Chapter four :Price And Out Put Determination Under

Perfect Competition
4.1 Definition and Assumptions
 Perfect competition is a market structure characterized by a complete absence of
rivalry among the individual firms.

 Thus, perfect competition in economic theory has a meaning diametrically opposite

to the everyday use of this term.
4.1.1 Assumptions of perfect competitive market

The model of perfect competition was constructed based on the following assumptions
 Large number of sellers and buyers
 Products of the firms are homogeneous.
 Free entry and exit of firms
 The goal of all firms is profit maximization.
 No government regulation
 Perfect mobility of factors of production
 Perfect knowledge.
4.2 Costs under perfect competition

 The per unit cost (AVC &AC) have U –shape due to the law of variable proportions (in
the short run) and thCosts under perfect competition e law of returns to scale (in the
long run).
 4.3 Demand and revenue functions under perfect
competition
 Due to the existence of large number of sellers selling homogenous products, each
seller is a price taker in perfectly competitive market.

 Thus firms in perfectly competitive market are price takers and sell any quantity
demanded at the ongoing market price.

 Therefore, the demand function that an individual seller faces is perfectly elastic or
horizontal line.
 And its total revenue is given as:-
TR = P.Q ( total revenue = price * quantity)
4.3.1 marginal revenue under perfect competitive market.

 The marginal revenue (MR) and average revenue (AR) of

a firm under perfect competition are equal to the market
price.
To see this, let’s find the MR and AR functions from TR
functions.
 TR = P*Q and MR= ∆TR/ ∆Q and
Hence MR=P
AR = TR/ Q = P.Q/Q = P.
 Therefore, under P.C AR and MR is equals to market price(P), as indicated in the
graph above.
Activity 4.1

1) How do you define a perfectly competitive market? Is there a real competition

among firms operating in such markets?
2) Is promotion activity (such as advertising the product) necessary for a firm
operating under perfect competition? Why or why not?
3) What are the assumptions used to construct the model of perfect competition?
4) Explain why the demand curve of an individual firm operating in a perfectly
competitive market is perfectly elastic. What will happen to the quantity of sales of
an individual firm if he raises the price above the market price?
4.3.2 Short run equilibrium of the firm

 Under P.C , the firm is said to be in equilibrium when it produces level of output
which maximizes its profit, given the market price.

 Thus, determination of equilibrium of the firm in P.C means determination of the

profit maximizing output since the firm is a price taker.

 The level of output which maximizes the profit of the firm can be obtained in two
ways:
 Total approach
 Marginal approach
Continued….

1. Total approach: In this approach, the profit maximizing

level of output is at level of output at which:- the
vertical distance between the TR and TC curves is
Maximum

 And Provided that the TR curves lies above the TC curve at this point as indicated
in the above grapgh.
Continued….
2. Marginal Approach
 In this approach the profit maximizing level of
output is that level of output at which: MR=MC and
MC is increasing

 As indicated in the graph the profit maximizing out put is Qe, where MC=MR
and MC curve is increasing.
 For all output levels from Q* to Qe the marginal cost of producing
additional unit of output is less than the MR . Hence the firm should produce
additional output until it reaches Qe.
4.3.3 Firms profit and ATC in perfect competitive
market.

 Whether the firm gets positive or zero or negative profit depends on the level of ATC
at equilibrium thus;
 If P > ATC it earn positive profit, if P= ATC , normal/zero profit and If, P< ATC firms
earn negative profit as indicated in the above, graphs.
4.4 The short run supply curve of the firm and the industry

4.4.1 The short run supply curve of the firm

 Under this concept , we observe how the equilibrium quantity supply of the firm
varies with the market price.
 Therefore, the quantity supplied by the firm increases as the market price increases.
 On the other hand, firma not supply if the market price is not covers it variable
costs.
 Therefore, the supply curve of firms is up ward sloping, hence, the quantity supply
is direct relation with market price.
4.4.2 Short run supply curve of the industry

 The word ’industry’ is defined as group of firms producing homogeneous products.

 Therefore, the industry supply is the total supply or market supply of individual
firms.
 Or the industry –supply curve is the horizontal summation of the supply curves of the
individual firms.
4.5 Short run equilibrium of the industry

 Short run equilibrium of the industry is defined by the intersection of the market
demand and market supply.

 Therefore, the intersection of market demand and market supply of a given

commodity determines the equilibrium price and quantity of the commodity in the
market.
 Or at the point where :-
Market supply = market demands ( Qd = Qs)
Continued….

 Industry supply curve is horizontal sum of the supply curves of all firms in the
industry and the equilibrium point is Intersection of S and D: which is at the point of
market price $5 & quantity of 1,200,000 as indicated above in the graph.
4.6 Equilibrium of an individual firm in the long run

 In the long run firms at equilibrium when the market price is equal to the minimum
long run AC
 Thus since price is equal to long run AC at the long run equilibrium, firms will be
earning just normal profits (zero profits).
Firms get only normal profit in the long run due to two reasons.
First, if the firms existing in the market are making excess profits, it reduce price
results from supply > demand, and increase cost results from demand for factors > its
supply, this leads to P= LAC
Continued…

 Second, if the firms are incurring losses in the long run (P < LAC) they will leave the
industry (shut down).

 This will result in higher market price ( market supply decreases) and lower costs
( market demand for inputs decreases).
 These changes will continue until the remaining firms in the industry cover their total
costs inclusive of the normal rate of profit.
 Thus, due to the above two reasons, firms can make only a normal profit in the long
run.
 The condition for the long run equilibrium of the firm is the point of LMC = LAC = P.
4.6.1 Long run shut down decision

 The long-run shut down decision (point) is different from that of the short run.

 The firm shuts down if its revenue is less than its avoidable or a variable cost.
 In the long run all costs are variable because the firm can change the quantity of all
inputs.

 Thus, in the long run the firm shuts down when its revenue falls below the long run
total cost.
 In other words, if the market price falls below the minimum LAC of the firm.
4.6.2 The long-run supply curves the firm

 Previously, we have noted that, in the long run shuts down is if the market price is
below the its minimum LAC.

 Thus, the firm will not supply for all price levels below the minimum LAC.

 On the other, hand, the firm's long run equilibrium out put is defined by the equality
of the MR and its LMC.
4.6.3 Long-run equilibrium of the industry

 LRE is when all firms are producing at the minimum point of their LAC curve and
making just normal profits.
 Under these conditions there is no further entry or exit of firms in the industry (since
all the firms are getting only normal profit.
 Or LRE is at the point where, LMC=SMC=P=MR. and industry supply is stable.
4.7 Perfect competition and optimal resource allocation

The optimality is shown by the following conditions all of which prevail in the long run
equilibrium of the industry;
 The out put is produced at the minimum feasible cost. That is all firms produce at
the minimum of their LAC.
 Consumers pay the minimum possible price which just covers the marginal cost of
production,
 Plants are used at full capacity in the long- run so that there is no waste of resources
 Firms earn only normal profits.
Activity 4.2
1) How can firms operating in a perfectly competitive market decide the profit maximizing output?
2) What do we mean by shut down point? What minimum price is required by a firm to stay in the
business?
3) Suppose that the firm operates in a perfectly competitive market. The market price of his product
is$10. The firm estimates its cost of production with the following cost function:
TC=10q-4q2+q3
A) What level of out put should the firm produce to maximize its profit?
B) Determine the level of profit at equilibrium.
4) Suppose that a competitive firm’s marginal cost of producing output q is given by
MC (q) = 3+2q . Assume that the market price for the firm’s product is $9.
• What level of output will the firm produce?
• Suppose the firm’s fixed cost is known to be $3. Will the firm be earning positive, negative or zero
profit?
5. Price And Out Put Determination Under Monopoly

Concept and definition of monopoly market

 Monopoly is quite opposite to perfectly competitive market and it is defined as:, a
market situation dominated by single seller
 It is also a market structure, there is no close substitute.
 In monopoly there are no similar products whose prices or sales will influence the
monopolist price or sales.
5.1 Common characteristics of monopoly

Monopoly markets share the following common characteristics.

1-Single seller and many buyers
2-Absence of close substitutes goods and services.
3-Price maker
4-Barrier to entry
5.2 Causes for the emergence of monopoly

There are many factors that create monopoly and help the monopolists to maintain
monopoly power. Some of the factors will be:,
 Ownership of strategic or key inputs
 Exclusive knowledge of production technique
 Patents and copyright
 . Government Franchise and License
 Economies of scale may operate (i.e. the long run average cost may fall)
5.3 The demand and revenue curves of the monopoly firm

 In the perfectly competitive firm is a price taker and faces a demand curve that is
horizontal or infinitely elastic
 However, a monopolist firm is at the same time the industry and thus, it faces the
negatively sloped market (industry) demand curve for the commodity.
 In other words, because a monopolist is the sole seller of a commodity, it faces a
down ward sloping demand curve.

 This means, to sell more units of the commodity, the monopolist must lower the
commodity price.
 5.3.1 marginal revenue of monopoly firm

 The marginal revenue of monopoly firm is change in TR that happens due to a one
unit change in quantity of sales.
 Algebraically it is given as:,

MR = ∆TR/ ∆Q
Activity 4.3

1) How do you define monopoly? What are the basic differences between the
characteristics of monopoly and perfectly competitive markets?
2) Explain the reasons for the existence of monopoly and give at least two local
examples for each.
3) Explain how the monopoly firm affects the wellbeing of the society?
 5.3.2 Profit maximization in the short run

 Price and out put combination that maximizes the monopolist profit can be with
similar fashion of perfectly competitive firm.

 Therefore, the price- output combination that yields the monopolist the maximum
profit can be determined in two ways:
Total approach
Marginal approach
5.4 Long – run Equilibrium under Monopoly

 we have seen that a perfectly competitive firm can earn only normal profit in the
long run.

 The monopolist firm can, however, get a positive profit even in the long run because
there are entry barriers that discourage new firms to enter the industry, attracted by
the positive profit.
 Therefore, monopolist incur loss in the short run if (SAC>P)& continue if P>Avc
 However, point of output level the monopolist maximizes its profit in LR is when LMC
equals MR & slope of LMC being greater than the slope of MR.
5.5 The multi- plant monopolist

 Under monopoly firm, for many firms, however, production takes place in two or
more different plants whose operating cots can differ.
 The reasons are, to minimize transport cost, to approach the consumers or for
different reasons.
 However, the operating costs of these plants can also vary due to many reasons, like,
variation in prices of raw materials, wage of labors and etc.
5.5.1 Profit maximization under multi-plant monopoly

 In short, the condition of equilibrium in multi- plant monopolist is: MR = MC of multi

plant monopolist and to allocate the total out put among each plant, the condition
must satisfy:
 MC1 = MR = MC of multi plant monopolist(1)
 MC2 = MR = MC of multi plant monopolist(2)
There fore finally, the profit maximizing output and price is solved for two plants.
Activity 4.4

 Q1) Suppose the monopolist faces a market demand function given by P=40-Q. The
firm has a fixed cost of $ 50 and its variable cost is given as TVC=Q2 . Based on the
above information determine:
A) The profit maximizing unit of output and price?
B) The maximum profit/loss?
Continued…….

Q2) Suppose Ethiopian Electric Light and Power Corporation (EELPC) is a multi plant
monopolist having two plants, Tekeze plant (plant1) and Fincha plant (Plant2). The
operating costs of the two plants are given as follows:
Tekeze Plant: TC1 = 10 Q12 & Fincha plant: TC2 = 20 Q22 and its estimates demand
function is P= 700 – 5Q where Q = Q1 +Q2
A) What level of output (electric power) should EELPC produce and what price per
Kilowatt should it charge to maximize its profit?
B) How much of the total output should be produced in each plant?
5.5.2 Price Discrimination

 Price discrimination refers to the charging of different prices for the same good.

 But not all price differences are price discrimination.

 If the costs of offering a certain uniform commodity (service) to different group of

customers are different, price of the commodity may differ. But this can not be
considered as price discrimination.
 A firm is said to be price discriminating if it is charging different prices for the same
commodity with out any justification of cost differences.
5.5.3 Necessary conditions for price discrimination

 The Necessary conditions for price discrimination are:-

 There should be effective separation of markets for different classes ( resale of
goods are impossible b/c of location

 the price elasticity of demand should be different in each sub market( willingness
to pay of consumer is different for same product)

 Lastly, the market should be imperfectly competitive ( the supplier should have
monopoly power)
5.5.4 Degrees (types) of price discrimination

There are three types of price discrimination

A) First degree price discrimination (Perfect price discrimination) : this is based on
customer is willing to pay for each unit bought.

B) Second degree price discrimination (block pricing): this is based on with the
number of units the customer buys

C) Third degree price discrimination (multi-market price discrimination) this is

based on dividing potential customers in to two or more groups and set a different
price for each group based on their potentials.
5.5.5 Social costs of monopoly

 In a competitive market, price equals marginal cost of production.

 Monopoly power, on the other hand, implies that price exceeds marginal cost.
 Therefore, because monopoly power results in higher prices and lower quantities
produced, we would expect it to make consumers worse off and the firm better off
6 Oligopoly market structure.

 Oligopoly market is a market structure dominated by few sellers of homogenous or

differentiated product.

 As a result, the action of each firm affects the other firm’s decision in the industry.

 A beer industry in Ethiopia is a good example of such type of industry.

 Each of the major beer producers takes in to account the reaction of others when
they formulate their price and output policies.
 6.1 Characteristics of oligopoly market

In summary, Oligopoly market structure is a market structure which contain firms

characterized by the following features
 Few number of firms in a given industry
 Interdependence of firms in decision making
 Firms produce homogenous or differentiated product
 Firms have some power to set price
6.2 Causes of Oligopoly market.

There are many cause of oligopoly market. Some of them are

 Economies of scale ( large amount of production with low cost of production)

 Barriers to entry(This barrier may be technological, skill, cost, size of the market
in relation to economies of scale , patent right )

 Collusion /merger of small firms(Small firms collide to get market power)

6.2.1 Barriers to Entry

Barrier to entry is b/c of Economies of Scale, limit pricing, control channel

of distribution and Brand Proliferation
1) Economic of scale
 Large firms produce on a large scale and benefit from decreased cost per unit.
 If a new firm tries to enter the market the existing firm that is well established can
afford to lower price to deter them.
 New firms will be unable to compete due to the huge set up costs involved.
Continued ……

2)Limit pricing
 Is an agreement between firms to set a relatively low price to make it unprofitable
for new firms to enter the industry
3) Control over channel of distribution
 Oligopolies may refuse to supply retailers who stock the products of competitors
4) Brand Proliferation
 The same firm produces several brands of the same type of product. This will leave
very little room for new firms to competitor
6.2.2 Non price competition

 None price competition Is when competing firms try to increase sales/market share
by methods other than changing prices
 Some of examples are:-
1)Branding
2)Packaging
3) Competitive advertising, Opening hours, Quality of service, Sponsorship of
local or national events
6.3 Shape of the demand curve of a firm in oligopoly

 Price in perfect competition, monopoly and monopolistic competition markets

adjusts rapidly to changing in cost or demand conditions.
 However, in the case of oligopolistic the demand is kinked demand curve.
 The kinked demand curve model, developed by Paul Sweezy in 1939, explains why
prices are rigid in some oligopoly market.
 According to this model therefore, demand curve facing each firm in oligopoly
market is kinked at prevailing market price
 That means if a firm increases its price, it would loss most of its customer and cause
total revenue to decrease.
 This is because other firms in the industry would not follow the increase in price.
Continued….

 From the graph if price increase above (P1)

Firms incur loss of customer

 If oligopoly firms reduce price below (P1) firms

Face loss of revenue
 Therefore the demand curve of the oligopoly firm
is not straight rather it is kicked b/c reactions of one firms on others and homogeneity
of production.
Continued…

 To sum up, the kinked demand curve model give us why price and output will not
change despite changes in cost and demand in oligopoly market structure.

 The only case where a rise in cost results in increase in price is when the rise in cost
equally affects all firms in the industry.
6.3.1 Relationship between the demand curve and the
marginal revenue curve

As indicated in the graph:-

 Because the demand curve is kinked the firms MR
curve consists of two distinct parts.

 It is constant between D and E.

 Between these points if MC changes, price will not

change
6.3.2 Long run equilibrium of a firm in oligopoly

In the long run equilibrium is at the point,

 where MC=MR & MC is rising, This occurs at
point G on the diagram.
The firm will produce at Q 1 and the firm will
charge price P 1
Even if costs rise between D & E prices remain
rigid at P 1.
6.4 Chapter activity

1) Define concept and causes of oligopoly market?

2) How the oligopoly market influence the government interference?
3) Why oligopoly firms face kinked demand curve?
4) What are none price competition under oligopoly market