Market Structures and Firm Supply Functions

Lesson 5: Market Structures and Firm Supply Functions

Perfect Competition
- Characteristics:
  - Many firms operate in the market.
  - Produce a homogeneous good (identical products).
  - No individual firm has market power or influence on prices.
Monopoly
- Characteristics:
  - Only one firm dominates the market.
  - Has significant market power to set prices.
Imperfect Competition
- Characteristics:
  - Several firms operate in the market, each aware that sales depend on
    the price they charge and their actions (e.g., advertising).
- Oligopoly
  - A limited number of firms exist, each concerned about their rivals' responses.
- Monopolistic Competition
  - Many firms with some market power due to product differentiation (products are not homogeneous).

Criterion for Production Decision: Profit Maximization
- Firms in perfect competition are guided by the criterion to maximize profits by ensuring that:
  - Price (P) equals Marginal Cost (MC):
    P = MC

Short Run Supply Function
- The supply function reflects the price at which the firm is willing to sell each quantity of product.
- Firms must cover at least their Variable Costs (VC) in the short run.
- Relationship between Average Cost (AC) and Price (P):
  - P > AC leads to profits ( > 0)
  - P = AC leads to zero profit ( = 0)
  - P < AC leads to losses ( < 0)
- Key Points:
  - Opening Point or Closing Point: Refers to the output levels where firms decide to enter or exit, based on profitability conditions.
Long Run Supply Function
- In the long run, firms aim for long-term equilibrium where profit approaches zero due to free entry and exit of firms:
  - Profits in short run ( > 0) attract new firms to enter the market, resulting in:
    - Long run profits = 0
  - Zero profits in short run ( = 0) imply no incentive for firms to enter or exit, leading to:
    - Long run profits = 0
  - Losses in short run ( < 0) cause firms to exit:
    - Long run profits = 0
- Condition of Long Run Supply Function:
  - At long-run equilibrium:
    - P = AC
  - Thus, profit in long run is zero, leading to:
    - Profit_{lr} = 0
  - This results in:
    - Minimum Efficient Scale (MES):
      - The smallest output a firm can produce, minimizing its long-run average costs, usually denoted as q^{*}(MES).

Market Supply Definition:
- The total market supply is the summation of the supply of all individual firms in the market.
Characteristics of Market Supply:
- As the number of firms in the market increases, the total quantity supplied varies more while the price level becomes more stable.
- The overall market supply curve in the long run achieves a perfectly elastic (horizontal) response due to the dynamics of free entry and exit in perfect competition markets:
  - High elasticity indicates responsiveness of supply to price changes: P ext{ (Price) vs. } Q ext{ (Quantity)}

Perfect Competition
- Characteristics:
- Many firms operate in the market.
- Produce a homogeneous good (identical products).
- No individual firm has market power; they are "price takers."
- Perfect information: Consumers and producers have full knowledge of prices and technology.
- No barriers to entry or exit in the long run.
Monopoly
- Characteristics:
- Only one firm dominates the entire market.
- Has significant market power to set prices ("price maker").
- High barriers to entry (e.g., patents, resource control, or economies of scale).
Imperfect Competition
- Characteristics:
- Several firms operate in the market, each aware that sales depend on the price they charge and their strategic actions.
Oligopoly
- A limited number of large firms exist.
- Firms are mutually interdependent; each is concerned about their rivals' responses to price or output changes.
- High barriers to entry often exist.
Monopolistic Competition
- Many firms with some market power due to product differentiation (products are not homogeneous).
- Low barriers to entry and exit.
- Rely heavily on non-price competition like advertising and branding.

Criterion for Production Decision: Profit Maximization ( \pi = TR - TC )
Firms in perfect competition maximize profits by ensuring that:
- Price (P) equals Marginal Revenue (MR) and Marginal Cost (MC):
- P = MR = MC
- The firm will produce where the cost of the last unit produced is exactly equal to the revenue it generates.

Short Run Supply Function
- The supply function reflects the price at which the firm is willing to sell each quantity of product.
- The Shutdown Rule: In the short run, a firm should continue to operate as long as it can cover its Variable Costs (VC). If P < AVC, the firm should shut down.
- Relationship between Average Cost (AC) and Price (P):
- P > AC leads to economic profits ( \pi > 0 ).
- P = AC leads to zero economic profit ( \pi = 0 ), also known as the break-even point.
- P < AC results in economic losses ( \pi < 0 ). If the price is still above Average Variable Cost (AVC), the firm continues to produce in the short run to minimize losses.

Market Supply Definition:
- The total market supply is the horizontal summation of the supply of all individual firms currently in the market.
Characteristics of Market Supply:
- As the number of firms in the market increases, the total quantity supplied varies more while the price level becomes more stable.
Long Run Equilibrium:
- In the long run, firms can enter or exit the market. If there are profits, new firms enter, increasing supply and driving price down to the minimum of the AC curve.
- The overall market supply curve in the long run can be perfectly elastic (horizontal) in a constant-cost industry:
- High elasticity indicates high responsiveness of supply to price changes: P \text{ vs. } Q.