Market Structure

Market structure depends on 2 main factors:

Quantity Product
Price of the Product in the Market
How markets are organized :
1. Types of product produced
2. How many firms in the industry
3. The freedom of entering and leaving the market
4. The market price of the product (Profit levels)
5. The knowledge of sellers and buyers towards the product
6. The degree of monopoly power each firm has
7. The degree to which the firm can influence price
8. Firms’ behaviour – pricing strategies, non-price competition,
output levels
9. The extent of barriers to entry
10. The impact on efficiency
 Market Structure
Perfect Pure
Competition Monopoly

More competitive (fewer imperfections)

Less competitive (greater degree of imperfection)

 Market Structure
Pure
Perfect
Monopoly
Competition

Monopolistic Competition Oligopoly Duopoly Monopoly

The further right on the scale, the greater the degree

of monopoly power exercised by the firm.
Market Structure
Importance:
Degree of competition affects the consumer –
will it benefit the consumer or not?
Impacts on the performance and behaviour of
the company/companies involved
Market Structure
Models – a word of warning!
Market structure deals with a number of economic ‘models’
These models are a representation of reality to help us to understand
what may be happening in real life
There are extremes to the model that are unlikely
to occur in reality
They still have value as they enable us to draw comparisons and
contrasts with what is observed
in reality
Models help therefore in analysing and evaluating – they offer a
benchmark
Market Structure
Characteristics of each model:
Number and size of firms that make up
the industry
Control over price or output
Freedom of entry and exit from the industry
Nature of the product – degree of homogeneity (similarity)
of the products in the industry (extent to which products
can be regarded as substitutes for each other)
Diagrammatic representation – the shape
of the demand curve, etc.
Market Structure
Characteristics: Look at these everyday products – what type of
market structure are the producers of these products operating
in?

Remember to think about the

nature of the product, entry and
Electric exit, behaviour of the firms,
number and size of the firms in
Guitar Vodk
the industry.
– Jazz a
Body You might even have to ask what
the industry is??
Bananas

Canon SLR Camera

4 Types of Market
Competitive / Perfect competition Market
Many buyers and sellers in the market

Monopoly Market
Only one sellers in the market

Monopolistic Competition Market

Many sellers and buyers in the market but the
competition is as high as in the competitive market.

Oligopoly Market
Only few sellers in the market
Market Structure
Number of firms ?

One firms Few firms Many firms

MONOPOLY OLIGOPOLY
• water • oil / petrol
• electricity • flight Differentiated Identical
• phone (house) • tyres products products

MONOPOLISTIC COMPETITIVE
COMPETITION MARKET
• movies • instant noodle
• novels • pen
• magazines • canned drink
A Perfectly Competitive Market
A perfectly competitive market is one in which economic forces
operate unimpeded.
A perfectly competitive market must meet the following
requirements:
 Both buyers and sellers are price takers.
 The number of firms is large.
 There are no barriers to entry.
 The firms’ products are identical.
 There is complete information.

Perfect competition is a firm behavior that occurs when many firms produce
identical products and entry is easy. Characteristics of perfect competition:
There are many sellers.
The products sold by the firms in the industry are identical.
Entry into and exit from the market are easy, and there are many potential
entrants.
Buyers (consumers) and sellers (firms) have perfect information.
A Perfectly Competitive Market
For a market to be perfectly competitive, six conditions must be
met:
1. Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by
market supply and demand as given
2. The number of firms is large – any one firm’s output compared to the market output is imperceptible and what
one firm does has no influence on other firms
3. There are no barriers to entry or exit – barriers to entry are social, political, or economic impediments that prevent
firms from entering a market
4. Firms’ products are homogeneous ( identical) – this requirement means that each firm’s output is
indistinguishable from any other firm’s output
5. Both Consumers and producers have perfect knowledge --There is complete information to all consumers
know all about the market such as prices, products, and available technology
6. Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit
7. Perfectly elastic demand curve at the price set by the market
8. Each producer supplies a very small proportion of total industry output

14-12
 Perfect Competition Given the assumption of profit maximisation, the
firm produces at an output where MC = MR (Q1).
This output level is a fraction of the total industry
supply.
The average cost curve is the
Diagrammatic representation standard ‘U’ – shaped curve.
The MCtheis AC
the curve
cost ofat its
MC cuts
producing additional
lowest point because of the
Cost/Revenue
MC (marginal) units
mathematical
falls at first
between
of output. It
relationship
(due and
marginal to the law of
average
diminishing
values. returns) then rises
as output rises.
AC
The industry price is
determined by the
demand and supply of
the industry as a whole.
The firm is a very small
P = MR = AR supplier within the
At thisindustry
output and has no
the
control over price. They
firm will sell each extra unit for
is making
the same price. Price
therefore = MR and AR
normal profit.
This is a long
run equilibrium
Q1 Output/Sales
position.
 Average and Marginal costs
could be expected to be
lower but price, in the short
run, remains the same.
The lower AC and MC would

Perfect Competition
imply that the firm is now
earning abnormal profit
(AR>AC) represented by the
grey area.
Diagrammatic representation
Because the model assumes
Now assume
perfect a firm the
knowledge, makes
firm
Cost/Revenue
MC some formadvantage
gains the
its product
of modification
or gains
to a
for only
somecopy
MC1 short
form
time before others
the idea or are attracted(say
of cost advantage a
to the
new production
industry method). of
by the existence
AC What would happen?
abnormal profit. If new firms
enter the industry, supply will
increase, price will fall and the
AC1 firm will be left making normal
profit once again.

P = MR = AR
Abnormal profit
AC1
P1 = MR1 = AR1

Q1 Q2 Output/Sales
The Definition of Supply and Perfect
Competition
• These strong six conditions are seldom met
simultaneously, but are necessary for a perfectly
competitive market to exist
• Supply is a schedule of quantities of goods that will be
offered to the market at various prices
When a firm operates in a perfectly
competitive market, its supply curve is its
short-run marginal cost curve above average
variable cost

14-15
The Necessary Conditions for Perfect Competition
Both buyers and sellers are price takers.
A price taker is a firm or individual who takes the market price as
given.
In most markets, households are price takers – they accept the price
offered in stores.
A firm in a perfectly competitive market is said to be a price taker
because the price of the product is determined by market supply
and demand, and the individual firm can do nothing to change that
price.
Both buyers and sellers are price takers.
The retailer is not perfectly competitive.
A retail store is not a price taker but a price maker.
The number of firms is large.
Large means that what one firm does has no bearing on what other
firms do.
Any one firm's output is minuscule when compared with the total
Monopolistic or Imperfect Competition
Where the conditions of perfect competition do not
hold, ‘imperfect competition’ will exist
Varying degrees of imperfection give rise to varying
market structures
Monopolistic competition is one of these – not to be
confused with monopoly!
Characteristics:
Large number of firms in the industry
May have some element of control over price due to the fact
that they are able to differentiate their product in some way
from their rivals – products are therefore close, but not
perfect, substitutes
Entry and exit from the industry is relatively easy – few
barriers to entry and exit
Consumer and producer knowledge imperfect
Monopolistic or Imperfect Competition
 This is a short run equilibrium
position for a firm in a
monopolistic market structure.
 The demand curve facing the firm
will be downward sloping and
Implications for the diagram: represents the AR earned from
MC sales.
Cost/Revenue  Since the additional revenue
received from each unit sold falls,
the MR curve lies under the AR
AC curve.
£1.00  Marginal Cost and Average Cost
will be the same shape. However,
because the products are
Abnormal Profit differentiated in some way, the
firm will only be able to sell extra
£0.60 output by lowering price.
 We assume that the firm
produces where MR = MC (profit
maximising output). At this output
level, AR>AC and the firm makes
abnormal profit (the grey shaded
area).
MR D (AR) Ifeach the firm produces Q1 and sells
unit for £1.00 on average
Q1 with the cost (on average) for each
Output / Sales unit being 60p, the firm will make
40p x Q1 in abnormal profit.
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC Because there is relative
Cost/Revenue
freedom of entry and exit
into the market, new
firms will enter
AC encouraged by the
existence of abnormal
profits. New entrants will
increase supply causing
price to fall. As price falls,
the AR and MR curves
shift inwards as revenue
from each sale is now
less.

AR1 D (AR)
MR1 MR
Q1 Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC Notice that the existence
Cost/Revenue
of more substitutes makes
the new AR (D) curve
more price elastic. The
AC firm reduces output to a
point where MC = MR
(Q2). At this output AR =
AC and the firm will make
AR = AC
normal profit.

AR1 D (AR)
MR1 MR
Q2 Q1 Output / Sales
 Monopolistic or Imperfect
Competition
Implications for the diagram:
MC This is the long run
Cost/Revenue
equilibrium position
of a firm in monopolistic
competition.
AC

AR = AC

AR1
MR1
Q2 Output / Sales
Monopolistic or Imperfect Competition
Some important points about monopolistic competition:
May reflect a wide range of markets
Not just one point on a scale – reflects many degrees
of ‘imperfection’
Examples :
Restaurants
Plumbers/electricians/local builders
Solicitors
Private schools
Plant hire firms
Insurance brokers
Health clubs
Hairdressers
Funeral directors
Estate agents
Damp proofing control firms
In each case there are many firms in the industry
Each can try to differentiate its product in some way
Entry and exit to the industry is relatively free
Consumers and producers do not have perfect knowledge of the
market – the market may indeed be relatively localised. Can you
imagine trying to search out the details, prices, reliability,
quality of service, etc for every plumber in the UK in the event
of an emergency??
Oligopoly
Competition between the few
May be a large number of firms in the industry but the industry is
dominated by a small number of very large producers
Concentration Ratio – the proportion of total market sales
(share) held by the top 3,4,5, etc firms:
A 4 firm concentration ratio of 75% means the top 4 firms account
for 75% of all the sales in the industry
Features of an oligopolistic market structure:
Price may be relatively stable across the industry – kinked demand curve?
Potential for collusion
Behaviour of firms affected by what they believe their rivals might do – interdependence of firms
Goods could be homogenous or highly differentiated
Branding and brand loyalty may be a potent source of competitive advantage
Non-price competition may be prevalent
Game theory can be used to explain some behaviour
AC curve may be saucer shaped – minimum efficient scale could occur over large range of output
High barriers to entry
Oligopoly
Example:
Music sales – The music industry has
a 5-firm concentration
ratio of 75%.
Independents make up
25% of the market but
there could be many
thousands of firms that
make up this
‘independents’ group.
An oligopolistic market
structure therefore
may have many firms
in the industry but it is
dominated by a few
large sellers.
Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html
 The firm therefore, effectively faces a ‘kinked demand curve’ forcing it to

Oligopoly
maintain a stable or rigid pricing structure. Oligopolistic firms may
overcome this by engaging in non-price competition.
If the firm seeks to lower its price to gain a competitive
advantage, its rivals will follow suit. Any gains it makes
The kinked demand curve - an explanation for price stability?
will quickly be lost and the % change in demand will be
smaller than the % reduction in price – total revenue
would again fall as the firm now faces a relatively
Price inelastic demand curve.
The principle of the kinked demand curve rests on the principle that:
a. If a firm raises its price, its rivals will not follow suit
b. If a firm lowers its price, its rivals will all do the same
Assume the firm is charging a price of £5 and
producing an output of 100.
If it chose to raise price above £5, its rivals
would not follow suit and the firm effectively
£5 faces an elastic demand curve for its product
(consumers would buy from the cheaper rivals).
The % change in demand would be greater
Total than the % change in price and TR would fall.

Revenue B
Total Revenue A
D = elastic
Total Revenue B Kinked D Curve
D = Inelastic

100 Quantity
Duopoly
Market structure where the industry is dominated by two
large producers
Collusion may be a possible feature
Price leadership by the larger of the two firms may exist – the smaller firm
follows the price lead
of the larger one
Highly interdependent
High barriers to entry
Cournot Model – French economist – analysed duopoly – suggested long run
equilibrium would see equal market share and normal profit made
In reality, local duopolies may exist
Monopoly
Pure monopoly – where only one producer exists in the
industry
In reality, rarely exists – always some form of substitute
available!
Monopoly exists, therefore, where one firm dominates the
market
Firms may be investigated for examples of monopoly
power when market share exceeds 25%
Origins of monopoly:
Through growth of the firm
Through amalgamation, merger or takeover
Through acquiring patent or license
Through legal means – Royal charter, nationalisation,
wholly owned plc
Monopoly

Monopoly power – refers to cases where firms influence

the market in some way through their behaviour –
determined by the degree
of concentration in the industry
Influencing prices
Influencing output
Erecting barriers to entry
Pricing strategies to prevent or stifle competition
May not pursue profit maximisation – encourages unwanted
entrants to the market
Sometimes seen as a case of market failure
Monopoly
Summary of characteristics of firms exercising monopoly
power:
Price – could be deemed too high, may be set to destroy
competition (destroyer or predatory pricing), price
discrimination possible.
Efficiency – could be inefficient due to lack of competition (X-
inefficiency) or…
could be higher due to availability of high profits
Innovation - could be high because
of the promise of high profits, Possibly encourages high
investment in research and development (R&D)
Collusion – possible to maintain monopoly power of key
firms in industry
High levels of branding, advertising and non-price
competition
Monopoly
Problems with models – a reminder:
Often difficult to distinguish between a monopoly
and an oligopoly – both may exhibit behaviour
that reflects monopoly power
Monopolies and oligopolies do not necessarily aim
for traditional assumption of profit maximisation
Degree of contestability of the market may influence behaviour
Monopolies not always ‘bad’ – may be desirable
in some cases but may need strong regulation
Monopolies do not have to be big – could exist locally
 Monopoly This is both the short
run and long run
equilibrium position for
a monopoly
Costs / Revenue Given the barriers to
entry, the monopolist
MC will be able to exploit
abnormal profits in the
£7.00 long run as entry to the
market is restricted.
AC AR (D) curve for a
Monopoly monopolist likely to be
relatively price inelastic.
Profit Output assumed to be
at profit maximising
output (note caution
£3.00 here – not all
monopolists may aim
for profit maximisation!)

MR AR
Output / Sales
Q1
 Monopoly
Welfare implications of monopolies The higher price and lower output
means that consumer surplus is
reduced, indicated by the grey
shaded area.
Costs / Revenue
The monopoly price would be £7 per
unit with output levels lower at Q2.
MC On the face of it, consumers face
higher prices and less choice in
£7 monopoly conditions compared to
AC more competitive environments.
Loss of consumer The price in a competitive market
surplus would be £3 with output levels at Q1.
look back at the diagram for perfect
£3 competition will reveal that in
equilibrium, price will be equal to the
MC of production.
We can look therefore at a
comparison of the differences
between price and output in a
competitive situation compared to a
monopoly.

AR
MR
Output / Sales
Q2 Q1
 Monopoly
Welfare
Costs / Revenue implications of
monopolies
MC
The monopolist will benefit
be
£7 affected
from additional
by a loss
producer
of producer
AC surplus equal
showntobythe
thegrey
grey
triangle but……..
shaded rectangle.
Gain in producer
surplus
£3

AR
MR
Output / Sales
Q2 Q1
 Monopoly
Welfare
Costs / Revenue implications of
monopolies
MC The value of the grey shaded
£7 triangle represents the total
AC welfare loss to society –
sometimes referred to as
the ‘deadweight welfare loss’.

£3

AR
MR
Output / Sales
Q2 Q1
 Contestable Markets
• Theory developed by William J. Baumol, John Panzar and Robert Willig
(1982)
• Helped to fill important gaps in market structure theory
• Perfectly contestable market – the pure form – not common in reality
but a benchmark to explain firms’ behaviours
• Key characteristics:
– Firms’ behaviour influenced by the threat of new entrants to the
industry
– No barriers to entry or exit
– No sunk costs
– Firms may deliberately limit profits made to discourage new
entrants – entry limit pricing
– Firms may attempt to erect artificial barriers to entry
• Hit and Run’ tactics – enter the industry, take the profit and get
out quickly (possible because of the freedom of entry and exit)
• Cream-skimming – identifying parts of the market that are high
in value added and exploiting those markets
 Contestable Markets
• Over capacity – provides the opportunity to flood the market
and drive down price in the event of a threat of entry
• Aggressive marketing and branding strategies to ‘tighten’ up
the market
• Potential for predatory or destroyer pricing
• Find ways of reducing costs and increasing efficiency to gain
competitive advantage
• Examples of markets exhibiting contestability
characteristics:
– Financial services
– Airlines – especially flights
on domestic routes
– Computer industry – ISPs, software, web development
– Energy supplies
– The postal service?
Market Structures
Final reminders:
Models can be used as a comparison – they are not necessarily meant to BE reality!
When looking at real world examples, focus on the behaviour of the firm in relation to
what the model predicts would happen – that gives the basis for analysis and
evaluation of the real world situation.
Regulation – or the threat of regulation may well affect
the way a firm behaves.
Remember that these models are based on certain assumptions – in the real world
some of these assumptions may not be valid, this allows us to draw comparisons and
contrasts.
The way that governments deal with firms may be based on a general assumption
that more competition is better than less!
The Necessary Conditions for Perfect Competition
There are no barriers to entry.
 Barriers to entry are social, political, or economic impediments
that prevent other firms from entering the market.
 Barriers sometimes take the form of patents granted to produce a
certain good.
Technology may prevent some firms from entering the market.
 Social forces such as bankers only lending to certain people may
create barriers.
The firms' products are identical.
 This requirement means that each firm's output is
indistinguishable from any competitor's product.
There is complete information.
 Firms and consumers know all there is to know about the market –
prices, products, and available technology.
 Any technological breakthrough would be instantly known to all in
the market.
Demand Curves for the Firm and the
Industry
The demand curves facing the firm is different
from the industry demand curve.
A perfectly competitive firm’s demand schedule
is perfectly elastic even though the demand
curve for the market is downward sloping.
Perfect Competitors’ Demand Curve

The result is that the individual firm perceives

the demand curve for its product as being
perfectly horizontal.
Market Demand Versus Individual Firm
Demand Curve

Market Firm
Price Market supply Price
$10 $10
8 8 Individual firm
6 6 demand
4 Market 4
2 demand 2
0 0
1,000 3,000 Quantity 10 20 30 Quantity
Market Supply and Demand
and Single-Firm Demand
The Definition of Supply and Perfect
Competition
• These strong six conditions are seldom met
simultaneously, but are necessary for a perfectly
competitive market to exist
• Supply is a schedule of quantities of goods that will be
offered to the market at various prices

When a firm operates in a perfectly

competitive market, its supply curve is its
short-run marginal cost curve above average
variable cost

14-44
Revenue Concepts
in Perfect Competition Market
Total Revenue (TR) = P x Q
The value of the firm’s sale

Average Revenue (AR) = TR / Quantity sold

Revenue per unit sold

Marginal revenue (MR) = Change in TR

Change in quantity
The change in TR resulting from one unit change in the
quantity sold.
In perfect competition, the price is constant. So the change
in TR is equal to price. ( MR = PRICE )
 Demand Curve, AR curve
and TC curve AR is always equal to
Price Price
Output Price TR AR MR
RM RM

1 3 3 3 3

3.00 2 3 6 3 3

P = AR = MR 3 3 9 3 3

MR is equal to price only

for firms in perfectly
Quantity sold competitive market.
Profit Maximizing Output
Because the firm cannot affect the price of its product,
to maximize profit it adjust the level of production.

Profit maximizing level of output can be determined

using two approaches :
TR and TC approach
Marginal Analysis
 Profit Max : The Smith Dairy Farm
Price Quantity Total Revenue Total Cost Profit Marginal Revenue Marginal Cost
(P) (Q) (TR=PxQ) (TC) (TR-TC) (MR=T R / Q ) MC=  T C /  Q
0 $0.00 $3.00 -$3.00
$6.00 1 $6.00 $5.00 $1.00 $6.00 $2.00
$6.00 2 $12.00 $8.00 $4.00 $6.00 $3.00
$6.00 3 $18.00 $12.00 $6.00 $6.00 $4.00
$6.00 4 $24.00 $17.00 $7.00 $6.00 $5.00
$6.00 5 $30.00 $23.00 $7.00 $6.00 $6.00
$6.00 6 $36.00 $30.00 $6.00 $6.00 $7.00
$6.00 7 $42.00 $38.00 $4.00 $6.00 $8.00
$6.00 8 $48.00 $47.00 $1.00 $6.00 $9.00

 Profit is maximized if the farm produces 4 or 5 gallons of milk

 The profit-maximizing quantity can also be found by comparing marginal
revenue and marginal cost.
 As long as marginal revenue exceeds marginal cost, increasing output will raise

profit.
 If marginal revenue is less than marginal cost, the firm can increase profit by
decreasing output.
 Profit-maximization occurs where marginal revenue is equal to marginal cost.
The Marginal-Cost Curve and the Firm’s
Supply Decision
Cost curves have special features that are important
for our analysis.
a.The marginal cost curve is upward-sloping.
b.The average total cost curve is u-shaped.
c.The marginal cost curve crosses the average
total cost curve at the minimum of average
total cost.

Marginal and average revenue can be shown by a

horizontal line at the market price.
Profit Maximization for the Competitive
Firm...
The firm maximizes
Costs profit by producing
and the quantity at
Revenue which marginal cost
equals marginal
MC
MC
revenue.

P=MR1 P = AR = MR

0 Quantit
Short Run Equilibrium in
Perfect Competition
3 alternative situations :
Situation A – Economic Profit
Situation B – Break Even
Situation C – Economic Loss
Measuring Profit in the Graph for the Competitive Firm...

Why the a. A Firm with Profits (Economic Profits)

firm gains Price
an
economic MC ATC
profits? Profit
1. P P = AR = MR
Producin ATC
g an
output
where
MC=MR
2.
P/MR/AR
> ATC 0 Q Quantity
Profit-maximizing quantity
Measuring Profit in the Graph for the Competitive Firm...

Why the firm gains a break-event?

1. Producing an output where MC=MR

2. P/MR/AR= ATC, that means the firm
still can cover its fixed cost.
3. Earns normal profit
Measuring Profit in the Graph for the
Competitive Firm...
b. A Firm with break-even
Price
(Normal profit)

MC

ATC

P=ATC P = AR = MR

0 Q Quantity
Break-even quantity
Measuring Loss in the Graph for the
Competitive Firm...

Why the firm experience losses?

1. Producing an output where MC=MR

2. But P/MR/AR< ATC, that means
the firm still can cover its fixed cost.
3. Earns normal profit
Measuring Loss in the Graph for the
Competitive Firm... c. A Firm with Losses

Price

MC ATC

ATC

P P = AR = MR
Loss

0 Q Quantity
Loss-minimizing quantity
 There are 2 types of losses?
1. P > AVC
• can cover its AVC such as raw materials, wages
and part of its fixed costs
• firm may continue to operate in short run

2. P < AVC
• can’t cover its AVC and ATC
• the firm profit maximizing action is to shut down
temporarily at P=AVC
Measuring Loss in the Graph for the
Competitive Firm... c. A Firm with Losses
(P>AVC)
Price/ Cost
ATC
MC

AVC
ATC

P P = AR = MR
AVC
Loss

0 Q Quantity
Loss-minimizing quantity
Measuring Loss in the Graph for the
Competitive Firm... c. A Firm with Losses
Price/Cost (P<AVC)
ATC
MC

AVC
ATC

AVC
P P = AR = MR

Loss

0 Q Quantity
Loss-minimizing quantity
The Marginal-Cost Curve and the
Firm’s Supply Decision...
Because of firm’s MC curve determined
how much the firms is willing to supply
at any price
Costs This section of the
and firm’s MC curve is
Revenue also the firm’s
supply curve. MC

P2
P1 ATC

AVC

0 Q1 Q2 Quantity
The Firm’s Short-Run Decision to Shut Down
@ 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 Firm’s Short-Run Decision to Shut
Down
The firm considers its sunk costs when deciding to
exit, but ignores them when deciding whether to
shut down.
Sunk costs are costs that have already been
committed and cannot be recovered.

The firm shuts down if the revenue it gets from

producing is less than the variable cost of
production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC
 The Firm’s Short-Run Decision to
Shut Down...
Firm’s short-run
P/Costs supply curve.
MC
If P > ATC,
keep producing
at a profit.
ATC
If P > AVC,
keep producing AVC
in the short run.

If P < AVC,
shut down.

0 Quantity
 The Firm’s Long-Run Decision to Exit or Enter a
Market

 In the long-run, the firm  A firm will enter the

exits if the revenue it
would get from industry if such an
producing is less than its action would be
total cost. profitable.
Exit if TR < TC
Enter if TR > TC
Exit if TR/Q < TC/Q
Exit if P < ATC Enter if TR/Q > TC/Q
Enter if P > ATC
 The Competitive Firm’s Long-Run
Supply Curve...
Costs
MC = Long-run S
Firm enters
if P > ATC
A area
ATC

AVC

Firm exits
if P < ATC B area

0 Quantity
Summary
Because a competitive firm is a price taker, its revenue is
proportional to the amount of output it produces.
The price of the good equals both the firm’s average
revenue and its marginal revenue. (P=AR=MR)
To maximize profit a firm chooses the quantity of
output such that marginal revenue equals marginal cost.
(MR=MC)
This is also the quantity at which price equals marginal
cost.(P=MC)
Therefore, the firm’s marginal cost curve is its supply
curve.(MC=SS curve)
Summary
In the short run when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily
if the price of the good is less than average variable
cost.(P<AVC)
In the long run when the firm can recover both fixed
and variable costs, it will choose to exit if the price is
less than average total cost.(P<ATC)
In a market with free entry and exit, profits are driven
to zero in the long run and all firms produce at the
efficient scale.