Market Structures-Profit Maximization and Competitive Supply
We will now examine the problem of determining price and output levels in alternative
market structures. Market structures are categorized in terms of number of firms or the
number of sellers present in the market and whether we are considering a homogeneous or
We will consider four types of market structures:
1. Pure Competition
2. Pure Monopoly
3. Monopolistic Competition
Market classifications from the buyer’s angle are,
1. Pure Competition
2. Pure Monopsony
A bilateral monopoly is a situation where a single seller confronts a single buyer.
Answers to two questions are sought throughout the analysis:
1. How do firms make pricing and production decisions?
2. What are the social welfare implications of those decisions?
Homogeneous Vs Differentiable Commodity
A product is homogeneous if all units of the product offered for sale are of the same quality
at least in the eyes of the buyer. When an industry produces a homogeneous product, each
firm produces a commodity which is identical to that produced by every other firm in the
industry. Hence, as long as firms charge the same price, buyers are indifferent about the
firm they actually buy the good from. Differentiated products are imperfect substitutes and
buyers are particular about the source of the good.
Characteristics of Pure Competition
1. A large number of independent sellers
2. Standardized homogeneous product
3. All sellers are price takers
4. Free entry and exit
5. Perfect factor mobility
6. Perfect knowledge about market conditions
These are extremely restrictive assumptions and may be hard to replicate in real life.
Closest approximations are the agricultural product market (grains), stock market etc.
However, the pure competition model is extremely useful in predicting real world situations
in terms of economic efficiency and optimal allocation of resources.
Pure Competition is characterized by many producers of a homogenous product. The
demand curve of a perfectly competitive firm is perfectly elastic, or horizontal, because the
firm is a price taker.
Now, by definition,
AR = P*Q / Q = P
These three equalities hold for each type of market structure.
However, in case of pure competition alone,
where MR or Marginal Revenue is the addition to total revenue by selling one extra unit of
Profit Maximization in The Short Run
The firm achieves maximum profit where the vertical distance between the total revenue
and total cost curves is greatest.
In the short run, the firm will maximize profit or minimize loss by producing that output at
which marginal revenue equals marginal cost (MR=MC).
Features of the MR=MC rule:
This is a general rule for all types of market structures.
Firms choose to produce rather than shut down.
To maximize profit or minimize loss, the competitive firm should produce at that point
where price equals marginal cost (P=MC). This is a special rule for pure competition.
Hence here, P=MC=MR
The Individual firm and the Market
We can derive a market supply curve by adding up individual supply curves. Then we
combine this market supply curve with the market demand curve to get the market price,
which in turn, determines whether a perfectly competitive firm has enjoyed economic profit
or has suffered a loss.
Remember, MC curve crosses both the ATC and the AVC curves from below at their
minimum points and moves above.
Let us consider three cases:
1. P>minimum ATC: Profit maximizing case
2. minimum AVC<P<minimum ATC: Loss minimizing case
3. P<minimum AVC: Shutdown case
Note that only in case 1 and 2 does the MR=MC rule apply, in case 3, a perfectly
competitive firm will choose to produce nothing at all.
MC Curve and Short Run Supply Curve
The portion of the firm’s MC curve lying above its AVC curve ( ‘b’ and above) is its short-
run supply curve.
Profit Maximization in The Long Run
Some simplifying Assumptions:
The only long run adjustments relate to the entry and exit of firms
All firms have identical cost curves
The industry under discussion is a constant cost industry
After all long run adjustments are made, production takes place at,
P= minimum ATC (Productive Efficiency)
P=MC (Allocative Efficiency)
P=MR=MC= minimum ATC
The long run supply curve for a constant-cost industry is horizontal.
The long run supply curve for an increasing-cost industry is upward sloping.
The long run supply curve for a decreasing-cost industry is downward sloping.
Social Welfare Implications In Terms of Efficiency
Productive efficiency: P = minimum ATC
Goods are produced in the least costly way.
Allocative efficiency: Goods are allocated in the most efficient way, that is, no other
composition of total output can achieve a greater net gain for society as a whole.