1. Types of Market Structure
Pure Competition or Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly

2. Perfect Competition

3. Assumptions of Perfect Competition
Many independent firms
Each seller is small relative to the whole market
Homogeneous (identical) product
Easy entry and exit (no barriers to entry)

4. Price Taking
The perfectly competitive firm is said to be a price-taker, because it takes the market price as given and has no control over the price. Why?...

5. If the firm tried to charge a higher price, it would lose all its business. Customers could go elsewhere to buy the same product for less.
Since the firm is very small, it can sell as much as it wants at the market price. So there’s no reason to charge a lower price.

6. The demand curve for the product of the perfectly competitive firm shows how much can be sold at specific prices. Let’s see what it would look like...
The firm can sell as little or as much as it wants at the market price. Suppose, for example, the market price is $5.

7. The firm can sell 10 units for $5.
price $5
quantity

8. The firm can sell 20 units for $5.
price $5
quantity

9. The firm can sell 30 units for $5.
price $5
quantity

10. The firm can sell 40 units for $5.
price $5
quantity

11. The firm can sell 50 units for $5.
price $5
50 quantity

12. So all these points are on the demand curve for the firm’s product.
price $5
quantity

13. Connecting these points, we have the demand curve for the firm’s product.
price $5
demand
quantity

14. The demand curve for the perfectly competitive firm’s product is a horizontal line at the market price.
price
market price
demand
quantity

15. Total Revenue = Price x Quantity
Recall: Total Revenue
Total Revenue = Price x Quantity
TR = P Q

16. Recall: Marginal Revenue (MR)
Marginal Revenue is the additional revenue earned from selling one additional unit of output.
MR = DTR / DQ

17. comment
For ease of writing, instead of writing the “perfectly competitive” firm we will frequently write the “p.c.” firm.

18. The MR Curve for the p.c. Firm
For the p.c. firm, MR is equal to the market price. So MR is a horizontal line at the level of that price.
The demand curve for the p.c. firm is also a horizontal line at the level of the market price. So, for the p.c. firm, the demand curve and the MR curve are the same horizontal line.

19. The demand curve (D) and the MR curve for the perfectly competitive firm’s product.
price
market price
D = MR
quantity

20. Optimal Output Level Recall:
To maximize profit, the firm will produce at the output level where MR = MC.
So the firm will produce where the MR and MC curves intersect.

21. Draw your axes; label them quantity and $.

22. Draw your ATC, AVC, and MC curves
Draw your ATC, AVC, and MC curves. (Make sure MC intersects ATC and AVC at the minimum.) $
ATC
AVC MC
Quantity

23. Draw the D = MR curve horizontal at the market price.$
D = MR
ATC
AVC MC
Quantity

24. If the market price is P1 , the quantity produced will be Q1.$
D = MR P1
ATC
AVC MC
Quantity Q1

25. If the market price is P2 , the quantity produced will be Q2.$
ATC
D = MR P2
AVC MC
Quantity Q2

26. If the market price is P3 , the quantity produced will be Q3.$
ATC
AVC P3
D = MR MC
Quantity Q3

27. If the market price is P4 , the quantity produced will be Q4.$
ATC
AVC P4
D = MR MC
Quantity Q4

28. If the market price is P5 , the quantity produced will be Q5.$
ATC
AVC
D = MR P5 MC
Quantity Q5

29. Price P5 was the minimum of the AVC curve (the shutdown point)
Price P5 was the minimum of the AVC curve (the shutdown point). If the price fell any lower than P5 the firm would produce no output.

30. The p.c. firm’s short run supply curve
The firm’s supply curve shows the quantity the firm will produce at each price.
The P, Q values we have shown, therefore, are points on the firm’s supply curve.
But those points are all on the firm’s MC curve.
So, the firm’s supply curve is the part of the MC curve that is above the minimum of the AVC curve.

31. The p.c. firm’s short run supply curve$
ATC
AVC MC
Quantity

32. The market short run supply curve
To determine the total amount that all the firms will produce at each price, we simply add up the amounts that each of the firms will produce at that price.

33. Graphing Profit

34. A little trick for graphing a firm’s profit Recall for a rectangle: Area = length . width

35. We also know TR = P . Q. So, if we can find a rectangle whose length is P and whose width is Q, then its area must be total revenue. P TR Q

36. To determine Total Cost, first remember ATC = TC / Q So, ATC . Q = TC

37. To determine Total Cost, first remember ATC = TC / Q So, ATC . Q = TC
Now, if we can find a rectangle whose length is ATC and whose width is Q, then its area is TC. Q

38. Then to determine profit, we just subtract the TC area from the TR area.

39. Graphing Profit: The six steps

40. Step 1 a. Draw your axes and label them Q and $. ( Label the origin 0
Quantity

41. Step 1b. Draw the firm’s ATC curve
Step 1b. Draw the firm’s ATC curve. (If the price is below the minimum of ATC, you will also need to draw the AVC curve.) MC $
ATC P
Quantity

42. Step 1 c. Draw the MC curve and D=MR curve
Step 1 c. Draw the MC curve and D=MR curve. (For a positive profit, D must be at least partly above ATC.) MC $
ATC P
D = MR
Quantity

43. Step 2: Determine the profit-maximizing output (Q
Step 2: Determine the profit-maximizing output (Q*) by finding where MR = MC. MC $
ATC P
D = MR
Quantity Q*

44. Step 3: Find your TR = PQ rectangle.MC $
ATC P
D = MR
Quantity Q*

45. Step 4: Determine ATC at the profit-maximizing output level.MC $
ATC P
D = MR
ATC
Quantity Q*

46. Step 5: Find your TC = ATC . Q rectangle.MC $
ATC P
D = MR
Quantity Q*

47. Step 6: Find profit p = TR - TC.MC $
ATC P
p r o f i t
D = MR
Quantity Q*

48. You follow the same steps to draw a firm that is making a loss or breaking even (zero profits). Let’s do a firm with a loss.

49. MC $ ATC AVC D = MR Quantity
Step 1: Draw & label the curves & axes. For a loss, put D above the minimum of AVC & below the minimum of ATC. MC $
ATC
AVC P
D = MR
Quantity

50. Step 2: Determine the profit-maximizing output (Q
Step 2: Determine the profit-maximizing output (Q*) by finding where MR = MC. MC $
ATC
AVC P
D = MR
Quantity Q*

51. Step 3: Find your TR = PQ rectangle.MC $
ATC
AVC P
D = MR
Quantity Q*

52. Step 4: Determine ATC at the profit-maximizing (or loss-minimizing) output level.MC $
ATC
ATC
AVC P
D = MR
Quantity Q*

53. Step 5: Find your TC = ATC . Q rectangle.MC $
ATC
ATC
AVC P
D = MR
Quantity Q*

54. Step 6: Find profit (or loss) p = TR - TC.MC $
ATC
AVC
l o s s P
D = MR
Quantity Q*

55. A firm that is breaking even (zero profits)

56. Step 1: Draw & label the curves & axes
Step 1: Draw & label the curves & axes. To break even, make D tangent to the minimum of ATC. MC $
ATC
D = MR P
Quantity

57. Step 2: Determine the profit-maximizing output (Q
Step 2: Determine the profit-maximizing output (Q*) by finding where MR = MC. MC $
ATC
D = MR P
Quantity Q*

58. Step 3: Find your TR = PQ rectangle.MC $
ATC
D = MR P
Quantity Q*

59. Step 4: Determine ATC at the profit-maximizing output level.MC $
ATC
D = MR
ATC = P
Quantity Q*

60. Step 5: Find your TC = ATC . Q rectangle.MC $
ATC
D = MR
ATC = P
Quantity Q*

61. Step 6: Find profit p = TR - TC.MC $
ATC
D = MR
ATC = P
Quantity Q*

62. Adapting to Changes in Demand

63. Constant Cost Industry
an industry in which costs of production remain constant as output in the industry expands

64. Let’s start with the industry in long run equilibrium.
What is each firm’s economic profit (+, – , or 0)?
Zero.
That means that the price is at the minimum of the ATC curve and is just sufficient to cover the cost per unit of producing the good.
Next suppose that demand increases.
What happens to the price?
It increases.

65. If firms were just breaking even (zero economic profit) at the old price, what will profit be at the new higher price?
It will be positive.
Does positive economic profit mean that the firms are doing better, worse, or about the same as firms in other industries are doing?
Better.
What is the nature of barriers to entry in perfect competition?
There are no barriers to entry.
So we’ve got positive economic profit and no barriers to entry. What will happen?
Firms will enter the industry.

66. What will happen to the supply of the product as new firms enter the industry?
It will increase.
What happens to the price of the product?
It falls.
So the price goes back to where it was before the demand change, but there is more output being produced by more firms.
Note that if the price didn’t drop enough, there would still be positive economic profits and firms would continue to enter the industry, supply would keep increasing, and the price would drop some more.
If the price dropped too much, it would not cover costs per unit, and there would be losses. Firms would leave the industry, supply would fall and the price would come back up to just covering costs per unit.

67. So what has happened as a result of the increase in demand in this constant cost industry?
We now have the same price we had before, but we now have more output because we have more firms in the industry.
So in a constant cost industry, firms will produce as much or as little as the economy demands at a price which is just enough to cover the cost per unit.

68. That means that the long run supply curve in a constant cost industry is horizontal.
Market P
long run supply curve
P1= P2
Q Q2

69. Increasing Cost Industry
an industry in which costs of production increase as output in the industry expands

70. Let’s start again with the industry in long run equilibrium.
What is each firm’s economic profit (+, – , or 0)?
Zero.
So the price is at the minimum of the ATC curve and is just sufficient to cover the cost per unit of producing the good.
Next suppose that demand increases.
What happens to the price?
It increases.

71. If firms were just breaking even (zero economic profit) at the old price, what will happen to profit at the new higher price?
It will be positive.
Are the firms are doing better, worse, or about the same as firms in other industries are doing?
Better.
What is the nature of the barriers to entry in perfect competition?
There are no barriers to entry.
So we’ve got positive economic profit and no barriers to entry. What will happen?
Firms will enter the industry.

72. What will happen to the supply of the product as new firms enter the industry?
It will increase.
Before when we had a constant cost industry, the costs remained the same as the industry expanded.
However, now we have an increasing cost industry. That means that as the industry expands, it puts upward pressure on the price of the inputs used in the industry and the cost of production increases.
So visualize all the cost curves, including the ATC, creeping up.

73. So the industry supply curve is shifting to the right, and the ATC and other cost curves are creeping up.
As the supply increases, what happens to the price of the product?
It falls.
But the price does not fall back to where it was before the demand change, which was at the minimum of the old ATC curve.
It only drops until we are back to zero economic profits under the new conditions, which is at the bottom of the new, higher, ATC curve.

74. So what has happened as a result of the increase in demand in this increasing cost industry?
Supply expanded in response to the increased profits resulting from the increase in demand.
However, costs increased so that we ended up with a higher price that is just enough to cover the new higher cost per unit.

75. That means that the long run supply curve in an increasing cost industry is upward sloping.
Market P
long run supply curve P2 P1
Q1 Q2 Q

76. Decreasing Cost Industry
an industry in which costs of production fall as output in the industry expands

77. Let’s start again with the industry in long run equilibrium.
What is each firm’s economic profit (+, – , or 0)?
Zero.
So the price is at the minimum of the ATC curve and is just sufficient to cover the cost per unit of producing the good.
Next suppose that demand increases.
What happens to the price?
It increases.

78. If firms were just breaking even at the old price, what will happen to profit at the new higher price?
It will be positive.
Are the firms are doing better, worse, or about the same as firms in other industries are doing?
Better.
What is the nature of the barriers to entry in perfect competition?
There are no barriers to entry.
So we’ve got positive economic profit and no barriers to entry. What will happen?
Firms will enter the industry.

79. What will happen to the supply of the product as new firms enter the industry?
It will increase.
Now we have a decreasing cost industry. That means that as the industry expands and infrastructure improves, the cost of production decreases.
So visualize all the cost curves, including the ATC, sliding down.

80. So the industry supply curve is shifting to the right, and the ATC and other cost curves are sliding down.
As the supply increases, what happens to the price of the product?
It falls.
But the price does not fall back to where it was before the demand change, which was at the minimum of the old ATC curve.
It keeps dropping until we are back to zero economic profits under the new conditions, which is at the bottom of the new, lower, ATC curve.

81. So what has happened as a result of the increase in demand in this decreasing cost industry?
Supply expanded in response to the increased profits resulting from the increase in demand.
However, costs decreased so that we ended up with a lower price that is just enough to cover the new lower cost per unit.

82. That means that the long run supply curve in an decreasing cost industry is downward sloping.
Market P P1
long run supply curve P2
Q Q2 Q

83. Good Things about Perfect Competition
Costs are minimized.
Competition forces efficient operation. Inefficient firms will have losses and be forced out of business.
P = MC
The price (which comes from the demand curve) is the amount that consumers value a good.
MC is the cost of producing an additional unit of a good.
So firms produce up to the point where the amount that consumers value a good is equal to the amount it costs to produce an additional unit of the good.