Micro Economics: Chapter 6:
Profit Maximising under Perfect
Competition and Monopoly
Profits are maximised when MC = MR.
6.1 Alternative market structures
Perfect competition A market structure where there are many firms, none of which is large;
where there is freedom of entry into the industry; where all firms produce an identical
product; and where all firms are price takers.
Monopoly A market structure where there is only one firm in the industry. (Note that this is
the economic definition of a pure monopoly. In UK competition law, the part that applies to
the abuse of monopoly power covers firms that are in a position of ‘market dominance’.
Such firms will have a large share, but not necessarily a 100 per cent share, of the market.
See Chapter 13 for more on this.)
Monopolistic competition A market structure where, as with perfect competition, there are
many firms and freedom of entry into the industry, but where each firm produces a
differentiated product and thus has some control over its price.
Oligopoly A market structure where there are few enough firms to enable barriers to be
erected against the entry of new firms.
The market structure under which a firm operates will determine its behaviour. This
behaviour (conduct) will in turn affect the firm’s performance: its prices, profits, efficiency,
etc. The collective conduct of all the firms in the industry will affect the whole industry’s
performance.
Structure Conduct Performance
Imperfect competition The collective name for monopolistic competition and oligopoly.
, 6.2 Perfect competition
Assumptions of perfect competition
The model of perfect competition is built on four assumptions:
- Firms are price takers
- There is complete freedom of entry into the industry for new firms
- All firms produce and identical product (homogeneous)
- Producers and consumers have perfect knowledge of the market
Advantages such as keeping prices down to marginal cost and preventing firms from making
supernormal profit over the long run.
The short run and the long run
Short run under perfect competition The period during which there is insufficient time for
new firms to enter the industry.
In the short run, the number of firms is fixed.
Long run under perfect competition The period of time that is long enough for new firms to
enter the industry.
In the long run the level of profits affects entry and exit from the industry.
Rate of profit Total profit (TΠ) as a proportion of the capital employed (K): r = TΠ/K.
Whether the industry expands or contracts in the long run will depend on the rate of profit.
The short-run equilibrium of the firm
Price
The price is determined in the industry by the intersection of demand and supply.
Output
The firm will maximise profit where marginal cost equals marginal revenue (MR = MC).
Profit
If the average cost (AC) curve (which includes normal profit) dips below the average revenue
(AR) ‘curve’, the firm will earn supernormal profit. Supernormal profit per unit at Qe is the
vertical difference between AR and AC at Qe. Total supernormal profit is the shaded
rectangle in Figure 6.1.
What happens if the firm cannot make a profit at any level of output? This situation would
occur if the AC curve were above the AR curve at all points. This is illustrated in Figure 6.2,
where the market price is P1. In this case, the point where MC = MR represents the loss-
minimising point (where loss is defined as anything less than normal profit). The amount of
the loss is represented by the shaded rectangle.
It will shut down in the short run only if the market price falls below P2 in Figure 6.2.
Profit Maximising under Perfect
Competition and Monopoly
Profits are maximised when MC = MR.
6.1 Alternative market structures
Perfect competition A market structure where there are many firms, none of which is large;
where there is freedom of entry into the industry; where all firms produce an identical
product; and where all firms are price takers.
Monopoly A market structure where there is only one firm in the industry. (Note that this is
the economic definition of a pure monopoly. In UK competition law, the part that applies to
the abuse of monopoly power covers firms that are in a position of ‘market dominance’.
Such firms will have a large share, but not necessarily a 100 per cent share, of the market.
See Chapter 13 for more on this.)
Monopolistic competition A market structure where, as with perfect competition, there are
many firms and freedom of entry into the industry, but where each firm produces a
differentiated product and thus has some control over its price.
Oligopoly A market structure where there are few enough firms to enable barriers to be
erected against the entry of new firms.
The market structure under which a firm operates will determine its behaviour. This
behaviour (conduct) will in turn affect the firm’s performance: its prices, profits, efficiency,
etc. The collective conduct of all the firms in the industry will affect the whole industry’s
performance.
Structure Conduct Performance
Imperfect competition The collective name for monopolistic competition and oligopoly.
, 6.2 Perfect competition
Assumptions of perfect competition
The model of perfect competition is built on four assumptions:
- Firms are price takers
- There is complete freedom of entry into the industry for new firms
- All firms produce and identical product (homogeneous)
- Producers and consumers have perfect knowledge of the market
Advantages such as keeping prices down to marginal cost and preventing firms from making
supernormal profit over the long run.
The short run and the long run
Short run under perfect competition The period during which there is insufficient time for
new firms to enter the industry.
In the short run, the number of firms is fixed.
Long run under perfect competition The period of time that is long enough for new firms to
enter the industry.
In the long run the level of profits affects entry and exit from the industry.
Rate of profit Total profit (TΠ) as a proportion of the capital employed (K): r = TΠ/K.
Whether the industry expands or contracts in the long run will depend on the rate of profit.
The short-run equilibrium of the firm
Price
The price is determined in the industry by the intersection of demand and supply.
Output
The firm will maximise profit where marginal cost equals marginal revenue (MR = MC).
Profit
If the average cost (AC) curve (which includes normal profit) dips below the average revenue
(AR) ‘curve’, the firm will earn supernormal profit. Supernormal profit per unit at Qe is the
vertical difference between AR and AC at Qe. Total supernormal profit is the shaded
rectangle in Figure 6.1.
What happens if the firm cannot make a profit at any level of output? This situation would
occur if the AC curve were above the AR curve at all points. This is illustrated in Figure 6.2,
where the market price is P1. In this case, the point where MC = MR represents the loss-
minimising point (where loss is defined as anything less than normal profit). The amount of
the loss is represented by the shaded rectangle.
It will shut down in the short run only if the market price falls below P2 in Figure 6.2.
