THEORY OF THE

FIRM AND MARKET

STRUCTURE
 AND MARKET
STRUCTURES
 A market structure is a classification
system for the key traits of a market.
 There are 4 types of market
structure; perfect competition,
monopoly, monopolistic competition
and oligopoly.
 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)
Profit max → MR = MC
 PERFECT COMPETITION (PURE
COMPETITION)

 A market structure characterized by a large

number of small firms, a homogenous product
and very easy into or exit from the market.

Characteristics
a) Large number of sellers and buyers
There are many small firms, so their size is
small relative to the size of the market. There
are also many buyers in the market.
b) Homogeneous product
All firms produce a standardized or
homogeneous product. Advertising is totally
absent in this market.
c) Very easy entry and exit
No restriction is imposed. Firms face no
barriers to entry and exit.
d) Firm is price taker
Price is determined through market forces
(demand and supply) and firms have no
power to control the price.
e) Perfect knowledge of market
Both the sellers and the buyers have perfect
knowledge about the market situation. This
means that they know the prevailing prices in
the market.
f) Perfect mobility of factors of production
Factors of production especially labor are free
to move from one place to another without
any restrictions or rules from the
government.
 The Demand of Perfect Competition

 The individual firm’s demand curve is perfectly

elastic (horizontal) at the market equilibrium
price.
 Short-run Equilibrium
 Short-run is a time period in which there is
no change in the fixed inputs.
 In short-run, the perfect competitive firms
can attain 3 possible profits.

a) Economic Profit (Supernormal Profits)

 Economic profit is a situation where total
revenue is greater than total cost.
 Conditions to attain economic profit:
 MR = MC = Price
 AR > ATC
 TR > TC
b) Normal Profit
 Normal profit is a
situation where total
revenue equals total
cost.
 Conditions to attain
normal profit:
 MR = MC = Price
 AR = ATC
 TR = TC
c) Economic Loss
 A loss occurred
when total cost is
greater than total
revenue.
 Conditions to get a
loss:
 MR = MC = Price
 AR < ATC
 TR < TC
 Long-Run Equilibrium

 In long run, the firm can earn normal profit.

There are 2 reasons:

 If firms earn economic profit in short run,

this will encourage them to expand
production. New firms will enter the
market. As a result, supply will increase
and price falls.
 A loss in short run will force the firms to
reduce production. A loss will not attract
new firms. Some existing firms will leave
the market. So supply will decrease and
price is forced to go up.