1.5 Theory of the firm and market structures (HL only)

Goals of Firms

Perfect Competition

Assumptions of the mode: a large number of firms; a homogeneous product; freedom of entry and exit; perfect information; perfect resource mobility.

Each firm is aprice taker. There are so many firms in that industrythat each one produces an insignificantly small portion of total industry supplies, and therefore hasno power to effect the price of the product. The only thing that the firm can do is choose the quantity it produces. The demand curve the firm faces is horizontal.

There is complete freedom toenter the industry or market. This however only applies in the longrun.

All firms produce a homogenous product (indentical). The product is the same therefore there is no branding or advertising.

Producers and consumers have perfect knowledge of the market. Consumers know the price and quantity available at each seller. Furthermore, Producers are fully aware of prices costs and market opportunies.

The assumptions are very strict there most likely are no real-world cases, however some agricultural markets do come close.

Advantages of perfect competion: price is equal to the marginal cost of production (allocatively efficient MC=P), firms do not make an abnormal profit in the long run.

Revenue curves:

Profit maximization in the short run:

In the short run when one factors of production it is possible for a firm to make a supernormal profit. Consequently, the number of firms is fix.

The level of profit in the long run will affect entry and exit from the industry. If supernormal profits are made, new firms will be attracted into the industry which will cause the supply curve to shift to the right.

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Profit maximization in the long run:

Shut-down price and break-even price is the price at which will choose to shut down; in the short run it is where P= minimum AVC

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The break-even point in perfect competition is the price at which the firm makes normal profit, i.e. P=minimum ATC

In the short run, a loss-making firm tries to minimize its losses. Since it is in the short run, it has at least one fixed input, and therefore has fixed costs. If it shuts down, its losses will equal its fixed costs. If it can make losses smaller than its fixed costs by continuing to produce.

Average fixed costs =ATC-AVC

Long-run equilibrium of  firms in perfect competition



The firms are productively efficiency = producing at the lowest possible cost; occurs where production takes place at minimum ATC

The Firms are a allocatively efficient because the cost of producing the good or service is equal to its cost; occurs when MC


Monopolistic Competition

Assumptions of the model,

  • there are a large number of firms competing in the market, each firms has some degree of market power
  • firms are price makers they can choose the price at which they sell their goods. Each firm has a small share of the market as there are many firm presents.
  • There is freedom of entry of new firms into the industry. If any firm wants to set up business they will not face any barriers to entry.
  • Firms have some product differentiation (they do not make a homogenous product) which causes them to have a downward sloping demand curve, although it will be quite elastic due to the number of rivals

Examples of monopolistic competition: Restaurants, hairdressers and builders.

Revenue curves

Profit maximization in the short run

Profit maximization in the long run

Non-price competition

Monopolistic competition and efficiency

Monopolistic competition compared with perfect competition and monopoly


Assumptions of the model

Game theory

Open/formal collusion

Tacit/informal collusion

Non-collusive oligopoly


Assumptions of the model: For a firm to maintain its monopoly position, there must be barriers to entry of new firms. Barriers also exist under an oligopoly, but in a monopoly they must be high enough to completely block the entry of new firms.

Some barriers to entry

  • Economies of scale
  • Network Economies. When a product or service is used by everyone in the market, there are benefits to all users from having access to others. For example, ebay provides such large network economies, that it makes it very difficult for other online auction houses to compete.
  • Economies Of scope. A firm that produces a range of products is also likely to experience a lower average cost of production. For example, a large pharmaceutical company producing a range of drugs can use shared research.
  • Product differentiation and brand loyalty. If a firm produces a clearly differentiated product, where the consumer associates the product with thebramd, it will be very difficult for a new firm to break into that market.
  • Ownership of, or control over, key inputs of production. In some markets a firm may govern the supply of vital inputs,say byowning the sole supplier of some component part. For example, De Beers has a monopoly over diamonds since all diamonds producers market their diamonds through them
  • Ownership or control over wholesale or retail outlets. If a firm controls or owns all outlets through which a product can be sold. It can hinder potential rivals from gaining access to the consumer. Coca Cola gives stores free display units, however only Coca Cola products can be sold from them.
  • Legal Barriers  some firms may be granted a legal monopoly (patents for a drug)
  • Mergers and Takeovers.  The monopolist can put in a takeover bid for any new entrant. The mere threat discourages new entrants.
  • Aggressive tactics. A monopolist can sustain losses for a longer period of time than a new entrant. Thus it can start a price war,  have massive advertising campaigns .

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By definition there only one firm in the industry, consequently the industries demand curves is the same as the firm’s.  The demand curve of the firm will be relatively inelastic at each price due to the barriers to entry and product differentiation. A monopoly can raise its price and consumers will have no alternative industry to turn to. Monopolies are price makers unlike firms in perfect competition which are price takers.

As with firms in other market structures a monopolist will maximise profit where MR=MC.


Limit Pricing if the barriers to entry of new firms are not total and a very large abnormal profit is earned by the monopolist there is potential of rivals breaking into the industry. In such cases the monopolist will deliberately restrict the size of its profits in order not to attract new entrants.

Provided the price is kept below Pl,new firms cannot make a profit and will not enter the market.

Fears of government intervention to curb the monopolist’s practices may have similar restraining effect on the price that the monopolist charges.

Advantage of a monopoly


Higher price and lower output than under perfect competition. Economies of scale
Monopolies are electively inefficient and productively inefficient Innovation and new products. The promiseof supernormal profits, protected perhaps by patents, may encourage the development of new industries producing new products.
Possibility of higher cost curves due to lack of competition. Monopolies do not have incentive to be more efficient due to the large barriers to entry protecting supernormal profits.  This is often referred to as X inefficiency. The more comfortable the situation Dynamic efficiency – the possibility of lower cost curves due to more research and development and more investment. Due to the abnormal profits a monopoly is earning it is able to invest in new ways of manufacturing and shift the cost curves down.
Monopolies will cause an unequal distribution of income. The high profits of monopolist may be considered unfair, by competing firms or anyone on a low income. Competition for corporate control. Even though monopolies may not have to compete in the market they may face alternative competition from the financial markets. A monopoly with potentially low costs, which currently runs inefficiently is likely subject to a takeover bid from another company. Competition for corporate control  my thus force a monopoly to be efficient in order to avoid being taken over

Internal Economies of scale. It is a long run concept. It occurs when all factors of production are varaible. As the scale of output increases, there is a decrease in the long run average total cost of production. This process is also referred to as “Increasing returns to scale” There are 5 major types of internal economies of scale.

  1. Marketing economies of scale
    1. Advertising costs can be spread across products
    2. Bulk buying, if you buy more units the cost falls
  2. Technical Economies of scale
    1. The principle of multiples.
    2. This economy of scale is conserned with the reduction in the cost of production.
    3. Economies of increase dimensions. The law of increased dimensions applies mainly to transportation and distribution industries. It says that doubling the height and width of, for example, an inventory warehouse, leads to a more than proportionate increase in the cubic storage capacity of the building.
  3. Financial Economies of scale
    1. Firms can borrow money with a lower interest rate as they are seen as a less risky investment.
    2. Large firms can also sell shares when operating as public companies
  4. Managerial Economies of Scale.
    1. Large businesses can employ specialist staff (division of labour)
    2. Specialisation in management reduces cost because they are more efficient
  5. Risk bearing Economies of scale
    1. Large firms produce a variety of different goods this allows them to spread risks and thus lower the average cost of production.
    2. Examples of this are large conglomerates such as GE

Natural monopoly  is a type of monopoly that exists as a result of the high fixed costs or startup costs of operating a business in a specific industry. Additionally, natural monopolies can arise in industries that require unique raw materials, technology or other similar factors to operate. Since it is economically sensible to have some monopolies like these, governments allow them to exist but provide regulation, ensuring consumers get a fair deal.

Natural monopolies occur due to an industry’s high cost structure; in most cases, a single firm is able to supply a product or service at a lower cost than any potential competitor, and at a volume that can service an entire market. This makes pure natural monopolies very rare, but they do exist, and most often as a single player in an industry. But just because a company operates as a natural monopoly does not explicitly mean it is the only company in the industry. Since natural monopolies use an industry’s limited resources efficiently to offer the lowest unit price to consumers, it is actually advantageous in many situations to have a natural monopoly. In fact, a successful natural monopoly, such as a railroad company, becomes so efficient it is actually in a government’s best interest to help it flourish. Further, oftentimes an industry cannot support two or more major players, and a highly competitive market with unique resources and a high cost structure is unsustainable.


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If substantial economies of scale can be achieved by a monopoly then it may be a desirable to have a monopoly in an specific industry. For example, figure 6.11 shows two MC curves, if the mc curve of the monopoly is below the point x even when profit maximizing (MC=MR) it will be beneficial to the consumer to have a monopoly. As the profit maximising  price will be below that of one if the firms were perfectly competitive and the quantity will be higher.

Contestable market market theory is an economic concept that refers to a market in which there are only a few companies that, because of the threat of new entrants, behave in a competitive manner.

A market is only perfectly contestable when the cost of entry and exit by potential rials are nothing, and when such entry can be done fast. In such a case, the moment it becomes possible to earn an supernormal profit new firms will enter the market driving down the profits to a normal level. The sheer threat of this happening ensures that a firm in a perfectly contestable market will produce at ATC=AR.

Another way to say it is is important for there to be no sun costs or very low sunk costs in the industry. (sunk costs are costs that cannot be recouped. Examples could be very specialised machinery which cannot be resold easily)


When comparing

Contestable markets and natural monopolies.

The advantages and disadvantages of monopoly compared with perfect competition

Price Discrimination

Necessary conditions for the practice of price discrimination

Types of price discrmination

Alternative goals of firms

Growth maximization. Growth maximization Firms may be interested in maximizing growth (in terms of the quantity of output produced) rather than profits (i.e. give up some profit for the sake of more growth). Advantages of greater growth include achievement of greater economies of scale hence lower average costs, greater diversification into other products, greater market power(=ability to influence price) and lower risk of take-overs by other firms.

Managerial utility maximization. Large firms run by managers who are no the owners may try to maximize their personal utility by giving themselves larger benefits, such as higher salaries, use luxurious company cars and expense accounts, all of which will reduce profits.

Satisficing.  This is an alternative to maximizing behavior. Firms have many different goals, some of which may conflict, and they may not want to “maximize· anything(profit, revenue, growth, managerial utility) that could give rise to a significant sacrifice of something else. They may prefer a strategy that makes compromises among different objectives and achieves a satisfactory outcome with respect to all the important goals.

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