1. EC-103
Semester 2
Lectures 4 & 5
Market structure, perfect competition,
monopoly and imperfect competition

2. Firms in competitive markets
An industry is a group of firms which produce similar products.
The total output of an industry is the output of firms within that
industry.
A characteristic of an industry is they can have varying numbers
of firms making up the output.
Microsoft is the only supplier of ‘Windows’ products.
However, the UK has over 100,000 farms producing agricultural
products.

3. In the next couple of lectures we will be examining why some
industries have many producers, some a few and others only
one.
Initially we will examine two special benchmark cases, which will
help us understand what determines market structure and the
behaviour of sellers, perfect competition and monopoly.

4. Characteristics of a perfectly competitive market
•there are many buyers and sellers in the market
 therefore actions of any single buyer or seller has no affect on market
prices
• firms take the market price as given
 as a result have a horizontal demand curve
• the product sold by all firms is the same – homogeneous
• there is perfect customer information
• firms can freely enter or exit the market

5. The competitive firm’s demand curve
Price
Quantity
P D=AR=MR
For competitive firms, marginal revenue equals price

6. Objective of a perfectly competitive firm
•The goal of a competitive firm is to maximise profits
•Maximum profits are where the difference between total costs
and total revenue is greatest
•Profit maximisation is found where marginal costs equals
marginal revenue
Π max where MC = MR

7. REVISION
Maximizing profits
OutputQ1
E
MC,MR
MC
MR
0
If MR > MC, an increase
in output will increase
profits.
If MR < MC, a decrease
in output will increase
profits.
So profits are maximized
when MR = MC at Q1
(so long as the firm
covers variable costs)

8. The supply curve under perfect competition (1)
• Above price P3 (point
C), the firm makes profit
above the opportunity
cost of capital in the
short run
• At price P3, (point C),
the firm makes
NORMAL PROFITS
P1
£
Output
SAVC
SMC
Q1
SATC
P3
A
C
Q3

9. The supply curve under perfect competition (2)
• Between P1 and P3, (A
and C), the firm makes
short-run losses, but
remains in the market
• Below P1 (the SHUT-
DOWN PRICE), the firm
fails to cover SAVC, and
exits
P1
£
Output
SAVC
SMC
Q1
SATC
P3
A
C
Q3

10. The supply curve under perfect competition (3)
– showing how much the
firm would produce at
each price level.
P1
£
Output
SAVC
SMC
Q1
SATC
P3
A
C
Q3
• So the SMC curve above SAVC
represents the firm’s SHORT-
RUN SUPPLY CURVE

11. The firm and the industry in the short run
under perfect competition (1)
INDUSTRY
Output
£
Q
P
SRSS
D
Firm
SAC
P
£
Output
SMC
D=MR=AR
q

12. The firm and the industry in the short run
under perfect competition (1)
INDUSTRY
Output
£
Q
P
SRSS
D
Firm
Market price is set at industry level at the intersection of
demand and supply
– the industry supply curve is the sum of the individual firm’s
supply curves
SAC
P
£
Output
SMC
D=MR=AR
q

13. The firm and the industry in the short run
under perfect competition (2)
INDUSTRYFirm
The firm accepts price as given at P
– and chooses output at q where SMC=MR to maximize profits
SAC
P
£
Output
SMC
D=MR=AR
q
Output
£
Q
P
SRSS
D

14. The firm and the industry in the short run
under perfect competition (3)
INDUSTRY
Output
£
Q
P
SRSS
D
At this price, profits are shown by the shaded area.
These profits attract new entrants into the industry.
As more firms join the market, the industry supply curve shifts
to the right, and market price falls.
SRSS1
P1
SAC
Firm
P
£
Output
SMC
D=MR=AR
q Q1

15. Long-run equilibrium
INDUSTRYFirm
LAC
P*
£
Output
LMC
D=MR=AR
q*
The market settles in long-run equilibrium when the typical
firm just makes normal profit by setting LMC=MR at the minimum
point of LAC. Long-run industry supply is horizontal.
If the expansion of the industry pushes up input prices (e.g. wages)
then the long-run supply curve will not be horizontal, but upward-sloping.
SRSS
D
Output
£
Q
P*
LRSS

16. 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.

17. An Increase in Demand in the Short Run and Long Run
Firm
(a) Initial Condition
Quantity (firm)
0
Price
Market
Quantity (market)
Price
0
DDemand, 1
SShort-run supply, 1
P1
ATC
Long-run
supply
P1
1Q
A
MC
1q

18. An Increase in Demand in the Short Run and Long Run
Copyright © 2004 South-Western (diagrams)
MarketFirm
(b) Short-Run Response
Quantity (firm)
0
Price
MC ATCProfit
P1
Quantity (market)
Long-run
supply
Price
0
D1
D2
P1
S1
P2
Q1
A
Q2
P2
B
q1 q2
If market demand curve shifts from D1 to D2
In the short run the new equilibrium is P2Q2
Individual firms increase output from q1 to q2 (along MC curve) as price increases
The shaded area shows resulting profits, which attaches more firms to the industry

19. An Increase in Demand in the Short Run and Long Run
Copyright © 2004 South-Western
P1
Firm
(c) Long-Run Response
Quantity (firm)
0
Price
MC ATC
Market
Quantity (market)
Price
0
P1
P2
Q1 Q2
Long-run
supply
B
D1
D2
S1
A
S2
Q3
C
q1
This shifts the supply curve from S1 to S2
Industry output increases to Q3, price falls to P1 and the individual output of the firm
falls to q1. Increase in market supply is made up of firms entering the market
producing output q1

20. Why the Long-Run Supply Curve Might Slope Upward
Whilst a constant Long-Run supply curve may exist other cases
are possible.
For example, when an industry expands its output, the increased
demand for inputs (materials, labour etc.) may lead to an
increase in their prices.
This shifts up the average cost curve, reducing profits, attracting
fewer firms and price settles above P1 resulting in an upward
sloping long-run supply curve.
If input costs fall as a result of increased demand, the long-run
supply curve may be downward sloping.