Managerial Economics

Ch-4: 1- Competitive market structure

By: Dr. Solomon Getachew

Email: [email protected]
 Market
 A market consists of all firms and individuals willing and
able to buy or sell a particular product.

 This includes firms and individuals currently engaged in

buying and selling a particular product, as well as
potential entrants.
 Market structure
Market structure is the market characteristics that
determine the economic environment in which a firm
operates.

The structure of a market governs the degree of pricing

power possessed by a manager, both in the short run and
in the long run.
 Classification of Markets
Market structure is typically characterized on the basis of
four important industry characteristics:

1. The number and size of active buyers and sellers and

potential entrants,

2. The degree of product differentiation among competing

producers,

3. Conditions of entry and exit.

4. The amount and cost of information about product

price and quality.
Types of Market Structure
 Perfect Competition:
Perfectly competitive market is a market in which there is perfect
Competition in practical scenario, this type of market structure
cannot exist.

Many buyers and sellers of similar or homogeneous

(undifferentiated products). Tough competition b/n similar products

 A single firm is so small compared to the market and it cannot

affect the market prices (MP). Prices are set not on the basis of your
cost benefit objectives.

 MP is determined by the market forces namely demand and supply

of the products or buyers and sellers interaction. Market controlled
price environment.
Features and Conditions of perfect competition
1. Large number of buyers and sellers

2. Each firm produce homogeneous product, the output

decision depends upon the demand for their products.

3. Buyers and sellers have perfect knowledge about

market conditions: (quality and price…)

4. Free entry and Free exit, existing firms cannot derive

any monopoly power. No government regulation.

5. No transaction cost (cost of traveling to store)

6. Firms are price takers, as every firm tries to offer lower
prices to their customer to increase their market share.

7. Only normal profits made, so producers just cover their

opportunity cost.

8. There is no need to spend money on advertising,

because there is perfect knowledge and firms can sell all
they can produce.

9. Products have close substitutes. Example??

 Perfect Competition: Demand Curve
Firms are price takers, the firm must take the price as given, and
then decide the quantity to be supplied.
The individual firm’s demand curve is market price ??
 The individual firm’s demand curve is perfectly elastic ??
Buyers and sellers have perfect information.

The demand curve the market would The demand curve for a competitive firm
remain as downward sloping. would be just a horizontal line i.e P=MR=D
Perfect Competition: Maximum Profit
 Perfect Competition: Maximum Profit
The profit maximizing level of output (Q*) is the
level at which the vertical distance b/n the
revenue line and the cost curve is greatest.
The slope of the cost curve is at the profit-
maximizing level of output (E) exactly equals the
slope of the revenue line.
Slope of cost curve is MC and slope of revenue
line is MR.
Thus, the profit-maximizing output is the output
at which MR=MC.
Since MR is equal to market price for a perfectly
competitive firm, the manager must equate the
market price with MC to maximize profits.
Perfect Competition: Maximum Profit
Perfect Competition: Maximum Profit
 How to maximize profit in the case of perfectly
competitive market.
Market price = 8
Total cost = 40+0.5Q+0.05Q2
P=MC so now we can find marginal cost from total cost equation
MC= d Tc
d q = 0.5+0.1q
p = MC = 8=0.5+0.1q
0.1q= 7.5
q= 75
So to maximize profit this firm will produce 75 units.
• TR= P*Q ( 8*75) = 600
• TC= 40+0.5(75)+0.05(75)2 = 358.75
• Profit of the firm = TR-TC= 241.25
 Maximize profit function
Marginal profit is the extra profit you get from selling one more unit.

When marginal profit is zero, we will lose profit by increasing or

decreasing output (must check second order condition).

dp(q)/dq= 0
Increase the level of an activity if its marginal benefit exceeds its
marginal cost, but reduce the level if the MC exceeds the MB.
π, Profit

If possible, pick the level π* dπ/dq=0

at which the marginal dπ/dq>0 dπ/dq<0

benefit equals the Profit, π*q

marginal cost. 0 q* Quality, q, Units per day

 Computing the Total Revenue of a Price-
taker that is constant price
Output: Output: Total
Total
Rakes per Rakes per Revenue
Revenue Short-run Price
Minute Price ($)
Minute ($)
($) Total Cost Profit ($)
Q P
Q TR
TR STC P
0 25
0 0.00
0.00 36 -36 25
1 25
1 25.00
25.00 44 -19 25
2 25
2 50.00
50.00 48 2 25
3 25
3 75.00
75.00 51 24 25
4 25
4 100.00
100.00 56 44 25
5 25
5 125.00
125.00 63 62 25
6 25
6 150.00
150.00 72 78 25
7 25
7 175.00
175.00 84 91 25To maximize profit, a producer
8 25
8 200.00
200.00 101 99 25finds the largest gap between
9 25
9 225.00
225.00 126 99 25total revenue and total cost.
10 10
25 250.00
250.00 166 84 25

Perfectly competitive firm accept constant price, the shape of its

total revenue is an upward-sloping line that changes only with
changes in the quantity sold.
Perfect Competition: Maximum Profit
 Perfect Competition: Maximum Profit
2. What would be the market share of output for each firm?
3. What would be the marginal cost for each firm?
Solution:
Qd = Qs, 35,000 - 20P = 5000 + 10P, 30P = 30,000, P = 1000.
Substituting the market price ($1000) in either the demand or supply equation
would yield the equilibrium quantity of the industry:
Qd = 35,000 - 20(1000) = 15,000,
Qs = 5000 + 10(1000) = 15,000.
Since the industry contains 5000 competitive firms, each firm would produce
15,000/5000= 3 units. Since the profit-maximizing condition is achieved when
P = MR = MC, the marginal cost should be the same as the price. That is $1000.
 Perfect Competition: Maximum Profit
Example
Consider a competitive firm with a fixed cost of $800 and a variable cost
function of VC = 75Q - 12Q2 + 2Q3.
1. When would this firm prefer to shut down?
2. Draw a graph to show the price and quantity of the shut-down decision.
Solution:
The firm would shut down when the price of its product falls to a point where
the price is equal to its average variable cost (i.e., P = AVC). So, we have to find
the average variable cost:
AVC =VC/Q= (75Q - 12Q2 + 2Q3)/Q ,
AVC = 75 - 12Q + 2Q2
 Perfect Competition: Maximum Profit
Taking the first derivative of the AVC, setting it to zero, and solving
for Q would give us the output level at which the firm would shut
down: ∂AVC/∂Q= -12 + 4Q = 0, 4Q = 12, Q = 3.
To find the price, we know that a competitive firm has a price equal
to its marginal revenue which is equal to marginal cost. Marginal cost
is the first derivative of the total cost, which is TC = FC + VC,
TC = 800 + 75Q - 12Q2 + 2Q3, MC = ∂TC/∂Q = 75 - 24Q + 6Q2.
This is the marginal cost that would be equal to the price
P = MC = 75 - 24Q + 6Q2 = 75 - 4(3) + 6(3)2 = 57.
So, the firm would prefer to shut down once the price falls to $57 or
below.
 Perfect Competition: Shut-Down Decision

If P > SAVC, the firm

should continue to
operate
If P < SAVC, the firm
should shut down
 Short run equilibrium price and output determination

1. The short run is a period in which the number and plant size of
the firms are fixed. In this period, the firm can produce more
only by increasing the variable inputs.

2. As the entry of new firms or exits of the existing firms are not
possible in the short-run, the firm in the perfectly competitive
market can either earn super-normal profit or normal profit or
incur loss in the short period.

3. Since a firm in the perfectly competitive market is a price-taker,

it has to adjust its level of output to maximize its profit.
 SR Increase in Demand and the Incentive to Enter

• An increase in market demand puts upward pressure on price.

As price increases, there is an opportunity to earn profit in the
short run, and the industry attracts new firms.
 Long run equilibrium, price and output determination

1. In the long run, all factors become variable and new firms can
enter the industry and the existing firms can leave the industry.
As a result, all the existing firms will earn only normal profit in
the long run. They earn zero economic profit in the long run.
2. Hence, the firms can increase their output by increasing the
number and plant size of the firms.
3. If the existing firms earn supernormal profit, the new firms will
enter the industry to compete with the existing firms. As a
result, the output produced will increase.
4. As total output increases, the demand for factors of
production will increase leading to increase in prices of the
factors. This will result in increase in average cost.
5. On the other side, when the output produced increases,
the supply of the product increases. The demand remaining
the same, when the supply of the product increases, the
price of the product comes down.
6. Thus, all the perfectly competitive firms will earn normal
profit in the long run.
 Long-run Supply Curve for an Constant-cost Industry
•In a constant-cost industry, firms continue to buy inputs at the same
prices.
•The long-run supply curve is horizontal at the constant average cost
of production.
•After the industry expands, the industry settles at the same long-run
equilibrium price as before.

An increase in the demand

for ice increases the price
of ice to $5 per bag.

In the long-run, the price of

ice returns to its original
level.
Long-run Supply Curve for the Ice
Industry

 An increase in
the demand for
ice increases the
price of ice to $5
per bag.
 In the long-run,
the price of ice
returns to its
original level.
Long run equilibrium, price and output determination