firms/Sellers
• No individual can influence the market price.
• Firm follows an independent price-output policy.

• Will be stiff competition among firms for products and not

for the price of the product.
• Sellers uses various methods to attract buyers to buy a
particular brand.
• Types of nob-price competition practices are
2 Advertising is needed
 advertisements,
 promotions,
 discounts,
 free gifts,
 after-sales services
52
 • Firms produce goods which are differentiated, that is, they are
not identical.
• Seller will use various method to differentiate their products
from other sellers to create a preference among buyers.
Homogeneous or • Differentiation of the product may be through the
3
differentiated product  Packaging,
 Design,
 Labeling,
 Advertising,
 Brand names.

• Enter and exit are unrestricted.

4 Easy entry and exit • New firms may enter the industry with close substitutes to the
existing brand.

53
 Characteristic Explanation
• Due to the fairly small size of every firm in monopolistic
competition, they cannot determine the prices of goods and
services.
• They have less control over the prices of products. Each firm
will follow an independent price-output policy.
5 Less control over price
• For example, there is a situation where consumers prefer a
specific product and are willing to pay more to satisfy their
preferences.
• There is also a situation where consumers will find
substitutes for a product whenever the price increases.

54
 Demand and Revenue
for the Monopolistic competition

• MR and AR curve are relatively flatter.

• The demand for the monopolistic competitive

firm is more elastic.

• Because there are many firms and many

substitute goods.

55
 • Supernormal profit (AR>AC)
and (TR>TC at MR=MC)

• Subnormal profit (AR<AC) and

(TR<TC at MR=MC)
3 Type's of
Short Run • Normal profit (AR=AC) and
(TR=TC at MR=MC)
Profits
56
 Supernormal
profit
• The monopolistically competitive firm
reaches equilibrium at point E, when MR =
MC.
• At point E, the firm will produce an output
of 0Q0 at price 0P0.
• At output level 0Q0, the total revenue is
0P0AQ0 , and the total cost is 0P1BQ0.
• Therefore, the firm will generate a
supernormal profit of P1P0AB.
• Thus, it will generate supernormal profit in
the short run are MR = MC and AR > AC.

57
 Supernormal profit
(AR>AC) and (TR>TC at MR=MC) - PROFIT

58
SAMPLE QUESTION 1

• Calculate profit/loss.
• A – RM10
• M – 10 unit
• B – RM5

59
 Subnormal profit
(AR<AC) and (TR<TC at
MR=MC) - LOSS

• The monopolistically competitive firm

reaches equilibrium at point E , when MR =
MC.
• At point E, the firm will produce an output
of 0Q2 at price 0P2 .
• At output level 0Q2, the total revenue is
0P2BQ2 , and the total cost is 0P1AQ2 .
• Therefore, the firm will generate a
subnormal profit of P2P1AB .
• Thus, it will generate subnormal profit in the
short run when MR = MC and AR < AC .

60
Subnormal profit

61
SAMPLE QUESTION 2

• Calculate profit/loss.
• A – RM10
• M – 10 unit
• B – RM15

62
 Normal profit
(AR=AC) and (TR=TC at
MR=MC) - BREAKEVEN

• The monopolistically competitive firm

reaches equilibrium at point A , when MR =
MC .
• At point A, the firm will produce an output
of 0Q1 at price 0P1 .
• At output level 0Q1, the total revenue is
0P1BQ1 , and the total cost is 0P1BQ1
• Therefore, the firm will generate a normal
profit .
• Thus, it will generate normal profit in the
short run when MR = MC and AR = AC .

63
Normal profit

64
SAMPLE QUESTION 3

• Calculate loss.
• A – RM10
• M – 10 unit
• B – RM10

65
In the long run, monopolistically
competitive firms will only earn
normal profit due to freedom of
entry and exit.
Monopolistic
The long run equilibrium of the
Competition
firm depends on the short
equilibrium.
Long Run
Equilibrium
The two effects which are the
entry and the exit effect are
described in study guide. (please
refer it)

66
 long run
equilibrium
• The long run equilibrium is
achieved at the intersection
point between MR and MC at
point E*.
• The equilibrium quantity is
achieved at Q and the price is
constant at P.
• The monopolistically
competitive firm earns
normal profit in the long run
when AR equals LRAC due
to freedom of entry and exit.

67
MARKET STRUCTURE

OLIGOPOLY
 69

There are few firms in the industry .

These few firms produce either

identical or differentiated product.
Definition of Entry of any new sellers is difficult
Oligopoly or impossible .

Goods produced and sold are

homogenous or differentiated.
• EXAMPLE:
 Characteristics
Characteristic Explanation
• The number of firms is few in the industry, but the size of each firm is
large.
• The firm dominates the market because their market share is large.
1 Few in number but large in size Even though they are few in the industry, they have the power to
control the whole industry.
• For example, there are few petroleum companies in Malaysia, namely
Petronas, Shell, Caltex, Petron, etc.

• An oligopoly may produce either standardized products or

differentiated products.
• Examples of oligopoly that produce homogenous products are the
Homogeneous or differentiated
2 petroleum, cement, steel, copper, and aluminum industries.
product
• Examples of firms in oligopoly which produce differentiated products
are the automobile industry, household appliances, tires, electronic
appliances, sports equipment, etc
70
 • The firms is an oligopoly always consider the reaction of their rivals
when choosing the price, sales target, advertising budgets and other
business policies.
3 Mutual interdependence • Since the number of firms is small, changes in price or output by one
firm can have a direct effect on another firm.
• For instance, McDonald’s decide their marketing and advertising
strategies, it will consider how KFC and Burger King might react.

• There are various barriers to entry.

• Although similar to a monopoly, the firms in an oligopoly will restrict
new entrants into the market.
• The type of barriers to entry are
4 Barriers to entry
 economies scale,
 force to merge,
 ownership of patents and
 copyrights to name a few. 71
 72

Price Rigidity and Kinked

Demand Curve
• Since there is mutual interdependence between oligopoly firms, the prices
in the market are more stable. This is called price rigidity in oligopoly
market.
• The price rigidity explains the behaviour of an oligopoly firm that has no
incentive to increase or decrease the price.
• The theory of the kinked demand curve is based on two assumptions.

 First assumption: When one firm increases the price, others will not
follow.
 Second assumption:When one firm reduces the price, others will follow.
 Because of this assumption,
an oligopolist faces kinked
demand curve.
Price (RM)
According to the assumption,
when the firm increases the price
(P*), no other firms will follow.
Above P*, the firm will follow the
dd curve.
If the firm decreases the price,
other firms will follow. Below P*,
the firm follow the DD curve.

An oligopoly firm faces

two demand curve,
individual demand curve
P* (dd) and industry demand
curve (DD).

dd

DD

Q* Quantity
 This shows the price rigidity
in the oligopoly market. At this range of MR, any
change in the MC does not
Price (RM)
reflect changes in the profit
maximizing price and output. The kinked demand
curve  below Point E
MC1 creates a gap in the MR,
which is indicated by the
MC2
dotted line ab.
E
P*

b DD

Q*
MR Quantity
 75

• Supernormal profit (AR>AC)

and (TR>TC at MR=MC)

3 Type's of
• Subnormal profit (AR<AC) and
Short Run (TR<TC at MR=MC)
Profits
• Normal profit (AR=AC) and
(TR=TC at MR=MC)
 76

Supernormal profit (AR>AC) and

(TR>TC at MR=MC)
• Supernormal profit is achieved when
average revenue exceeds average cost at
the intersection between marginal revenue
and marginal cost.
• The profit-maximizing price is determined
at A and the profit-maximizing quantity is
represented at Q.
• The shaded area ACDB reflects the
supernormal profit experienced by the
firms.
SAMPLE QUESTION 1

77
 78

Subnormal profit (AR<AC) and

(TR<TC at MR=MC)
• Subnormal profit occurs when AR is less
than AC at the equilibrium point
(MC=MR).
• Points A and Q represent the profit-
maximizing price and output respectively.
• The shaded area ADCB shows the
subnormal profit experienced by the firm.
SAMPLE QUESTION 2

79
 80

NORMAL PROFIT (AR=AC) AND

(TR=TC AT MR=MC)
• Normal profit as illustrated in Figure is
attained when AR equals AC at the
equilibrium position (MR=MC).
• The profit-maximizing price and output is
shown at points A and Q respectively.
• It is necessary for the firm to stay in
business since its price is equal to average
cost.
SAMPLE QUESTION 3

81
EXAM SAMPLE QUESTION 4

82
Welcome Queries…