Unit III- Market Structure Dr. R. Jayaraj, M.A., Ph.D., UPES

Theory of Firm The theory of the firm consists of a number of economic theories which describe the nature of the firm, company, or corporation, including its existence, its behaviour, and its relationship with the market. In simplified terms, the theory of firm aims to answer these questions: 1.Existence - why do firms emerge, why are not all transactions in the economy mediated over the market? 2.Boundaries - why the boundary between firms and the market is located exactly there? Which transactions are performed internally and which are negotiated on the market? 3.Organization - why are firms structured in such specific way? What is the interplay of formal and informal relationships? These questions are not answered by the established economic theory, which usually views firms as given, and treats them as black boxes without any internal structure.

Nature of a Market To determine structure of any particular market, we begin by asking – How many buyers and sellers are there in the market? – Is each seller offering a standardized product, more or less indistinguishable from that offered by other sellers Or are there significant differences between the products of different firms? – Are there any barriers to entry or exit, or can outsiders easily enter and leave this market? Answers to these questions help us to classify a market into one of four basic types – Perfect competition – Monopoly – Monopolistic – Oligopoly

Perfect Competition: The Three Requirements Large numbers of buyers and sellers, and – Each buys or sells only a tiny fraction of the total quantity in the market – Sellers offer a standardized product – Sellers can easily enter into or exit from market

A Large Number of Buyers and Sellers In perfect competition, there must be many buyers and sellers – How many? Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells

A Standardized Product Offered by Sellers Buyers do not perceive significant differences between products of one seller and another – For instance, buyers of wheat do not prefer one farmer’s wheat over another

Easy Entry into and Exit from the Market Entry into a market is rarely free—a new seller must always incur some costs to set up shop, begin production, and establish contacts with customers – But perfectly competitive market has no significant barriers to discourage new entrants Any firm wishing to enter can do business on the same terms as firms that are already there In many markets there are significant barriers to entry – Legal barriers – Existing sellers have an important advantage that new entrants can not duplicate Brand loyalty enjoyed by existing producers would require a new entrant to wrest customers away from existing firms – Significant economies of scale may give existing firms a cost advantage over new entrants

Easy Entry into and Exit from the Market Perfect competition is also characterized by easy exit – A firm suffering a long-run loss must be able to sell off its plant and equipment and leave the industry for good, without obstacles Significant barriers to entry and exit can completely change the environment in which trading takes place

Is Perfect Competition Realistic?  Assumptions market must satisfy to be perfectly competitive are rather restrictive  In vast majority of markets, one or more of assumptions of perfect competition will, in a strict sense, be violated  Yet when economists look at real-world markets, they use perfect competition more often than any other market structure  Why is this?  Model of perfect competition is powerful  Many markets—while not strictly perfectly competitive—come reasonably close  We can even—with some caution—use model to analyze markets that violate all three assumptions

Figure 1: The Competitive Industry and Firm Ounces of Gold per Day Price per Ounce D $400 S Market Demand Curve Facing the Firm $400 Firm 1.The intersection of the market supply and the market demand curve… 3.The typical firm can sell all it wants at the market price… Ounces of Gold per Day Price per Ounce 2.determine the equilibrium market price 4.so it faces a horizontal demand curve

Goals and Constraints of the Competitive Firm Perfectly competitive firm faces a cost constraint like any other firm Cost of producing any given level of output depends on – Firm’s production technology – Prices it must pay for its inputs

The Demand Curve Facing a Perfectly Competitive Firm Panel (b) of Figure 1 shows demand curve facing Firm – Notice special shape of this curve It’s horizontal, or infinitely price elastic Why should this be? – In perfect competition output is standardized – No matter how much a firm decides to produce, it cannot make a noticeable difference in market quantity supplied So cannot affect market price

The Demand Curve Facing a Perfectly Competitive Firm Means firm has no control over the price of its output – Simply accepts market price as given In perfect competition, firm is a price taker – Treats the price of its output as given and beyond its control Since a competitive firm takes the market price as given – Its only decision is how much output to produce and sell

Cost and Revenue Data for a Competitive Firm For a competitive firm, marginal revenue at each quantity is the same as the market price For this reason, marginal revenue curve and demand curve facing firm are the same – A horizontal line at the market price

Figure 2(a): Profit Maximization in Perfect Competition TR 550 $2,800 2,100 TC Slope = 400 Ounces of Gold per Day Dollars Maximum Profit per Day = $700

Figure 2(b): Profit Maximization in Perfect Competition MC $400 D = MR Ounces of Gold per Day Dollars

The Total Revenue and Total Cost Approach Most direct way of viewing firm’s search for the profit- maximizing output level At each output level, subtract total cost from total revenue to get total profit at that output level – Total Profit = TR - TC

The Marginal Revenue and Marginal Cost Approach Firm should continue to increase output as long as marginal revenue > marginal cost Remember that profit-maximizing output is found where MC curve crosses MR curve from below Finding the profit-maximizing output level for a competitive firm requires no new concepts or techniques

Measuring Total Profit  Start with firm’s profit per unit  Revenue it gets on each unit minus cost per unit  Revenue per unit is the price (P) of the firm’s output, and cost per unit is our familiar ATC, so we can write  Profit per unit = P – ATC  Firm earns a profit whenever P > ATC  Its total profit at the best output level equals area of a rectangle with height equal to distance between P and ATC, and width equal to level of output  A firm suffers a loss whenever P < ATC at the best level of output  Its total loss equals area of a rectangle  Height equals distance between P and ATC  Width equals level of output

Figure 3(a): Measuring Profit or Loss $ Profit per Ounce ($100) d = MR MC ATC Economic Profit Ounces of Gold per Day Dollars

Figure 3(a): Measuring Profit or Loss MC ATC d = MR $ Loss per Ounce ($100) Economic Loss Ounces of Gold per Day Dollars

The Firm’s Short-Run Supply Curve  A competitive firm is a price taker  Takes market price as given and then decides how much output it will produce at that price  Profit-maximizing output level is always found by traveling from the price, across to the firm’s MC curve, and then down to the horizontal axis, or  As price of output changes, firm will slide along its MC curve in deciding how much to produce

Figure 4: Short-Run Supply Under Perfect Competition ,000 2,000 4,000 5,000 7, $ MC ATC d 1 =MR 1 AVC (a) Firm's Supply Curve ,0004,000 5,000 7, $ (b) d 2 =MR 2 d 3 =MR 3 d 4 =MR 4 d 5 =MR 5 Bushels per Year Dollars Price per Bushel Bushels per Year

The Shutdown Price Price at which a firm is indifferent between producing and shutting down Can summarize all of this information in a single curve—firm’s supply curve – Tells us how much output the firm will produce at any price Supply curve has two parts – For all prices above minimum point on its AVC curve, supply curve coincides with MC curve – For all prices below minimum point on AVC curve, firm will shut down So its supply curve is a vertical line segment at zero units of output For all prices below $1—the shutdown price—output is zero and the supply curve coincides with vertical axis

Short-Run Equilibrium How does a perfectly competitive market achieve equilibrium? – In perfect competition, market sums buying and selling preferences of all the individual consumers and producers, and determines market price – Each buyer and seller then takes market price as given – Each is able to buy or sell desired quantity Competitive firms can earn an economic profit or suffer an economic loss

Figure 6 Perfect Competition Quantity Demanded at Different Prices Quantity Supplied at Different Prices Quantity Supplied by Each Firm Quantity Demanded by Each Consumer Individual Demand Curve Individual Supply Curve Quantity Demanded by All Consumers at Different Prices Quantity Supplied by All Firms at Different Prices Market Demand Curve Market Supply Curve P S D Q Market Equilibrium Added together

Figure 7: Short-Run Equilibrium in Perfect Competition 400,000700, $3.50 S D1D1 D2D2 MC d1d1 d2d2 ATC 7,0004, $ If the demand curve shifts to D 2 and the market equilibrium moves here... 4.the typical firm operates here and suffers a short-run loss. 2.the typical firm operates here, earning economic profit in the short run. 1.When the demand curve is D 1 and market equilibrium is here... Profit per Bushel at p = $3.50 Price per Bushel Market Bushels per Year Dollars Firm Bushels per Year Loss per Bushel at p = $2

Profit and Loss and the Long Run  In a competitive market, economic profit and loss are the forces driving long-run change  Expectation of continued economic profit (losses) causes outsiders (insiders) to enter (exit) the market  In real world entry and exit occur literally every day  In some cases, we see entry occur through formation of an entirely new firm  Entry can also occur when an existing firm adds a new product to its line  Exit can occur in different ways  Firm may go out of business entirely, selling off its assets and freeing itself once and for all from all costs  Firm switches out of a particular product line, even as it continues to produce other things

From Short-Run Profit to Long-Run Equilibrium As we enter long-run, much will change – Economic profit will attract new entrants Increasing number of firms in market – As number of firms increases, market supply curve will shift rightward causing several things to happen » Market price begins to fall » As market price falls, demand caurve facing each firm shifts downward » Each firm—striving as always to maximize profit—will slide down its marginal cost curve, decreasing output

From Short-Run Profit to Long-Run Equilibrium This process of adjustment—in the market and the firm— continues until…well, until when? – When the reason for entry—positive profit—no longer exits – Requires market supply curve to shift rightward enough, and the price to fall enough So that each existing firm is earning zero economic profit In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero

Figure 8(a/b): From Short-Run Profit To Long- Run Equilibrium S1S1 d1d1 ATC MC $4.50 With initial supply curve S 1, market price is $4.50… $ ,0009,000 So each firm earns an economic profit. A A Price per Bushel Market Bushels per Year Dollars Firm Bushels per Year D

Figure 8(c/d): From Short-Run Profit To Long-Run Equilibrium S1S1 d1d1 ATC MC $4.50 Profit attracts entry, shifting the supply curve rightward… $ ,0009,0005,000 until market price falls to $2.50 and each firm earns zero economic profit. S2S2 d1d1 A A 2.50 E E MarketFirm Price per Bushel Bushels per Year Dollars Bushels per Year D 1,200,000

From Short-Run Loss to Long-Run Equilibrium What if we begin from a position of loss? – Same type of adjustments will occur, only in the opposite direction In a competitive market, economic losses continue to cause exit until losses are reduced to zero When there are no significant barriers to exit – Economic loss will eventually drive firms from the industry Raising market price until typical firm breaks even again

Distinguishing Short-Run from Long- Run Outcomes In short-run equilibrium, competitive firms can earn profits or suffer losses – In long-run equilibrium, after entry or exit has occurred, economic profit is always zero When economists look at a market, they automatically think of short-run versus long-run – Choose the period more appropriate for the question at hand Basic Principle #7: Short-Run versus Long-Run Outcomes – Markets behave differently in the short-run and the long run – In solving a problem, we must always know which of these time horizons we are analyzing

The Notion of Zero Profit in Perfect Competition We have not yet discussed plant size of competitive firm The same forces—entry and exit—that cause all firms to earn zero economic profit also ensure – In long-run equilibrium, every competitive firm will select its plant size and output level so that it operates at minimum point of its LRATC curve

Perfect Competition and Plant Size  Figure 9(a) illustrates a firm in a perfectly competitive market  But panel (a) does not show a true long-run equilibrium  How do we know this?  In long-run typical firm will want to expand  Why?  Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit  By expanding firm could potentially earn an economic profit  Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset  Entry and expansion must continue in this market until the price falls to P*  Because only then will each firm—doing the best that it can do—earn zero economic profit

Figure 9: Perfect Competition and Plant Size P1P1 q1q1 d 1 = MR 1 LRATC MC 1 ATC 1 E d 2 = MR 2 LRATC MC 2 ATC 2 P* q* 4.and all firms earn zero economic profit and produce at minimum LRATC.. Dollars Output per Period 3.As all firms increase plant size and output, market price falls to its lowest possible level... 1.With its current plant and ATC curve, this firm earns zero economic profit. 2.The firm could earn positive profit with a larger plant, producing here.

A Summary of the Competitive Firm in the Long-Run Can put it all together with a very simple statement – At each competitive firm in long-run equilibrium P = MC = minimum ATC = minimum LRATC In figure 9(b), this equality is satisfied when the typical firm produces at point E – Where its demand, marginal cost, ATC, and LRATC curves all intersect In perfect competition, consumers are getting the best deal they could possibly get