CHAPTER 7- THEORY

OF FIRM AND MARKET

STRUCTURES
 Theory of a Firm
Definition of a Firm
 A firm is an institution that buys or hires factors
of production and organizes them to produce
and sell goods and services.
• A firm is an independent unit of producing goods
and services for sale.
Objectives of a Firm
• The main goal or objective of a firm is to
maximize profit and to minimize the cost.

2
 MARKET STRUCTURE
Definition of a Market
 An arrangement that facilitates buying and selling of a good,
service, factor of production or future commitment.
OR
• A market is a place where the buyers and sellers meet with one
another and involves transaction.

Definition of a Market Structure

• Market structure refers to the number and distribution size of
buyers and sellers in the market of a good and service.
 DETERMINATION OF
EQUILIBRIUM OF A FIRM
• There are 2 approaches to determine the profit-maximizing
level of output:

The Total Revenue-Total Cost Method (The Aggregate

Approach)

• The equilibrium point would be at output where difference

between total cost and total revenue is the greatest. It is
also known as the profit maximization point.
• The break-even point of a firm occurs when total cost is
equal to total revenue.
 The Total Revenue-Total Cost Method (The
Aggregate Approach)

Break-even →

Profit max point →

Break-even →
 The Marginal Revenue-Marginal Cost
Method (Marginal Approach)

• The firm can maximize profit when its

marginal revenue equals marginal cost.
The output produced is known as
optimum output.
• Moreover, marginal cost must cut
marginal revenue from below.
 The Marginal Revenue-Marginal Cost Method
(Marginal Approach)

Marginal Total Marginal

Output Price Total Revenue Revenue Cost Cost Profit
0 25 0 25 -25
1 25 25 25 49 24 -24
2 25 50 25 69 20 -19
3 25 75 25 86 17 -11
4 25 100 25 100 14 0
5 25 125 25 114 14 11
6 25 150 25 128 14 22
7 25 175 25 144 16 31
8 25 200 25 163 19 37
9 25 225 25 188 25 37
10 25 250 25 215 27 35
11 25 275 25 249 34 26
12 25 300 25 303 54 -3
13 25 325 25 363 60 -38
Profit max → MR = MC
 PERFECT
COMPETITION
PERFECT COMPETITION
Definition
• Defines as a market in which there are many
buyers and seller, the products are
homogeneous and sellers can easily enter and
exit from the market.
• Most of agricultural goods are included in the
perfect competition market.
• E.g. Vegetables, fruits, rice, wheat and others.
PERFECT COMPETITION
Characteristics
i. Large number of buyers and sellers
 An important feature of this type of market structure is the
existence of large number of buyers and sellers.
 The quantity a single sellers produce/sells is so small
compared to the overall industry.
 E.g. In the poultry industry, there are thousands of chicken
producers in Malaysia. Each firms only contribute a small
fraction to the total poultry production. Even though firm
increase its production by 100%, it does not affect much the
overall industry. Thus, there are no single firm/ seller that can
influence the market price of poultry products.
 Thus, in perfect competition, sellers are price takers since the
sales volume is relatively small compared to market volume.
PERFECT COMPETITION
Characteristics
ii. Homogeneous or standardized products
 In perfect competition market, firm must sell standardized
or homogeneous product.
 This means the buyers cannot differentiate the products of
one seller to another seller.
 E.g. Buyers cannot differentiate the chickens sold in Firm
A and Firm B. Therefore, Firm A and Firm B cannot
charge different prices for identical products.
 If buyers can notice the difference in terms of quality,
packaging, colour or design by different seller, then the
market is not a perfect competition market.
 A product is not homogeneous or standardized if buyer
can differentiate it.
PERFECT COMPETITION
Characteristics
iii. Free of entry and exit
 In perfect competition, firms are free to enter or exit
from the industry.
 Firms can easily enter into perfect competition market
and exit at anytime it want.
 E.g. Any firm who wish to open chicken farm can
operate the business if they has the necessary factors
of production. If any firm suffer losses, it can leave
the industry anytime without any regulation or
restriction.
PERFECT COMPETITION
Characteristics
iv. Role of non-price competition
 As there are many sellers sell identical products at a
fixed price, the role of non-price is insignificant.
 Non–price competition can also be referred as the
selling cost (expenditures spent to increase the sale of
a product or increase the demand for that particular
product) . Example of selling costs are expenses on
advertisement, promotion, sales training and so on.
 In perfect competition market, firms have no control
over price and goods are identical, thus there is no
selling cost.
 E.g. Firm will not advertise identical goods such as
vegetables, especially without any brand.
PERFECT COMPETITION
Characteristics
v. Perfect knowledge of the market
 All sellers and buyers in perfect competition will have perfect
knowledge of the market.
 Sellers and buyers have no influence against each other.
 Buyer and seller also know price charged by other seller.
 Since products are identical, if one seller charge higher price,
buyer will buy from another seller.
vi. Absence of transportation cost
 There should not be any cost of transportation between the
sellers.
 In perfect competition, it is assumed that various firms work
so close to each other that there are no transportation cost.
 If two identical goods are at two different places, the price
will be different because of the transportation cost.
 PERFECT COMPETITION

The price is Since the firms are price

determined by the takers, they face a
intersection of the horizontal demand curve
market supply curve Demand curve in perfect
and the market competition is horizontal or
Price demand curve. perfectly elastic. Therefore:
Price
Price = MR = AR

SS

RM10
RM10 P = MR = AR

DD

Q* Quantity
Quantity
Market Firm
Perfect Competition: Profit Maximization
In The Short Run
 Short run equilibrium
 In short run; at least 1 input is fixed, AR = MR.
 Based on MR-MC approach, firm will
maximize its profit when MR=MC.
 In short run, firm can face 3 possibilities types
of profits.
i. Economic profit or supernormal profit
ii. Breakeven or normal profit
iii. Economic losses or subnormal profit.
 Perfect Competition: Profit Maximization
In The Short Run
i. Economic profit/Supernormal profit
 Profit earned by a competitive firm when its total revenue is
greater than total cost (TR > TC) or when price is greater than
average total cost (P > ATC)
(RM) • Firms demand curve is horizontal where
DD=AR=MR. (perfectly elastic)
• MC curve intersect with DD curve at point
ATC B.
• When MR=MC, firm achieve the profit
20 A B
maximizing output and price at 60 units and
15 D C RM 20.

Total Profit (TP) = TR – TC

= (P x Q) – TC
(Kg)
60 = (P x Q) – (ATC x Q)
= (20 x 60) – (15 x 60)
= 300 (Economic profit)
 Perfect Competition: Profit Maximization
In The Short Run
ii. Breakeven or normal profits
 This type of profit is necessary for a firm to stay in business
 Achieved when total revenue is equal to total cost (TR=TC) or
when price equals to average total cost. (P= ATC).

Price ATC • When equilibrium price is equal to

(RM) ATC, firm has just able to cover its cost.
• At profit maximizing price of RM 15,
and quantity, 60kg, MR = MC and P =
ATC.
15
Total profit (TP) = TR – TC
= (P x Q) – (ATC x Q)
= (15 x 60) – (15 x 60)
= 0 (Breakeven)
Quantity
60 (Kg)
 Perfect Competition: Profit Maximization
In The Short Run
iii. Economic losses/ Subnormal profit
 Losses incurred when price is lower than average total cost (P<ATC)
or when total revenue is less than total cost (TR<TC)

Price • At price, RM15 firm suffer losses as

(RM)
price is below than ATC (P < ATC)
MC • In this situation, firm will minimize
ATC its cost where MR=MC and the
equilibrium price is RM10 and
quantity at 60kg

Total Profit (TP) = TR – TC

C
B = (P x Q) – (ATC x Q)
15
Losses MR = AR = DD = (10 x 60) – (15 x 60)
10 = -300 (Economic losses)
A D

60 Quantity (Kg)
Perfect Competition: Shut down point
• What would a firm do when losses incurs in short
run? Should the firm continue its operation or cease
its operation.
• The shutdown point is the point at which the firm
will be better off if it shuts down than it will if it stays
in business or when price is equal to minimum AVC.
(P = min AVC)
• The firm will shut down if it cannot cover average
variable costs.
– A firm should continue to produce as long as price
is greater than average variable cost. (P > AVC)
– If price falls below that point it makes sense to
shut down temporarily and save the variable costs.
 Perfect Competition: Shut down point
• At price, RM5 per kg, P=
Price AVC and output is 60kg.
ATC •At this point, losses incurred
equals to fixed cost.
•If price falls below RM5,
operating the firm will only
A B AVC incur more losses than fixed
15 cost and thus firm must shut
down
10 P = MR = AR =DD •The key to decide whether to
continue operation or shut
5 D P1 = MR1 = AR1 =DD1 down is related to the AVC:
C
i. If P < min AVC : Shut
down (Below RM 5)
ii. If P > min AVC : continue
0 60 Quantity operation (above RM 5)
2
iii. If P = min AVC : firm at
shut down point (Point C)
Perfect Competition: Profit Maximization In
The Long Run
• In the short run, a perfect competitive firm
can either earn profit or suffer losses.
• However, in the long run, the firm can only
earn zero economic profit or normal profit
(Breakeven).
• This is due to the absence of barriers to enter
and exit the market.
 Long-Run Equilibrium
• In long run, the firm can earn normal profit. There are 2
reasons:

– If firms in PC market earn economic profit in SR, this will

encourage them to expand production. New firms also will
enter the market. As a result, SS will increase and P will
fall.

– A loss in SR will force the firms to reduce

production/shutdown and therefore some existing firms
will leave the market. So SS will decrease and P is forced
to go up.
 Perfect Competition: Profit Maximization In
The Long Run
EFFECT OF SS0
DD
ENTRY ATC
SS1
A C
20
PROFIT
15
B D

60 60

• Initial equilibrium price and quantity determine by the market is RM 20 and 60

kg. Firm gain profit as shown by the blue-shaded (ABCD) region.
• The supernormal/ economic profit gain by firms attract newcomers to enter the
industry.
• This cause the supply in the industry to increase from SS0 to SS1.
• Since with the higher SS, profit gain by the firm in this perfect competition
will be zero and in the long run, firm will only gain normal profit.
• Price will be reduce to RM 15 (price-taker) and quantity remain at 60kg.

1. Initial equilibrium
price and quantity 2.
determine by the
market is RM 10 and
60 kg. Firm suffer
losses as shown by
the shaded area.
3. Supply curve will shift to left and
Price (RM) equilibrium market price will rise to
EFFECT OF EXIT
The losses in short run
4. The competitive firm sells 60 kg of chicken and
forces those sellers who
suffers losses shown by the shaded area.
cannot cover their AVC or
TVC to leave the market.
5. Firms that suffer losses in the
As many firms exit the
short run can still continue their
market, this will lead to a
operation as in the long run
decrease in the market
they are able to earn normal or
supply.
zero profits due to exit of the
firms.
Price (RM)
RM15.

SS1 MC AC

SS
15
15 P1 = MR1 = AR1

10 10
LOSSES
P = MR = AR

DD

Quantity Quantity
Q* 60
Market Firm
 Long-run equilibrium of the firm under perfect competition
£ (SR)MC
(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

O Q
 MONOPOLY
COMPETITION
 MONOPOLY
 Definition
• Monopoly is a type of market in which there is a
single seller and large number of buyers
• Selling product that have no close substitution
and have a high entry and exit barrier.
• E.g. Electricity and water provider in Sabah.
 MONOPOLY
 Characteristics
i. One seller and large number of buyer
• Monopoly exist when there is only one seller of a product
where this firm is the only firm exist which selling a
product which has no close substitute.
• The monopoly market is where the monopoly firm
operates, thus there is no difference between the firm and
the industry as there is only one firm in the industry.
• Since there is only one firm operates under this market, a
monopolist firm is a price maker.
• Price maker situation indicates that the firm has the
market power to control the price.
 MONOPOLY
 Characteristics
ii. No close substitution
• Monopoly firm would sell a product which has no close
substitute.
• This means consumers or buyers could not find any
substitute for the product.
• E.g. Electricity supply from local public utility which has
no close substitution such in Sabah, the only electricity
provider is Sabah Electricity Sdn Bhd (SESB).
• A monopoly power cannot exist when there is competition
or any substitute product.
 MONOPOLY
 Characteristics
iii. Restriction of entry of new firms
• In monopoly market, there are strict barriers to
the entry of new firm.
• Barriers to entry could be natural or legal
restriction that restrict the entry of new firms into
the industry.
• Barriers to entry is the main reason why a
monopolist firm faces no competition.
 MONOPOLY
 Characteristics
iv. Advertising
• Advertising in monopoly market depends on the
types of product sold.
• If the products are luxury goods such as imported
car, then monopoly firm will needs some
advertisement to inform the consumers on the
goods’ existence.
• Local public utilities such as water, electricity and
home phone services do not need advertisement
since consumers know where to obtain the
products.
 TYPES OF MONOPOLY
i. Natural Monopoly
• Can arise due to economies of scale (the larger the firm,
the lower would be the cost of production.
• Natural monopoly exists when one firm can produce at a
lower cost compared to what two or more firms could
produce.
• In simple word, natural monopoly refers to a single firm
that can meet the entire demand with lower price charge
than more firms.
ii. Government-Created monopoly
a) Government franchise
 Exclusive rights to a firm to sell certain goods and services
in certain area.
 E.g. Railway services, water supply, electric supply, postal
services and cable TV services.
 TYPES OF MONOPOLY
b) Government license
 License needed by firms to operate any kind of business.
 In monopoly market, obtaining a license will be much
difficult compared to other market structures,
c) Patent
 An exclusive right to the production of an innovative
product.
 Patents are given to the firms or individuals for their
discoveries and invention
d) Copyright
 Exclusive right given to the author of a book, composer of a
music or producer of a movie or artistic work.
e) Control over raw-material
 When one single firm has the exclusive control/right over
raw material, it will be impossible for other firm to enter the
market.
Monopoly : Profit Maximization In
The Short Run

 Short run equilibrium

 In short run; at least 1 input is fixed.
 In short run, firm can face 3 possibilities types
of profits.
i. Economic profit or supernormal profit
ii. Breakeven or normal profit
iii. Economic losses or subnormal profit.
 Monopoly : Profit Maximization In
The Short Run
i. Economic profit/Supernormal profit
 Profit earned by a firm when its total revenue is greater than
total cost (TR > TC) or when price is greater than average total
cost (P > ATC)
(RM) •Profit maximizing level occurs when
MR=MC, firm achieve the profit
maximizing output at 10 units.
•To find the profit maximizing price, use
ATC
the same vertical line with output up to the
200
demand curve where profit maximizing
150 price is RM200.

Total Profit (TP) = TR – TC

AR = DD = (P x Q) – TC
= (P x Q) – (ATC x Q)
= (200 x 10) – (150x 10)
10 = 500 (Economic profit)
 Monopoly : Profit Maximization In
The Short Run
ii. Breakeven or normal profits
 Achieved when total revenue is equal to total cost (TR=TC) or
when price equals to average total cost. (P= ATC).

Price • MR = MC and P = ATC at the

(RM) profit maximizing price of RM 150,
and quantity, 10.
MC
Total profit (TP) = TR – TC
ATC = (P x Q) – (ATC x Q)
= (150 x 10) – (150 x 10)
150 = 0 (Breakeven)

AR = DD
MR

10
 Monopoly: Profit Maximization In The
Short Run
iii. Economic losses/ Subnormal profit
 Losses incurred when price is lower than average total cost (P<ATC)
or when total revenue is less than total cost (TR<TC)

• At price RM150 firm suffer losses if

price is below than ATC (P < ATC)
ATC • In this situation, firm suffers
economic losses or subnormal profit
shown in the rectangle shaded area.
150 •At the equilibrium output of 10 units,
firm suffer a loss of RM 500 as TR <
100 TC
Total Profit (TP) = TR – TC
= (P x Q) – (ATC x Q)
= (10 x 100) – (10 x 150)
AR = DD = -500 (Economic losses)
10
 Monopoly: Profit Maximization in the
Long Run
• If in short run, a monopoly firm can
LRMC possibly experience three types of profit,
but in the long run, it can only earn
supernormal/economic profit.
LRAC • A monopoly firm will always earn
200
supernormal profit in the long run due to
150 the existence of barriers to entry.
• When a monopolist firm earned
supernormal profit, it will attract new
firms to enter the market.
• However, it is not possible for a new
10 firm to enter as there are barriers to
LRMR entry.
TP = TR – TC • Thus, in long run, the economic profit/
= (P x Q) – (ATC x Q) supernormal profit will remain to be the
= (200 x 10) – (150 x 10) only type of profit that a monopolist
= RM 500 (economic profit) firm will earned.
 PRICE
DISCRIMINATION
• Refers to the selling or charging different prices by a
firm to different buyers for a similar product.
• The difference in prices by a firm to different buyers
for similar product is not associated with costs.
• E.g. Firm charging lower rate to children, does not
mean that firm would reduce their profit.
• Because price discrimination is potentially
profitable, businesses have found many ways to do
it.
• E.g. Price charged for movie ticket is different
between adults, children and senior citizens.
Necessary condition for Price
Discrimination
• Not every firm can practice price discrimination
as there are some necessary condition for it to
work.
i. The firm must operate in imperfect competition, it
must be a price maker with a downwardly sloping
demand curve.
ii. The firm must be able to separate markets and
prevent resale. E.g. stopping an adults using a
child's ticket.
iii. Different consumer groups must have elasticity of
demand. E.g. students with low income will be
more price elastic.
 Different Types of Price
Discrimination
i. First Degree Price Discrimination
• This involves charging consumers the maximum price
that they are willing to pay.
• E.g. Auction sale
ii. Second Degree Price Discrimination
• This involves charging different prices depending
upon the quantity consumed.
• E.g. After 10 minutes phone calls become cheaper.
iii. Third Degree Price Discrimination
• This involves charging different prices to different
groups of people.
• E.g. Students discount, adults vs. children rate
 First-Degree Price
Discrimination
• Firm charges each consumer the maximum price
that they willing to pay for each unit.
• This type of price discrimination also known as
“perfect price discrimination”
• The best example to illustrate the first degree of
price discrimination is auction sale where customers
are willing to pay higher price to get the desired
product.
• At this situation, firm increases its profit by
charging each customer the highest amount that the
customer willing to pay.
 • The figure illustrates the DD
Price (RM) and MR curve for a firm selling
antique tables.
•The MC and ATC are assumed
E constant at RM400.
1200
Increase in profit from • If the firm does not practice
price discrimination price discrimination, then its
equilibrium price is RM1000
A B
1000 where quantity is 10 units.
A • Profit before price
discrimination is shown by the
yellow-shaded rectangle.
C D • After firm charges each
400 MC = ATC consumer the maximum price
they are willing to pay
DD = AR (RM1200), the firm can make
MR additional profit (shown in the
Q (antique table) blue-shaded region.
10

First-degree price discrimination

46
 Second-Degree Price
Discrimination
• Second-degree price discrimination is pricing
according to quantity consumed or in blocks.
• This kind of price discrimination is quite
common in our daily life.
• It occurs when the products are grouped into
blocks and each block is charged at a different
price.
• This type of price discrimination often applied
by public utilities such as electricity charges,
water charges, telephone charges and others.
 Second Degree Price Discrimination
• The figure shows the rate
Price (RM) schedule for parking charges for a
building where higher price is
charged for the first hour of
parking, RM 5, second hour RM 3
Profit-maximization and third hour RM2. The next
5 price without price
discrimination
hour are charged RM1 for each
MC
additional hour.
3 • The monopolist firm could earn
additional profit under this price
discrimination .
• Without price discrimination,
2
firm earn less profit at profit
maximization price of RM3, and
quantity of 2 (hours)
• Firm earns higher revenue when
DD -AR charging different price levels
MR
compared to single price.
Q
1 2 3
THIRD DEGREE PRICE
DISCRIMINATION
• This type of price discrimination also commonly
practiced by firms in many places.
• Under this kind of price discrimination, market
is divided into many submarkets or subgroups,
where each group is considered as a different
market, depending on the price elasticity of
demand.
• Third degree price discrimination occurs when
adults are charged higher price of movie ticket
compared to children, students and senior
citizens.
Perfect competition vs. Monopoly
• Large number of buyer and
sellers
• Sell homogenous product
• Price taker
• Free of entry and exit to the
industry
• Horizontal demand curve
• Earn normal profit in long run
due to free entry and exit
• Operates at the lowest point of
ATC in long run and more
efficient
• One seller, many buyers
• Sells goods that has no close
substitutes.
• Price maker
• Various barrier to entry and exit.
• Downward sloping demand
curve.
• Earn a supernormal profit since
there are barriers to entry
• Does not operate at minimum
point of ATC curve and less
efficient.
• Comparison between monopoly and perfect Diagram
competition
•
• Comparison of both markets is done in the long run
• Compare quantity, price, profit and level of efficiency

• i. Quantity
P.comp firm sold more than monopoly firm
(Qpc  Qm)

• ii. Price
• Monopoly firm charged higher than p.comp
• firm (Pm  Ppc)

• iii. Profit
• P.comp firm earned normal 
• Monopoly firm earned supernormal 
•
iv. Level of efficiency
– P.comp firm sold more quantity at the lowest
cost ( Qpc at the min. AC)
– Monopoly firm sold less quantity at higher cost

•  P.comp firm is more efficient than monopoly firm

MONOPOLISTIC
COMPETITION
 MONOPOLISTIC
COMPETITION
 Definition
 A market structure in which there are
large numbers of small sellers selling
differentiated products but there are close
substitutes to the product and easy to
entry and exit the market.
 E.g. Shoes, clothes, books, toothpaste,
soaps sellers is an example of a
monopolistic competition.
 CHARACTERISTICS
i. Large number of sellers and buyers
 Similar to the perfect competition market, there are a large
number of sellers and buyers under monopolistic
competition.
 However, the number of firm existing in this market is less
than the number of firm existing in the perfect competition
market.
 The size of firm compared to the whole industry is so small,
so a single monopolistic firm has no influence over the
market price.
 However, since each firm in monopolistic competition
market produces different or unique products, they have
some control over their product’s prices and will follow an
independent price-output policy.
 E.g. In toothpaste industry, the prices for a 250ml toothpaste
range among brands such as Colgate, Darlie and Fresh &
White.
 CHARACTERISTICS
ii. Product Differentiation
 Products the firm is selling or producing are not
identical and different from its competitor.
 Each seller would use various methods to
differentiate their product from other sellers in
order to attract buyers or consumers.
 The differentiation could be through packaging,
design, labelling, advertising and brand name.
 E.g. Consumer can differentiate each facial
foam in the market through the brand (Biore,
Garnier, Clean & Clear), packaging, labelling,
design and advertising.
 CHARACTERISTICS
iii. Easy Entry and Exit
 Like in perfect competition market, there are no
barriers to entry the monopolistic market.
 However, the entry and exit into the monopolistic
market is not as easy as in perfect competition
because of the existence of product
differentiation.
 Any new firm who wish to enter the monopolistic
market must find some differentiation with the
existing brands.
 E.g. When ‘May soap’ enter the bathing-soap
industry, this firm must find some difference in
term of quality, smell, shape or labelling in
order to be in this market.
 CHARACTERISTICS
v. Selling Cost
 Since each firm tries to promote its product to
consumer through different types of
expenditure on advertisement, it would incur
additional cost.
 Cost of banner, media advertisement,
billboards, pamphlet and others are some of
the expenditure incurred to attract consumers
towards a particular brand.
 These expenditure are called selling cost,
which need to be covered with the production
cost.
 CHARACTERISTICS
iv. Non-Price Competition
 In monopolistic market, there would be stiff
competition among the firms for their product
and not for the price.
 Firms in the monopolistic industry do not
compete using prices as the products in this
market have many substitutes.
 So, the producer or sellers use various methods
to attract customers to buy a particular brand.
 Non-price competition can be through
advertising, promotion, discount, free gifts,
after sale service and others.
PROFIT MAXIMIZATION :
SHORT RUN
 Short run equilibrium
 In short run; at least 1 input is fixed.
 The profit maximization is also based on MR
and MC.
 In short run, firm can face 3 possibilities types
of profits as in perfect competition and
monopoly market.
i. Economic profit or supernormal profit
ii. Breakeven or normal profit
iii. Economic losses or subnormal profit.
 PROFIT MAXIMIZATION :
SHORT RUN
i. Economic profit/Supernormal profit
 Profit earned by a firm when its total revenue is greater than
total cost (TR > TC) or when price is greater than average total
cost (P > ATC)
•Profit maximizing level occurs when
MR=MC, firm achieve the profit
(RM)
maximizing output at 10 units.
•To find the profit maximizing price, use
the same vertical line with output up to the
200 demand curve where profit maximizing
price is RM200.
150
Total Profit (TP) = TR – TC
AR = DD = (P x Q) – TC
= (P x Q) – (ATC x Q)
= (200 x 10) – (150x 10)
= 500 (Economic profit)
10
 PROFIT MAXIMIZATION :
SHORT RUN
ii. Breakeven or normal profits
 Achieved when total revenue is equal to total cost (TR=TC) or
when price equals to average total cost. (P= ATC).

Price • MR = MC and P = ATC at the

(RM) profit maximizing price of RM 150,
and quantity, 10.
MC
Total profit (TP) = TR – TC
ATC = (P x Q) – (ATC x Q)
= (150 x 10) – (150 x 10)
150 = 0 (Breakeven)

AR = DD
MR

10
 PROFIT MAXIMIZATION :
SHORT RUN
iii. Economic losses/ Subnormal profit
 Losses incurred when price is lower than average total cost (P<ATC)
or when total revenue is less than total cost (TR<TC)

• At price RM150 firm suffer losses if

price is below than ATC (P < ATC)
ATC • In this situation, firm suffers
economic losses or subnormal profit
shown in the rectangle shaded area.
150 •At the equilibrium output of 10 units,
firm suffer a loss of RM 500 as TR <
100 TC
Total Profit (TP) = TR – TC
= (P x Q) – (ATC x Q)
= (10 x 100) – (10 x 150)
AR = DD = -500 (Economic losses)
10
 PROFIT MAXIMIZATION :
LONG RUN
• If in short run, a monopolist firm can possibly
LRMC experience three types of profit, but in the
long run, it can only earn normal profit due to
the absence of barriers to entry.
LRAC • Whenever there is no barriers to entry exist in
200
any market structure, there would be only
150 normal profit earned in the long run.
• When a monopolistic firm earned supernormal
profit, it will attract new firms to enter the
market and supply will increase.
• Since with the higher SS, profit gain by the
10 firm in this market will be zero and in the long
LRMR run, firm will only gain normal profit.
TP = TR – TC • Thus, in long run, the normal profit will
= (P x Q) – (ATC x Q) remain to be the only type of profit that a
= (150 x 10) – (150 x 10) monopolistic firm will earned.
= RM 0 (normal profit)
 Monopolistic vs. Perfect
Competition
SIMILARITIES
• Firms in both markets are large in
number.
• Free of entry and exit in both
markets.
• Both markets maximizes profit
when MR=MC
• In short-run, both markets may
earn economic profit, normal
profit or suffer economic losses.
• In long-run, both markets can
only earn normal profit.
DIFFERENCES
• In P.C market, the forces of DD and
SS while in monopolistic market,
each firm has its own price policy
• P.C firm sells homogeneous products
while monopolistic firm sells
differentiated products.
• Selling cost occurs only in
monopolistic market and not in P.C
market.
• P.C’s DD curve is perfectly elastic
and MR=AR but in monopolistic
market, DD and MR curve is
downward sloping.
 OLIGOPOLY
COMPETITION
 OLIGOPOLY
COMPETITION
 Definition
 There are only a few firms selling either
standardized or differentiated products and
it restrict the entry into and exit from the
market.
 Under this kind of market structure, some
or all the firms in the market can earn
abnormal profit in the long run.
 E.g. Cigarettes, automobile and electrical
equipment is an example of goods in
oligopoly market.
 CHARACTERISTICS
i. Few numbers of firms
 The number of firms is small but the size of the
firms is large.
 Thus, the market share of each firm is large
enough to dominate the market where few firms
can control the overall industry under oligopoly.
 In here, few firms refer to the number of firms
(two or more than two) that dominate the
market.
 There is no specific number of firms that must
control the market before becoming
oligopolistic.
CHARACTERISTICS
ii. Homogeneous or differentiated
product
 Product sold under oligopoly can be either a
homogeneous or a differentiated product.
 E.g. Cement or electrical appliances produced
by one firm are identical to another firm
automobiles produced by major automakers are
different in terms of design, technology,
performance and prices.
 CHARACTERISTICS
iii. Mutual Interdependence
 Each firm in an oligopolistic market always
consider the reaction of their rivals when
choosing price, sales target, advertising
budgets and other business policies.
 This is the most important characteristics of
an oligopoly firm that differs from other
market structures.
 E.g. When Honda changed its products design
and prices, other automobile firm, such as
Mazda and Toyota will also respond by
changing their design and prices as well.
 KINKED DEMAND OR SWEEZY’S MODEL

• When oligopolist firms compete against each other, price is determined via
kinked demand curve

– A demand curve facing an oligopolist that assumes rivals will match a price
decrease, but ignore a price increase.

• Sweezy’s model is based on 2 assumptions:

– If one firm reduce price, rivals follow the cut in price to prevent losing
customers to the first firm.

– If one firm increase price, rivals will not follow. So they can gain customers
from the first firm.

70
 KINKED DEMAND OR SWEEZY’S MODEL
IMPORTANT!!!
– If Firm A increases price, rivals will not follow. So they can gain customers
from the first firm. (elastic demand)

– If Firm A reduces price, rivals follow the cut in price to prevent losing customers
to the first firm. (inelastic demand)

• Thus, each firm in the oligopoly market faces a demand curve that is kinked
at the current price & output.
– Above kink: demand is elastic. If ↑ price, large ↓ sale, since customers shift to
other firms that do not follow the price increase.

– Below kink: demand is inelastic. If ↓ price, small ↑ sale, since customers do not
shift to other firms as their prices also reduced (relative similar)

71
 How does Kinked demand curve happen?
When Firm A ↑ P, others do not
follow, customers shift to other
oligopolist firms = elastic demand
Price curve

Kinked demand
curve
P0 When Firm A ↓ P, others will follow,
customers would not shift to other
oligopolist firms since the P similar
Gap in MR = inelastic demand curve
curve

Q0
MR Quantity

72
 How does Kinked demand curve happen?
Price
Kinked demand
curve
P0

Gap in MR
curve

Q0
MR Quantity

73
 How does Kinked demand
MC 4
curve happen?
MC2
Price
MC1
P2 The model explains price
remains relatively stable
P0 overtime i.e. price
rigidity

P1 When an oligopolist firm

MC3 is facing a kinked demand
curve, as long as MC
cross MR within the gap,
P and Q will be constant

Q2 Q0 Q1 MR
Quantity

74
 How does Kinked demand curve happen?
Price
MC
ATC
Profit determination depends on
P0 the location of the ATC

In SR, oligopolist firm may get

ATC supernormal, normal or
subnormal profits

In LR, they will retain

Supernormal supernormal profit
profit

Q0 MR
Quantity

75
• Equilibrium or profit maximization output at Q0
(MR = MC), P is at P0

• If MC change → cost change. Output optimum

still at Q0. Thus, price still at P0.

• As long as MC cuts MR in (in the gap or

vertical segment of MR).

76
• At price P0, the oligopolist will sell at output Q.

• At prices above P0, the demand is elastic. Rival firms will

not match the increase in price because the fall in quantity
demanded will be greater than the increase in price. (loss of
sale)

• At prices below P or point A, the demand will be inelastic,

meaning the quantity demanded is not very responsive to a
price drop. Any reduction in the price of the oligopolist will
be matched by reductions by other firms.

77
• The kinked demand curve will lead to price rigidity. This explains
why price usually remains unchanged for a long period of time.

• Because of the unusual AR curve, the MR curve will be a

discontinuous line and even though MC may increase or decrease,
i.e at MC1 or MC2, MC is still equal to MR at the same level of
output.

• Thus the kinked demand curve model predicts that price and
quantity will be insensitive to small cost changes but will respond if
cost changes are large enough.

78
SUMMARY OF CHAPTER 7
THEORY OF FIRM AND
MARKET STRUCTURE
 Quick comparison between four
markets
Key Perfect Monopolistic Oligopoly Monopoly
characteristics Competition Competition
No. of Sellers Large number of Many sellers Few sellers One single seller
sellers
Price decision Price taker Price taker Price maker Price maker
(Price control) (no control over P) (little control) (some control) (complete control)

Type of product Homogenous/ Slightly Homogenous/ Unique

Identical differentiated Differentiated
Barriers to Entry No barriers/ Easy No barriers/ Easy Difficult of entry & Completely blocked
entry & exit entry & exit exit for entry
Type of SR profit Supernormal/ Supernormal/ Supernormal/ Supernormal/
normal/ normal/ normal/ normal/
subnormal profi subnormal profit subnormal profit subnormal profit
Type of LR profit Normal profit Normal profit Supernormal profit Supernormal profit

Demand curve Horizontal DD Downward sloping Downward sloping Downward sloping

curve, perfectly (elastic) or kinked DD curve (inelastic)
elastic demand, P=AR=D>MR P=AR=D>MR
D=MR=AR=P
80
STEPS TO CALCULATE PROFIT
First Step:
– Determine the point of intersection between
MR = MC
– This point indicate the profit maximization
and the profit equilibrium
– State the Price and Quantity of output
Second Step:
– Calculate the profit:
– Total Revenue – Total Cost
– TR = P X Q
– TC = ATC X Q
Third Step:
– Identify the type of profit (Supernormal,
Normal, Subnormal)
 PERFECT COMPETITION
• SHUT DOWN POINT
CONDITION FOR SHUT DOWN POINT:
- Price (P) = Average Variable Cost
(AVC)
The firm has to shut down the operation if:
- P < Minimum AVC
The firm can continue its operation if:
- P > Minimum AVC
 MONOPOLY
• PRICE DISCRIMINATION
– First degree price discrimination
• Ex: Auction Sale
– Second degree price discrimination
• Ex: Electric tariff
– Third degree price discrimination
• Ex: Student’s Price
 OLIGOPOLY
• Assumptions (Mutual Interdependence)
i. i - If an oligopolist reduces its price, its
rivals will follow and cut their prices to
prevent losing the customers.
ii. ii - If an oligopolist increase its price, its
rival do not increase the price and keep
their prices the same, thereby they gain
customers from the firm that increase the
price.
 SWEEZY’S MODEL: KINKED DEMAND
CURVE
• Demand is elastic above the kink where an
Price increase in price below above P will lead to
a large drop in quantity as more customers
switch to the rivals with lower prices. [Fit
F the assumption (ii)]
• Demand is inelastic below the kink, where
decreasing the price will only reflect small
increase in quantity since all other firms
reduce the prices below P and customers do
Inelastic not switch. [Fit the assumption (i)].
• Due to the existence of the two
assumptions, an oligopoly firm faces a
kinked demand curve.
• This kinked demand curve also shows the
Quantity characteristics of mutual interdependence
among oligopoly firms.
 Exercise
Cost/Price/Revenue (RM)
(RM)

MC1
14 MC2

AC

10

8
6

4
(i)

35
Output ( units )

(ii)

a) Label curve (i) and (ii)

b) Determine the profit maximizing price and output

c) Suppose production cost of the firm increases from MC1 to MC2, what is the
new equilibrium output and price?

d) Calculate total profit at the equilibrium and name type of profit the firm is
making

e) State two (2) assumptions of the above oligopoly model

f) This oligopolistic model is also known as _______________ model

86
END OF CHAPTER 7

THANK YOU