Market Structures; Pricing and
Output Decisions
Mr Augustine Owusu Mensah
Introduction
• We often think of the word market as a place where goods are being
bought and sold
• In economics, market is an arrangement where buying and selling of
goods and services takes place
• If a firm is a profit maximiser the price charged must be consistent
with the market structure and the environment within which the firm
operates.
• The price at which a firm sells, is determined by the market structure
in which the firm operates.
Introduction
• The term market structure refers to the environment within which
buyers and sellers interact.
• Markets can be categorised in terms of certain basic characteristics
that can be useful as benchmarks for a more detailed analysis of
optimal pricing behaviour
Characteristics that determines market
structures
• Number and size distribution of sellers
• Number and size distribution of buyers
• Product differentiation and
• The conditions of entry into and exit from the industry.
Types of market structures
1. Perfect Competition
2. Monopoly
3. Oligopoly
4. Monopolistic Competition
Firms in Perfectly Competitive Markets
• Perfectly competitive market: A market that meets the conditions of
(1) many buyers and sellers, (2) all firms selling identical products so
that each buyer and seller is a price taker, & (3) no barriers to new
firms entering the market (firms can freely enter or exit the market).
Examples: plantain, corn, pure water producers
• Price taker: A buyer or seller is unable to affect the market price.
Buyer/ seller must accept the price determined by the market.
Demand curve of a Perfect Competitive Firm
• A perfectly competitive firm faces a horizontal demand curve. In a
perfectly competitive market, price is determined by the intersection
of market demand and market supply
• At this market determined price, you can sell as many products as you
want, but you cannot sell any if you raise the price above this current
market price (no one will be willing to buy any). Also, there’s no
reason to charge a price below the current market price, because you
can sell any number of shares at the current price.
Figure 1: Demand curve of a Perfect Competitive
Firm
Price S Price
Pe Pc Dd=AR=MR
D
Quantity Quantity
Revenue of a Perfect Competitive Firm
• Total Revenue (TR) for a firm is the market price times the quantity sold.
• TR = (P ´ Q)
• Note: Perfect competitive firms can only change their level of TR by
varying their level of output because they have no ability to change the
price.
• Average revenue (AR): is how much revenue a firm receives for the typical
unit sold.
• Average revenue = Total Revenue divided by the Quantity sold. (AR=TR/Q)
• Marginal Revenue (MR): The change in total revenue from selling one
more unit of a product.
Revenue of a Perfect Competitive Firm
MR = change in total revenue ÷ change in quantity
(MR=△TR/ △Q)
• To understand how a firm maximizes profit in a perfectly competitive
market, consider a rice farmer who produces at most 10 bushels of rice per
year. Table 1 shows the revenue this farmer will earn from selling various
quantities of rice if the market price for rice is GHc4.
• Column 3 shows that the farmer’s TR rises by GHc4 for every additional
bushel he sells because he can sell as many bushels he wants at the price of
GHc4/bushel.
• Columns 4 & 5 show AR & MR from selling rice.
Table 1. Total, Average, and Marginal Revenue for
a Competitive Firm
Quantity (Q) Market Price (P) Total Revenue Average Revenue Marginal
(TR) (AR) Revenue (MR)
0 GHc4 GHc0 --- ---
1 4 4 GHc4 GHc4
2 4 8 4 4
3 4 12 4 4
4 4 16 4 4
5 4 20 4 4
6 4 24 4 4
7 4 28 4 4
8 4 32 4 4
9 4 36 4 4
10 4 40 4 4
Total, Average, and Marginal Revenue for a
Competitive Firm
• For example, if he sells 6 bushels for a total of GHc24, his AR is GHc24/6 =
GHc4. Notice that AR is also equal to the market price of GHc4.
• For any level of output, a firm’s AR is always equal to the market price.
Proof: TR = P x Q, & AR = TR/Q. So, AR = TR/Q = (P x Q)/Q = P.
• For each additional bushel sold, the farmer always adds GHc4 to his TR, so
his MR is GHc4.
• The farmer’s AR & MR are both equal to the market price. MR = ΔTR/ΔQ =
Δ(P x Q)/ΔQ = P.
• Note: AR is always equal to price. But MR is equal to price only for firms
that operate in perfectly competitive markets.
The Marginal Cost-Curve and the Firm’s Supply Decision
• Marginal Cost (MC) = ΔTC / ΔQ
• TC is total cost
• Q is quantity of output
• Profit maximization occurs at the quantity where marginal
revenue equals marginal cost.
– When MR > MC, increasing Q will raise profit
– When MR < MC, decreasing Q will increase profit
– When MR = MC, profit is maximized.
The Firm’s Short-Run Decision to Shut Down Vrs
Long-Run Exit
• A shutdown refers to a short-run decision not to produce anything
during a specific period of time because of current market conditions.
• Exit refers to a long-run decision to leave the market.
• The important difference is that, when a firm shuts down
temporarily, it still must pay fixed cost. If a firm exits the market in
the long run, it has no costs.
• If a firm shuts down, it will earn no revenue & will have only FC (no
VC).
The Competitive Firm’s Short-Run Supply Curve
• Therefore, a firm will shut down if the revenue that it would get from
producing is less than its variable costs of production.
• Shut down if TR < TVC. TR =P x Q & TVC = AVC x Q;
• therefore P x Q < AVC x Q
• Shut down can therefore be rewritten as: P < AVC. At this point, the
firm will produce no output.
• If P ≥ AVC, the firm will produce output level where MR = MC.
• Therefore, the competitive firm’s short run supply curve is the portion
of its marginal cost curve (MC) that lies above average variable cost
(AVC).
Figure 2: The Competitive Firm’s Short-Run
Supply Curve
Costs
MC
ATC
AVC
Firm
shuts
down if
P < AVC
0 Quantity
The Firm’s Long-Run Decision to Exit or Enter
a Market
• In the long run, firm exits if revenue it would get from producing is less
than its total cost.
– Exit if TR < TC; because TR = P x Q & TC = ATC x Q, therefore
– Exit if P x Q < ATC x Q
• we can rewrite this condition as: Exit if P < ATC
• A firm will enter the industry if such an action would be profitable; ie. If
revenues exceed costs:
• Enter if TR > TC
• Enter if TR/Q > TC/Q
• Enter if P > ATC
• If P = ATC, firm will not enter or exit because economic profits are
zero.
Figure 3 Profit for a Perfect Competitive Firm
Profit is the Area between Price and Average Total Cost
(a) A Firm with Profits
Price
MC ATC
Profit
ATC P = AR = MR
0 Q Quantity
(profit-maximizing quantity)
Figure 4 Loss for a Perfect Competitive Firm
Loss is the Area between Price and Average Total Cost
(b) A Firm with Losses
Price
MC ATC
ATC
P P = AR = MR
Loss
0 Q Quantity
(loss-minimizing quantity)
The Supply Curve in a Competitive Market
• Market supply equals the sum of the
quantities supplied by the individual firms in
the market.
• The market supply curve reflects the
individual firms’ marginal cost curves.
Figure 5 Short-Run Market Supply
(a) Individual Firm Supply (b) Market Supply
Price Price
MC Supply
Ghc2 Ghc2
1 1
0 100 200 Quantity (firm) 0 100,000 200,000 Quantity (market)
If the industry has 1000 identical firms, then at each market price, industry output will
be 1000 times the quantity supplied by each firm.
The Long Run: Market Supply with
Entry and Exit
• At the end of the process of entry and exit,
firms that remain must be making zero
economic profit.
• Entry and exit ends only when price and
average total cost are driven to equality.
• Long-run equilibrium must have firms
operating at their efficient scale.
Figure 6: The Long Run: Market Supply with
Entry and Exit
MC
ATC
P=ATC Supply
Efficient scale
A Shift in Demand in the Short Run and
Long Run
• An increase in demand raises price and
quantity in the short run.
• Firms earn profits because price now exceeds
average total cost (ATC).
• The profit will attract new firms into the
industry, hence shift the supply curve to the
right.
• This will lower price until it falls back to the
minimum of ATC & firms once again earn zero
economic profit.
