ECO101: Introduction to

Microeconomics
Lectures 14-15
Markets and Competition
Different firms operate in different markets/industries
with different degrees of competition
Generally, we have four major types of markets
• Perfect competition: large number of firms selling
identical products

COMPETITION
• Monopolistic competition: large number of firms but
with some degree of product differentiation
• Oligopoly: small number of firms with some degree
of product differentiation
• Monopoly: One firm producing a good/service
which has no close substitutes
Perfect Competition
A market structure in which
• Many firms sell identical products to many buyers
• No restrictions on entry into the market
• Established firms have no advantage over new ones
• Everyone has perfect information regarding prices (consumers know what all firms are
charging)

Note:
No single entity (buyer or seller) has any significant market power – no influence over prices.
Identical products so firms lose market share if they charge higher prices.
Entry/exit unrestricted means resources are mobile.
Perfect Competition
Perfectly competitive firms are price-takers
• A single firm’s production is an insignificant part of the total
market (q<Q)
• Any individual producer cannot influence the market price
• Demand for an individual firm’s products (not the same as
market demand for the good) is perfectly elastic – since perfect
substitutes exist, people will switch to other firms
• If you sell higher than the market price – lose all market share
• If you sell lower than the market price – giving away revenue
 Perfect Competition
Closest example of a perfectly competitive
market:
Market for agricultural goods/vegetables

Why is competition good?

• Lower prices
• Higher quality goods and services
• More innovation (to produce most efficiently)
• Unproductive firms are driven out of business
• Creates level-playing field for small businesses
Perfect Competition
Firm’s Goal: Profit Maximization

Recall
• Profit = Total Revenue – Total Cost
• Total Revenue = Price X Quantity

Marginal Revenue: Change in total revenue that results from a

one unit increase in quantity sold
𝛥 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
Marginal Revenue = 𝛥 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
Perfect Competition Market Demand Vs Firm Demand
• Market demand and market supply
determine market price
• Since each firm is a price taker,
demand for their product is
perfectly elastic (horizontal line)
• Each firm cannot change its price,
but can change the quantity it sells
• Each additional unit (jumper) sold
brings in a constant amount – £25
– the total revenue curve is an
upward-sloping straight line
• The change in total revenue that
results from a one-unit increase in
the quantity sold equals market
price
• In perfect competition, the firm’s
marginal revenue (also average
revenue) equals the market price
• MR = Prices
Perfect Competition
Firm’s Output Decision
What quantity should a firm produce?
- A perfectly competitive firm chooses the quantity that maximizes its economic
profit
- One way to do this is to look at TR and TC curves

We know
• A firm’s revenue curves (relationship between total revenue, marginal revenue
& output)
• A firm’s cost curves (relationship between total cost, marginal cost & output)
Perfect Competition
Firm’s Output Decision
Quantity Price
Total Marginal
Total Cost
Marginal Profit • In a perfectly competitive market,
(Q) (P)
Revenue Revenue
(FC+VC)
Cost (TR- price is given
(PXQ) =ΔTR/ΔQ = ΔTC/ΔQ TC)
0 25 0 22 -22 • Profit is maximized (Profit = 42) when
1 25 25 25 45 23 -20 Q* = 9
2 25 50 25 66 21 -16
3 25 75 25 85 19 -10 • Therefore, firm should produce 9
4 25 100 25 100 15 0 jumpers a day
5 25 125 25 114 14 11
6 25 150 25 126 12 24 • At outputs of less than 4 jumpers and
7 25 175 25 141 15 34 more than 12 jumpers a day, the firm
8 25 200 25 160 19 40 is incurring an economic loss.
9 25 225 25 183 23 42
10 25 250 25 210 27 40 • At either 4 or 12 jumpers a day, the
11 25 275 25 245 35 30 firm is making zero economic profit,
12
13
25
25
300
325
25
25
300
360
55
60 -35
0
called a break-even point.
Perfect Competition
Firm’s Output Decision
• Part a graphs TR & TC against Quantity produced
• Vertical distance between TR and TC gives profits
• Part b graphs Economic Profits against Quantity
• At low levels of production, firm is making losses
– its production level is not high enough to cover
its fixed costs
• At output levels greater than 4 jumpers and less
than 12 jumpers, the firm is enjoying varying
levels of economic profit, with profits reaching a
peak at 9 jumpers per day
• At greater levels of output, firm’s costs are
steeply rising (due to diminishing returns to
capital/labor) and therefore firm is making losses
once again
Perfect Competition
Firm’s Output Decision

Another way to find the profit-maximizing level of output is to use Marginal

Analysis
• Compare MR with MC
• In perfectly competitive markets, MR which equals price remains constant
• However, with increasing output, MC changes
• At low output levels, marginal cost decreases as output increases, but
eventually marginal cost increases (law of diminishing marginal returns)

Economic profits are maximized when MR=MC

 Perfect Competition
Firm’s Output Decision
• If marginal revenue exceeds marginal cost (if MR > MC ),
then the extra revenue from selling one more unit exceeds
the extra cost incurred to produce it.
• The firm makes an economic profit on the marginal unit,
so economic profit increases if output increases.
• If marginal revenue is less than marginal cost (if MR < MC
), then the extra revenue from selling one more unit is less
than the extra cost incurred to produce it.
• The firm incurs an economic loss on the marginal unit, so
its economic profit decreases if output increases
• If MR = MC, economic profit decreases if output changes
in either direction, so economic profit is maximized.
 Perfect Competition
Firm’s Output Decision
• We have seen that economic profits are maximized if
MR = MC
• However, profit-maximization does not guarantee that firm is making positive
profits (it may be just minimizing its loss)
• If the firm expects the loss to be permanent, it will go out of business (in the
long run)
• If the loss is temporary, should the firm shut down its production in the short
run? Or should it keep producing?
• We need to compare the losses (loss from closing down temporarily vs loss with
staying in business)
Perfect Competition
Firm’s Output Decision
How can we measure economic loss?
Economic Loss = Total Costs – Total Revenue
Economic Loss = Total Fixed Cost + Total Variable Cost – Total Revenue
𝑇𝑉𝐶
Economic Loss = TFC + (AVCXQ) – (PXQ) | (We know 𝐴𝑉𝐶 = 𝑄
, 𝑇𝑅 = 𝑃𝑋𝑄)
Economic Loss = TFC + Q(AVC – P)

If the firm decides to shut down temporarily, Q = 0

 Therefore, Economic Loss = TFC
 Even if the firm stops production, it has to pay its fixed costs – consider lease agreements,
interest payments on loans etc.
What if the firm remains in operation?
Perfect Competition
Firm’s Output Decision
What if the firm remains in operation?
It pays fixed costs, variable costs but also earns some revenue

If TVC > TR or AVC > P (see the derivation in the previous slide)
 The loss from operations exceeds the loss incurred when the firm is temporarily shut down
(which is just TFC)
 Therefore, the firm shuts down

If TVC < TR or AVC < P

 The loss from operations is less than the loss incurred when the firm is temporarily shut down
 Therefore, the firm remains in operation
Perfect Competition
The Shutdown Point
A firm’s shutdown point is the price and quantity at
which it is indifferent between producing and
shutting down in the short-run.
The shutdown point occurs at the price and the
quantity at which average variable cost is a
minimum.
The area of the red rectangle shows that at the
shutdown point the economic loss equals total
fixed cost.
At the shutdown point, the firm is minimizing its
loss, and its loss equals total fixed cost.
 Let’s look at the green lines

Perfect Competition Consider MR1, Price > ATC

Firm is making profits (sometimes called
abnormal profits)

Consider MR2, Price = ATC

Firm is at a break-even point and making zero
profits (sometimes called normal profits)
MR1
In the long-run, the firm is indifferent
between staying in operation or shutting
down
MR2
MR3
Consider MR3, Price < ATC but Price > AVC
MR4 Firm is not profitable
It will stay in operation in the short run to
minimize its loss, but it will eventually exit in
the long run
Perfect Competition Let’s look at the green lines
Consider MR4,
Price < ATC and Price < AVC

Firm should stop production in the

short-run as well as exit in the long-run
MR1
Price is so low that it does not make
sense to continue production

MR2
MR3 At MR = Price = AVC
MR4 Firm is indifferent in the short-run
(known as the shutdown point)
Perfect Competition Let’s look at the green lines
Consider MR1

How do we calculate profits from the

graph?
Revenue = MR X Q
MR1
TC = ATC XQ

MR2 Profit = Revenue – TC (area of green

MR3 shaded rectangle)
MR4
Perfect Competition