Market Structure and Pricing practices:

Price – Output Decisions Under different Market structure.

In economic language market is a study about the demand for & supply
of a particular item and its consequent fixing of prices.
The Pricing practices: i.e. Price – Output Decisions is made Under
different Market structure.
Thus the term Market Structure refers to the organizational
features of an industry that influence the firm’s behaviour in its
choice of price & output.
Market is classified into various types based on the following features.
Area: family market, local, regional, national & international
Time: very short period, short period, long period, very long period
Commodity: produce exchange, bullion market, capital market, stock market
Nature of Transaction: spot market, forward market and futures market
Volume of business: whole sale market, retail market
Importance: primary market, secondary market, territory market
Regulation: regulated market, unregulated market
Economics: Perfect market and imperfect market
The competitive environment in the market for any
product is the market structure faced by the firm.
But what is the market structure?
The term Market structure:
Refers to the physical characteristics of the market within
which firms interact.
It refers to the number & size distribution of buyers & sellers
in the market for a good or service.
It involves the number of firms in the market and the barriers
to entry.
Factors Determining the Nature of Competition are:
Effect on Buyer,
Production Characteristics,
Product Characteristics,
Conflict between Physical Characteristics and Minimum
Economic Size
Thus Based upon
Degree of price control,
Nature of demand curve,
Influence on activities of other firms
The number of firms/producers/sellers in the market and the
level of product differentiation,
the number of the actual buyers & their behavior,
Potential entrants or barriers to entry and exit,
Capital requirements,
The level of competition (potential competitors),
Price vs. Non-price competition,
The governmental policies,
Etc,
We categories market structure broadly into two market

A. Perfect market
B. Imperfect market
 Thus based on the nature of competitor (listed above),
Market structure is classified into two categories;
1. Perfectly competitive market &
2. Imperfectly competitive market.
The imperfect market in turn can be classified as
a. Monopoly or monopolistic market
b. Monopolistic competitive market
c. Oligopoly market structures.
Perfect competition, with an infinite number of firms, and
monopoly, with a single firm, are polar opposites.
Monopolistic competition and oligopoly lie b/n these two extremes.
Most real-world firms are along the continuum of
imperfect competition.
Market structure affects market outcomes, ie., the
price and quantity of goods supplied.
Perfectly competitive market structure is an ideal
market.
It is an extreme market structure where competition
reaches its maximum possible degree.
There is no as such pure perfectly competitive market
in the world; however, there are markets closes to
perfectly competitive market structure.

Perfect competitive market structure is thus a market

structure used as a reference to compare different
imperfectly competitive market structures; such as:
Monopolistic market,
Monopolistic competitive market, &
Oligopoly market structures.
 Perfectly Competitive Markets
Definition: Perfect competition is a market structure characterized
by a complete absence of rivalry/ conflict/ enmity/ competition
among the individual firms.
A perfectly competitive firm is one whose output is so small in
relation to market volume that its output decisions have no
perceptible impact on price.
No single producer or consumer can have control over the price
or quantity of the product.

In Perfect competition market

there is a large number of producers offer a homogeneous
product to a very large number of buyers of the product.
the number of sellers is so large that each seller offers a very
small fraction of the total supply, and therefore, as no control
over the market price and hence, no competition.
price, marginal revenue and average revenue are equal and are
horizontal along the market price.
 Perfect Competition

Profit maximiser
Identical product
Very small share of the market
Price-taker
Produces a homogeneous product
Perfect information
No barriers to entry (legal, technological, or resource)
No technical progress
No investment lag - Immediate implementation of
production decisions)
Homogeneous goals of the owners and managerial staff
 Characteristics of Perfect Competitive
market structure.
Perfectly competitive market structure is characterised by
the following Assumptions:
a. Large number of sellers and buyers:-
Thus, no single buyer/seller can affect the market
Under perfect competition, the number of firms (sellers
and buyers ) is assumed to be so large that the share of
each firm in the total supply of a product is so small that
no single firm can influence the market price by changing
its supply.
Therefore, firms are price takers not price makers.
Thus the demand curve facing a firm in perfectly
competitive market is perfectly elastic ,
indicating that the firm can sell any amount of
output at the prevailing market price
 b. Homogenous/identical products:
The commodities supplied by all the firms of an
industry are assumed to be homogeneous or
approximately identical.
This implies that buyers do not distinguish b/n
products supplied by the various firms of an industry.
Thus product of each firm is regarded as a perfect
substitute for the products of other firms.
This implies that individual firms are price taker
(P = MR = Demand).

c. Perfect mobility of factors of production:

The factors of production especially, labour and
capital are freely mobile between the firms.
 d. Free entry and exit of firms.
There is no legal or market barrier on entry of
new firms to the industry.
Nor is there any restriction on exit of the
firms from the industry.
That is, a firm may enter the industry and quit
it at its will.
Thus, when normal profit of the industry
increases, new firms enter the industry and
if profits decrease and better
opportunities are available, firms leave the
industry.
e. Perfect knowledge about the market
conditions:-
Both buyers & sellers have perfect/full
information about the prevailing and future
prices, quality of a product and availability of
the commodity.
Information regarding market conditions is
available free of cost.
There is no uncertainty.
f. No government interference:-
Government does not interfere in any way with
the functioning of the market.
That is, the government follows the free
enterprise policy.
Where there is intervention by the
government, it is intended to correct the
market imperfections.
g. Freedom in decision making:
– Absence of collusion & thus decisions are
made independently.
Perfect competition assumes that there is no
collusion b/n the firms.
 Overall Comparison of Market Structures
Basis Perfect Monopoly Monopolistic Oligopoly
Competition Competition
1. Number of Very large Single seller Few or Many Few Big sellers
Sellers (many)
2. Nature of Homogeneous No Close Closely related but Homogeneous under Pure
Product Products Substitutes differentiated Oligopoly & differentiated
(unique ) under Differentiated
Oligopoly
3. Entry and Exit Freedom of No (Entry of new Easy to Limited entry
of Firms entry and exit firms & exit of old entry & exit (Restrictions on entry of new
firms is restricted) firms)
4. Demand Curve Perfectly Downward sloping Downward sloping Indeterminate demand curve
elastic DC DC (less elastic) demand
(horizontal line) (but more elastic)
5. Ability to set Uniform price Price setter; Limited power; Price setter but have very
price as each firm is Firm is a price- Firm has partial limited power
a price-taker maker. So, price control over price Price rigidity due to fear of
discrimination is due to product price war
possible. differentiation.
6. Selling Costs No selling costs Only informative High selling costs Huge selling costs are
are incurred selling costs are are spent incurred
incurred
Strategic No Has no rival Yes Yes
dependence
8. Profit max’n P = MC=MR MR=MC MR=MC MR=MC
condition
Example Apple farmers Local utility Retail trades Automobile manufacturer,
OPEC
Profit Maximization Under Perfect Competition
Cost Structure: Under Perfect Competitive market structure
Similar to earlier discussion, as in theory of cost of production; AVC
& AC in Perfect Competitive have U–shape due to the law of variable
proportions (in the SR) & the law of returns to scale (in the LR).
Demand & Revenue function in Perfectly competitive market
firms are price takers & sell any quantity demanded at the
ongoing market price.
hence, the demand function that an individual seller faces is
perfectly elastic (or horizontal line).
Thus, the Demand Curve for a single firm Graphically, Horizontal
Price per unit ($)

Price = Demand
p

Demand Curve for firms operating

under perfectively competitive market. Q
Quantity per time period
 Profit Maximization Under Perfect Competition
The concept of profit:
The primary objective of any business is to maximize the profit.
Profit can be increased either by increasing total revenue (TR) or
by reducing the total cost (TC).
The profit is nothing but the difference b/n the revenue & the
cost.
i.e. The total profit = TR – TC

Let us assume that whatever produced is sold in the market.

TR = Quantity sold x price
To increase the revenue, it is better to either increase the
quantity sold or increase the price.

Therefore while increasing the revenue or minimizing the TC of

production over a period of time with attendant economies of
scale will widen the difference to gain more profit.
Total Revenue (TR)
Firm generates revenue from the sale of its product & Total Revenue
(TR): is the product of price and quantity of the product sold.
i.e. TR = P*Q , where P stands for unit price & Q quantity
of the product.
Since in a competitive market unit price is constant & the firm is
a price taker, TR is a linear function of quantity of output.

Given this demand function, the

total revenue (TR) of a firm is
given
by the product of the
market price & the quantities
of sales, i.e. TR = PQ
Since P is constant/fixed, TR
is linear & a positive function
of quantity of sales.
To increase TR, sale should
rise

Total Revenue for a firm facing a perfectively competitive market

 Average Revenue (AR) & Marginal revenue (MR)
Under Perfectively Competitive Market
Under a perfectively competitive market:
1. Average revenue: is total revenue per unit of output(Q).
AR = TR/Q = P …………….. Why?
2. Marginal revenue (MR): is additional revenue from the
additional unit of output.
It is a rate of change in total revenue associated with a unit
change in output.
Marginal revenue measures the slop of total revenue.
MR = ΔTR/ΔQ
In a competitive market MR = P ……….why?
When the firm is in equilibrium, producing the maximum output i.e.
cost of the last item produced is known as MC.
I.e. the slope of TC is MC
When the firm is operating in perfect market MC = AC.
When the firm is working in the perfect market the MR = AR.
Therefore the MC = MR = AR = AC = P in the short run.
In perfect market, the firm’s MC, AC, AR, & MR are equal to
the price(P) of the commodity.
 fig a) market demand ,supply curve & market
equilibrium for the industry
Market demand Market Supply

Pm Pm
D=MR=AR

Quantity Quantity

(a) (b)

Fig (b) firm’s demand curve

(D), marginal revenue(MR) &
average revenue(AR) curve &
Average revenue curve.
Equilibrium of firm in perfectly competitive
A firm is in its equilibrium when it produces output to a level that its
profit is maximised or loss is minimized ,given the market price.
Maximization of profits or minimization of loss depends on the
revenue & cost conditions.
Revenue & cost conditions vary according to whether the period under
reference is short or long.
Short Run Equilibrium of the firm
Under perfect competition, the firm is said to be in equilibrium when it
produces that level of output which maximizes its profit, given the
market price.
Thus, determination of equilibrium of the firm operating in a perfectly
competitive market means determination of the profit maximizing output
since the firm is a price taker.
In a perfectly competitive market, in the SR, firms make either profit
or incur loss (since there is FC in the SR).
Thus the equilibrium point of a firm in the SR: i.e. the level of output
which maximizes the profit of the firm can be obtained in two ways:
Total Approach: i.e. total Revenue-total Cost Approach &
Marginal Approach.
I) Total Revenue – Total Cost Approach
Profit by definition is the difference b/n the total amount of
money collected from sale & the total cost of operation.
i.e. Pr ofit (π ) = TR − TC ; i.e., π = PQ − TC
Thus, according to this approach profit is said to be maximized
at the level (rate) of output that:
maximizes the difference or excess of total revenue over cost
or
minimizes the excess of cost over total revenue.
Or geometrically, the profit maximizing level of output is that
level of output at which the vertical distance b/n the TR & TC
curves is maximum. (Provided that the TR curve lies above the
TC curve at this point).
Hence as to this approach:
Profit is maximized at level of output that makes the
difference between TR & TC is large.
Profit is maximum at a point where TR exceeds TC by
larger amount.
Graphically The firm will choose the
amount at which TR > TC
TC TR Profit is maximum at the
TC,TR point where the area b/n
TR & TC is large.
Larger area occurs at
the point where the slope
of TR is just equals to
the slope of TC.
Thus the profit
Q
Qo Qe Q1 maximizing level of output
is Qe
Profit (∏)
b/c it is at this out put
level that the vertical
distance b/n the TR & TC
curves (or profit) reaches
maximum.
0
Qo Qe Q1 Q For all output levels
below Q0 & above Q1
profit is negative b/c TC
is above TR.
 II) The Marginal Approach
The marginal approach is the continuation of the previous approach.
In the previous approach we have said that, profit is maximum at a
place on the graph where the TR curve exceeds the TC curve
by the larger amount.
This occurs when the Slope of TR = Slope of TC. But we know
that: slope of TR is MR & the slope of TC is MC.
Thus; the Marginal Approach states that: the profit maximizing
level of output is attained at the point where the Marginal Revenue
is equal to the Marginal Cost; i.e. when MR = MC.
This can be graphically represented as follows.
MC,
MR
NB: Recall that in a MC

perfectly competitive
market price, AR & MR A B
are equal P
P=MR=AR
(P= AR= MR).

Q1 Q2
 Marginal approach MC,
MR
From the figure it can be noted that MR = MC at MC
two points, at A & B.
But both of them are not the equilibrium point. P
A B
The profit maximizing output is the one at P=MR=AR
which MR = MC & at the increasing part of
MC.
In other words the MR must intersect MC
at the increasing part of MC. Q1 Q2
At Q1, MC = MR, but since MC is falling at Q
this output level, it is not equilibrium out put. point B is the only equilibrium
Thus firm should produce additional output point b/c the MC curve crosses
until MC is raises & reaches Qe (equilibrium the MR curve from below Or MC
output). is increasing.
For all output levels ranging from Q1 to Q2 the
MC of producing additional unit of output < Thus, the condition for
the MR obtained from selling this output. profit maximization
thus firm should produce additional
under perfect
output until it reaches Qe.
At Q2, MC = MR, while MC is rising. competition is
Thus the profit maximizing output level MR = MC………….
(Qe), is this output level, where MC = necessary condition
MR & MC curve is increasing &
Hence, equilibrium output is Q* not Q1
MC is increasing………….
sufficient condition
In the above figure we have determined the profit maximizing output.
However, the above analysis will not enable us to determine the level
of profit.
To determine the level of profit, we need information about the ATC.
The figure below incorporate ATC curve so that we can determine profit or
loss in our analysis.
Shortly speaking at equilibrium point or when it does not guarantees
that the firm is maximizing or is minimizing loss; the firm may
insure profit making or incur loss making.
But at equilibrium point; the firm is producing an output(Q) while:
making possible (max) profit, while it is making profit
or is making possible (min) loss, while it is incurring loss.

Thus at equilibrium, firm

will get
E
positive profit,
zero profit &
negative profit
depending on ATC.
Profit in this analysis is on the bases of average or unit profit and is
calculated as follows.
Profit/Unit = (TR/Q) – (TC/Q)
i.e. Profit per unit = P-ATC
In the above figure total profit is given by the shaded area.
However, it does not mean that the firm will always make profit.
Weather a firm makes profit or not depends up on the position/level of
Min of ATC.
Depending on the level of ATC different scenarios may emerge.

i. If the min of ATC is below the

market price(P) at equilibrium,
the firm earns a positive profit
ii. If the min of ATC is above the
market price , the firm incurs E
loss
iii.If the min of ATC = market
price, the firm gets zero
profit.
1. When P > ATC; in this case the firm makes profit.
This is the case which is presented above & is
presented again as follows.

In the graph the

equilibrium point is E,
where (MR = MC). E
At the equilibrium level
of out put(Qe), the
equilibrium price of the
production (P) is greater
than the average cost of
production (ATC).
There fore, in this case,( i.e. when
The profit is the shaded area. P > ATC) the firm is making
economic profit (or simply profit)
indicated by the shaded area.
2. When a P =
ATC, the firm is
in a break even
condition. E
That is there is
no profit or loss
(Profit = 0).
3. When P < ATC, the firm is
incurring loss.
When this situation happens the
firm faces two decision problems.
One is to continue in business
with the existing loss. E
The other is to shut down the
business.
The decision is made by
considering the value of AVC.
a) If the market price (P) >
AVC, the firm is covering the
costs of all variable inputs &
costs of some fixed inputs.
Hence the firm has to continue
in business.
In which cases the profit
maximization is equivalent to loss therefore, the firm is
minimization. incurring loss,
This los minimization condition is ( i.e. when P < ATC but >
depicted as in fig. AVC) which is indicated by
the shaded area .
b) If the market price
is just equals to AVC,
(P = AVC) the firm
should shut-down its E
business.
The short-run shut-
down price condition is
depicted as in fig.
 Deriving the Supply Curve
The supply curve of a firm is derived from the firm’s
optimization decision.
The portion of the MC curve above the SR supply curve
represents supply curve of a firm.
The following figure presents how supply curve is derived from the
firm’s equilibrium point that would occur at different price level.
SMC SAC

P4 S S
P4
P3 T T
P3
SAVC
P R P R
2 2
M M
P P
1 1

O O
Q Q Q Q4 Q Q Q Q
Output
1 2
(a)3 Output
1 (b)
2 3 4

Thus, the SR supply curve of a perfectly competitive firm is that part of MC

curve which lies above the minimum AVC (Shut down point)
Example: 1. Suppose a firm’s short run cost function is given by:
TC = Q 3 − 18 Q 2 + 100 Q + 250
Price of the commodity is Birr 40/unit
Determine
a) AVC & MC functions of the firm
b) Firm’s SR equilibrium(The level of output that maximize profit)
c) The price level to shut down the firm

2. Suppose a firm has a TFC of $2,000, a TVC of $ 5,000 & a TR of

$6,000 at equilibrium. Should the firm stop its operation? Why?

3. Suppose that the firm operates in a perfectly competitive market.

The market price of his product is $10.
The firm estimates its cost of production with the following cost
function: TC = 10q- 4q2 + q3
i. What level of output should the firm produce to maximize its
profit?
ii. Determine the level of profit at equilibrium.
iii. What minimum price is required by the firm to stay in the
market?