Market Structures in Economics: Perfect Competition

Chapter 8: Perfect Competition

Chapter Objectives

• Market Structures
  • Describe primary market structures and their characteristics.
  • Describe assumptions of perfectly competitive markets.
  • Determine profit-maximizing quantity and price for a perfectly competitive firm.
  • Analyze conditions for profit maximization, loss minimization, and plant shutdown.
  • Derive short-run supply curve for perfectly competitive firms.
  • Illustrate long-run equilibrium in perfectly competitive markets through entry and exit.
  • Explain public interest benefits of perfect competition.

Market Structure Analysis

• Key Observations
  • Industry characteristics help predict pricing and output behavior.
• Determinants of Market Structure:
  • Number of firms
  • Nature of products
  • Barriers to entry
  • Control over prices
  • Long-run profit potential

Primary Market Structures

1. Perfect Competition
2. Monopolistic Competition
3. Oligopoly
4. Monopoly

Characteristics of Perfect Competition

• Attributes:
  • Many buyers and sellers
  • Homogeneous products (near identical)
  • No barriers to market entry/exit
  • No price control (no market power)
  • No long-run economic profit
• Examples: Corn and wheat industries

Monopolistic Competition

• Attributes:
  • Many buyers and sellers
  • Differentiated products
  • Little to no barriers to entry/exit
  • Some price control
  • No long-run economic profit
• Example: Restaurant industry

Oligopoly

• Attributes:
  • Few large firms
  • Interdependent decision-making
  • Significant barriers to entry
  • Shared market power & considerable price control
  • Potential for long-run economic profit
• Example: Wireless data industry

Monopoly

• Attributes:
  • One firm
  • No close substitutes for its product
  • Nearly insurmountable barriers to entry
  • Significant market power & price control
  • Potential for long-run economic profit
• Example: NFL (National Football League)

Perfectly Competitive Markets

• Firms as Price Takers:
  • Individual firms cannot influence market price due to their size.
  • Firms decide on quantity to sell at given market price.

Market Dynamics

• Demand Curve:
  • Market demand vs. individual firm’s demand.
• Total Revenue (TR):
  • TR = Price × Quantity
• Marginal Revenue (MR):
  • MR = ΔTR / Δq

Profit Maximization Rule

• Rule: Firms maximize profit where MR = MC (Marginal Revenue = Marginal Cost).
• Example of Output Level:
  • Optimal output is at quantity where MR = MC.

Steps to Maximize Profit

1. Find MR = MC.
2. Determine optimal quantity (Q).
3. Determine optimal price (P).
4. Calculate Average Total Cost (ATC).
5. Calculate Profit.

Short Run vs. Long Run

• Short Run:
  • At least one fixed production factor (e.g., plant size).
• Long Run:
  • All factors are variable.
  • Firms enter/exit based on profit/loss conditions.

Profit Analysis

• Normal Profit:
  • Zero economic profit (P = ATC).
• Zero Economic Profit:
  • Firms in long-run equilibrium earn zero economic profit but can have substantial accounting profit.

Loss Minimization Conditions

• If Price < ATC:
  • Firms minimize losses by producing if Price > AVC or shut down if Price < AVC.
• Example Calculation:
  • Profit = (P - ATC) × Quantity.

Shutdown Point

• Firms should shut down when market price falls below the minimum point of the AVC curve.

Short-Run Supply Curve

• A firm’s supply curve is derived from the MC curve above the minimum AVC.

Long-Run Adjustments

• Economic Profit:
  • Attracts new firms into the industry.
• Economic Losses:
  • Causes firms to exit.
• Long-Run Equilibrium:
  • Occurs when Price = MR = MC = LRATC minimum.

Long-Run Industry Supply

• Affected by long-run average total cost (LRATC) and economies/diseconomies of scale.
• Industry Types:
  • Increasing Cost Industry: Resource prices rise as industry expands.
  • Decreasing Cost Industry: Economies of scale reduce costs as industry expands.
  • Constant Cost Industry: No significant changes in costs as the industry expands.

Key Concepts to Remember

• Market structure analysis
• Perfect competition
• Price taker
• Marginal revenue
• Profit-maximizing rule
• Break-even point
• Normal profit
• Shutdown point
• Short-run supply curve
• Increasing cost industry
• Decreasing cost industry
• Constant cost industry

Practice Questions

1. Which is likely to be a perfectly competitive industry?
   • A: Farm commodities.
2. If MR of a dozen tulips is $12 and MC is $8, why not optimal production?
3. What happens in a perfectly competitive firm when it produces at its optimal output??
4. Should a perfectly competitive firm continue producing with short-run losses?
   • A: Yes, if covering variable costs.