Goal of the firm
1. Profit maximization
This occurs at the level of output where profits cannot be increased any further ie
MR>MC. Profit maximization occurs where MR=MC.
2. Growth – Businesses want to increase their size
3. Sales and Revenue Maximization – firms are prepared to accept a lower price and
produce above the profit maximization output in order to increase its market
4. Market Dominance – The pursuit of sales or revenue maximization
5. Satisficing – Making reasonable profits that is sufficient to satisfy the
shareholders as well as to keep the work force and consumers happy.
Total Revenue – the firm’s total earnings per period from the sale of particular amounts
of output. TR = P x Q
Average Revenue – earnings per unit TR/Q
Marginal Revenue – The additional revenue from the sale of an additional product.
This occurs when revenue is greater than cost. It is the minimum return the owner must
make in order to remain in business. There are two types of profit namely normal and
abnormal (pure/economic/supernormal/excess) profits.
Normal Profits (MR =MC)
The opportunity cost of being in business ie the profit that could have been made
in the next best alternative business. It is the profit necessary to persuade firms to
stay in business in the long run but not enough to attract new firms to the industry.
If normal profits are not being made in the long run it would be best to shut down
TR>TC or MR>MC. This is where profits are greater than normal. In the long run new
firms are attracted to the industry.
Loss TC>TR or MC>MR
Less than normal profits. Firms want to leave the industry.
The characteristics of a market that influence the behaviour and performance of firms that
sell in the market
1. Perfect competition
3. Monopolistic competition
A market that consists of a large number of firms producing an homogeneous product.
This market structure does not really exist.
1. There are many suppliers who do not own a significant share of the market.
Therefore firms do not have control over price and are considered price takers.
2. Products are identical. Therefore they are perfect substitutes for each other.
3. Consumers have perfect information about prices. Therefore firms cannot charge
a higher price as consumers can easily find cheaper substitutes for the ruling
4. All firms have equal access to resources
5. No barriers to entry and exit in the long run. This cause firms to only make
normal profits in the long run.
Firms can sell any amount at the existing market price as they are price takers. Revenue
is the market price and quantity produced. TR = PxQ. For instance if the price of Pepsi
Bubbla is $50 and 20 Bubblas are produced then TR is $50 x 20 = $1000. Note that MC
varies with output firms will continue producing in the short run as long as MC is equal
to market price and in the long run as long as market price is greater than the AVC. Profit
is maximized where MR=MC=P. The market sets the price so in order to increase sale
the produce has to supply and sell large amounts. A firm operating under Perfect
Competition will always produce at the level of output where the MC of the last unit
produced is just equal to the market price.
The industry sets the price through the forces of demand and supply. The firms will then
have to sell at this price. Any amount of output can be sold at this price (perfect
elasticity). If one firm were to increase the price consumers would not buy their products
and if the firm were to sell at a lower price it would loose. Therefore it would be best to
sell at the market price. Abnormal profits can be made in the short run.
Price is constant therefore AR=MR. Profit maximization occurs where MR=MC. The
profit maximization quantity is Q1. Price in greater than average cost therefore abnormal
profits are made. However if the market price is lower than the AC then losses would
occur in the short run.
Firms may also make normal profits in the short run.
Long run curves
In the long run abnormal profits will attract new firms to the industry because there are
no barriers and firms have perfect knowledge of what is happening in the market causing
supply to increase forcing down the market price, demand increases to AR2 = MR2.
Abnormal profits will be competed away or exhausted and only normal profits (zero
economic profits) are made. Existing firms will remain in the industry; however no new
firms will enter the industry.
As it relates to losses in the short run, in the long run firms will exit the industry shifting
the supply curve to the left. Price will increase until normal profits are made.
Long run industry supply curve
Constant cost – more is supplied at the same price in the long run. The curve is
horizontal. Demand increases and abnormal profits are made. New firms enter the
industry shifting the supply curve to the right until the price returns to its old level.
As firms expand/buy new technology they experience economies of scale. Price falls. In
the long run the supply curve slopes downwards, more is supplied at a lower price in the
As new firms enter the industry price/cost of raw materials increase, more is supplied at a
higher price in the long run. The long run supply curve slopes upwards.
Short run – price must cover AVC. Supply is MC above AVC. If this is not happening
Long run – Firms must cover AC or ATC. Supply is MC above ATC or AC. If this is not
happening shut down.
Benefits of Perfect Competition
1. In the long run firms only make normal profits which is good for the consumer
2. They are allocative efficient as they produce where P=MC
3. They are productive efficient as they produce at the lowest possible cost per unit
ie the bottom of the AC
4. More efficient firms make abnormal profits in the short run so it is an incentive
for firms to be innovative and efficient.
1. Firms cannot afford research and development to earn economies of scale in the
long run because only normal profits are made in the long run
2. Firms lack variety
3. Firms are too small to have any dominance over the market.
Comparing total revenue with total cost to get the largest possible positive difference
ie TR>TC. (see cape book page 101- 102)
Compares the addition profit form the production and sale of an additional product.
This is the most widely used method of determining profit maximization. MR>MC
firm can produce more, MR<MC profits are falling so reduce production, MR=MC
profit is maximized. (see cape book page 102- 103)
Monopoly is characterized by the absence of competition. It is a situation where single
company owns all or nearly all of the market for a given type of good or service. The
firms are able to operate without competition by establishing barriers to entry.
Reasons for the existence of monopolies/ Barriers to entry
1. Secret formula that no other competitor or potential competitor is able to breach.
The firm may patent its unique formula for instance KFC
2. Access to strategic raw materials
3. The size of the market allows for only one firm to subsist. These monopolies are
called natural monopolies eg public utility firms in CARICOM
4. An industry may have more than one firm. However the most efficient firm with
the largest resource base can charge a lower price for its commodity compared to
its rival. Through what is known as limit pricing the most efficient firm can outcompete its rivals and gain control of the market. A more established firm can
build their goodwill and establish credit ratings to obtain preferential access to
credit from financial institutions.
5. The government may offer permission to franchise for instance KFC is owned by
Prestige Holdings in T&T.
6. Economies of scale
7. mergers and takeovers
8. Product loyalty
9. Intimidation and aggressive tactics
Sources of monopoly
1. Natural monopolies
2. Capital requirement – expensive to set up (nuclear plant)
3. Technological – reduces cost per unit
4. Legal - government grants patent or copyrights
5. Public- monopoly by law like the post office
1. There is one seller and many buyers therefore monopolies have significant control
over price. Hence they are price makers. They can increase prices at anytime
unlike those firms operating under perfect competition.
2. The product is unique and does not have close substitutes. JPS, NWC
Profit Maximizer: Maximizes profits where MR=MC
4. High Barriers to entry and exit: Other sellers are unable to enter the market of the
monopoly to compete away their supernormal profits made in the short run.
5. Price Discrimination: A monopolist can change the price and quality of the
product. He sells more quantities charging less for the product in a very elastic
market and sells less quantities charging high price in a less elastic market.
6. The demand curve tends to be downward sloping and more inelastic than the
The demand curve
The firm and industry demand curve is the same. It is downward sloping which
means in order to sell more market price must fall. The downward sloping curve
means that MR curve at the firm diverges from the AR curves. The MR falls below
the AR or demand curve unlike perfect competition where MR=AR=D.
AR and MR
Total Revenue curves
In the elastic portion of the curve MR is positive and so increasing quantity increases
TR. But where demand is price inelastic MR is negative and increases in quantity
produced reduces TR. Where elasticity is 1 MR is zero TR is at its highest. The
monopolist should therefore operate along the elastic portion of the curve.
The monopolist's profit maximizing level of output is found by equating its marginal
revenue with its marginal cost, which is the same profit maximizing condition that a
perfectly competitive firm uses to determine its equilibrium level of output. Indeed,
the condition that marginal revenue equal marginal cost is used to determine the
profit maximizing level of output of every firm, regardless of the market structure in
which the firm is operating.
Short run equilibrium of the firm and industry
The monopoly like ant other firm maximizes profits where MR=MC so it would be
ideal to sell at this price. However, in order to make abnormal profits the firm will
sell Qm at Pm which is above the AC curve. These abnormal profits may remain in
the long run because of barriers to entry and imperfections in the market.
The firm may make normal profits where AR=AC
It is also possible for monopolies to make losses where AC is greater than AR
The long run position of the monopolist
Barriers to entry and imperfect knowledge cause abnormal profits to remain in the
Monopoly and deadweight loss
This occurs because the monopoly produces less at a higher price unlike the perfect
competitor who produces where MC=AR=D. The monopoly is therefore allocative
inefficient because P>MC resulting in deadweight loss.
Advantages of monopoly
A monopoly enjoys economics of scale as it is the only supplier of product or
service in the market. The benefits can be passed on to the consumers.
Due to the fact that monopolies make lot of profits, it can be used for research and
development and to maintain their status as a monopoly.
Monopolies may use price discrimination which benefits the economically weaker
sections of the society. For example, Indian railways provide discounts to students
travelling through its network.
Monopolies can afford to invest in latest technology and machinery in order to be
efficient and to avoid competition.
Monopoly avoids duplication and hence wastage of resources.
They are allocative inefficient as P>MC which cause market failure
They are productive inefficient as they do not produce at the bottom of the ATC
Compared to s perfectly competitive industry with the same cost and demand
conditions, the monopolist will charge a higher price for less output.
Poor level of service, inefficiency and complacency
No consumer sovereignty.
Consumers may be charged high prices for low quality of goods and services.
Lack of competition may lead to low quality and out dated goods and services.
An industry in which the firm produces enough to meet the entire demand at a lower
cost than two or more other firms. Left unregulated it produces where P=AR;
regulated it produces where P=MC. The size of the market allows for only one firm to
subsist eg public utility firms in CARICOM. An industry in which economies of scale
makes it possible for a firm to dominate the entire market as a result of a AC. This
type of monopoly is especially likely to occur if the market is small. The firm does
not have to be large but its size relative to the total market demand for the product
Supernormal profits are made when only one firm is in the industry but when another
firm enters the industry they may have to share the market the demand curve may
pivot inwards and both firms may end up losing.
New Entrants and the existing monopoly
The existing firm set their prices below the average cost of the new entrant making it
difficult for the firm to survive in the industry.
Where the same commodity is sold to different consumers in different markets for
different prices for reasons that have nothing to do with cost, for this to occur:
1. Markets must be separable , with different price elasticities of demand
2. Arbitrage (taking advantage of a price difference between two or more markets)
must not be possible.
First-degree price discrimination
The seller can charge each consumer the maximum amount they are willing to pay for
each unit of the product purchased. The producer gets the entire consumer surplus. For
instance doctor charges his patient based on the patient’s perceived willingness and
ability to pay. This is perfect discrimination because the firm has perfect knowledge
about their consumers and uses this knowledge to receive the highest payment possible.
Second-degree Price discrimination
This is called quantity discrimination. The firm does not have perfect knowledge of the
consumer. This is where the consumer is charged different prices based on the quantity of
the commodity purchased. The consumer will pay more for the first unit of the
commodity and less for successive units of the commodity, so they may want to pay $60
for the on unit of water but $40 for each unit of water when buying a case of water. You
tend to pay relatively less for a larger soda than a smaller one.
Third-degree price discrimination
This is the most common type where distinct prices are charged in each of the different
markets. The monopolist can only discriminate if the elasticity of demand can be
identified and exploited. The monopolist can charge the highest price in the market for
which demand tends to be inelastic than in the market where demand is elastic.
Quantity supplied for each market is where MC= MRa = MRb. However in market ‘a’
the firm can charge as much as P to earn a greater revenue than in market ‘b’ where it can
charge as much as P2.
This is a market structure in which large number of firms produces differentiated
products but compete for the same consumers. Examples:
The restaurant business
Hotels and bars
General specialist retailing
Consumer services, such as hairdressing
1. Large number of buyers and sellers. Each firm controls a small portion of the
market. Each firm act independently of each other in terms of pricing and output
2. Weak barriers to entry and exit
3. Perfect knowledge of the market
4. products are differentiated
5. Firms are price makers
6. Firms advertise
7. The demand curve is downward sloping and fairly elastic
Nature of the product
Product differentiation means that products have attributes which make them different
for instance in terms of material used to produce the good, colour, taste etc. There
may be a perceived difference as a result of advertising. The aim of differentiation is
for the consumer to think that the product is unique. Product differentiation implies
that the products are different enough that the producing firms exercise a “minimonopoly” over their product this depends on the company’s success at
differentiation. The firms compete more on product differentiation than on price.
Entering firms produce close substitutes, not an identical or standardized product.
The firm has multiple dimensions
One dimension of competition is product differentiation.
Another is competing on perceived quality.
Competitive advertising is another.
Others include service and distribution outlets.
Profit is maximized where MR=MC
Like a monopoly
The monopolistic competitive firm has some monopoly power so the firm faces a
downward sloping demand curve
Marginal revenue is below price
At profit maximizing output, marginal cost will be less than price
Like a perfect competitor, zero economic profits exist in the long run
A monopolistically competitive firm prices in the same manner as a monopolist—
where MC = MR.
But the monopolistic competitor is not only a monopolist but act like a perfect
competitor as well.
In the short run the firm can make abnormal profits though product development and
advertising. However if the addition cost of advertising is greater than the additional
revenue from advertising then losses will occur. Normal profits can also be made in
the short run.
Profit is maximized where MR=MC. Supernormal profit are made in the short run.
The size of this profit depends on the strength of demand, the elasticity of demand,
and the uniqueness of the product.
1. At equilibrium, ATC equals price and economic profits are zero.
2. This occurs at the point of tangency of the ATC and demand curve at the output
chosen by the firm.
In the long run new firms enter the industry and abnormal profits are competed away.
The firm attempts to establish its product as a different product from that offered by
Differentiation means that in the consumer’s mind, the product is not the same.
Marketing is often the key to successful differentiation. Firms may differentiate
products by perceived quality, reliability, colour, style, safety features, packaging,
purchase terms, warranties and guarantees, location, availability (hours of
operation) or any other features.
Brand names may signal information regarding the product, reducing consumer
risk. A brand name is valuable to a firm; it makes the demand less elastic and can
enable the firm to earn higher profits. Once a consumer has had a positive
experience with a good, the price elasticity of demand for that good typically
decreases—the consumer becomes loyal to the product.
Monopolistic competitive firms are allocatively inefficient because P>MC and
productively inefficient since they are not producing at their lowest cost per unit ie the
Advantages of Monopolistic Competition
1. The Promotion of Competition (lack of Barriers to Entry)
2. Differentiation Brings Greater Consumer Choice and Variety
3. Product and Service Quality – Development – greater incentive to increase this to earn
4. Consumers become more knowledgeable of products through marketing and
1. They can be wasteful -- Liable of Excess Capacity - Some firms don't produce enough
output to efficiently lower the average cost and benefit from economies of scale and
reduces their economic profits. The cost of packaging, marketing and advertising can be
considered extremely wasteful on some levels.
2. Allocatively Inefficient
3. Higher Prices
4. Advertising - It distorts what consumers’ desire, as well as reduces competition as
consumers become captivated over the perception of differentiation.
Limitations of Monopolistic Competition
1. Firms do not have perfect knowledge of the market
2. It is impossible to derive an industry demand curve because products are
3. The firm may take part in non-price competition in order to maximize profits
4. Entry is not completely unrestricted because some firms have cost advantages or
their products are difficult to duplicate.
5. It may be difficult to forecast the effects that product development and advertising
will have on demand
6. Advertisements may have different effects at different price levels and different
profit maximization points
Oligopoly refers to a market with "few sellers". Oligopolies interact among
themselves. When an oligopolist changes a price, it must take into account how other
firms in the industry will respond. Within an oligopoly, the products can be similar or
differentiated. Oligopoly markets have high barriers to entry.
Examples of Oligopoly
Characteristics of Oligopoly
1. Industry dominated by small number of large firms - Supply is concentrated in the
hands of a relatively few firms.
2. Many firms may make up the industry
3. High barriers to entry - Substantial barriers, similar to monopoly but not as
restrictive may be present. Oligopolies are large firms and benefit from economies
of scale. It takes considerable “know-how” and capital to compete in this industry.
e.g. Petroleum or oil industry. In the long run dominant firms can maintain
4. Products could be highly differentiated – branding or homogenous Homogeneous product- pure oligopoly. e.g. Raw materials (oil, petrol, tin).
Differentiated product- imperfect/ differentiated oligopoly. e.g. (Cars, detergent)
5. Non–price competition - Compete not through price but other methods
(advertising, after-sales service, free gifts). Practiced by oligopoly and
monopolistic competition. Various forms:
a. Competitive advertising – to reinforce product differentiation and harden
b. Promotional offers – e.g.. Household detergent, toothpaste, shampoo (buy
2 get 1 free), (25% extra at no extra cost).
c. Extended guarantees/after sales service – esp. for consumer durables, by
offering free spare parts, labour guarantee.
d. Better credit facility
e. Attractive gift wrappings
6. Price stability within the market - kinked demand curve? - Prices are very
inflexible. Despite changes in underlying costs of production, firms are often
observed to maintain prices at a constant level. The kinked demand curve theory
is used to show price rigidity in an oligopoly market structure.
7. Potential for collusion? - Make agreement amongst them so as to restrict
competition and maximize their own benefit.
8. High` degree of interdependence between firms - Oligopoly firms are large
relative to the market in which they operate. If one oligopoly firm changes its
price or its market strategy, it will significantly impact the rival firms. E.g. if
Pepsi lowers its price to 60 dollars a bottle, coco cola will be affected. If coco cola
does not respond, it will loose significant market share. Therefore coco cola will
most likely lower its price too. In oligopoly a firm not only considers the market
demand for its products but also the reaction of other firms in the industry.
1. When firms collude – monopoly –supernormal profit – extra profit – extra capital –
to fund R&D – benefit to consumer.
2. Product differentiation – non-price competition– greater variety to consumers.
3. Price stability/rigidity – helps in planning, reduce uncertainty.
1. Collusive oligopoly - if they agree upon output – no variety and improvement in
quality – bad for consumers.
2. Acting like a monopoly
Restrict output and charge a higher price
Consumer sovereignty not respected
Greater inequality in income (supernormal profits)
Non-price competition (Collusion)
Oligopolies have strong incentives to collude or form Cartels ( a formal collusive
agreement) because while acting together, they can restrict output and set prices
so that abnormal economic profits are earned. The individual oligopolist has an
incentive to cheat because the firm's demand curve is more elastic than the overall
market demand curve. By secretly (tacitly) lowering prices, the firm can sell to
customers who would not buy at the higher price, as well as to customers who
normally buy from the other firms.
The companies act like a single firm. The cartel as a whole will sell at P0 with a perunit cost of A0 resulting in the cartel earning supernormal profits.
Oligopolistic agreements tend to be unstable due to these conflicting tendencies.
Obstacles to collusion
1. Low entry barriers
Particularly as time goes on, more firms will be attracted to the potential economic
profits, which will not be sustainable. For example, the OPEC's raising of oil prices
during the 1970s and early 1980s enticed more non-OPEC producers to produce
more. The market share of OPEC producers was drastically reduced and they had to
reduce prices in order to gain market share. In the long run, cartels are not usually
successful at raising prices.
2. Antitrust laws
These laws prohibit collusion. Although firms may make secret agreements, those
agreements will not be enforceable in a court of law.
3. Unstable demand conditions
These laws prohibit collusion. Although firms may make secret agreements, those
agreements will not be enforceable in a court of law.
4. Increasing the number of firms
An increasing number of firms in an oligopolistic industry will make agreements
harder to discuss, negotiate and enforce. Differences of opinion are more likely. As
the number of firms in the industry increases, the industry will behave more like a
5. Difficulties with detecting and stopping price cuts
These difficulties will undermine effective collusion. Sometimes oligopolistic firms will
cheat by enacting quality improvements, easier credit terms and free shipping. If quality
changes can be used to compete, collusive price agreements will not be effective.
Non-collusive Behaviour (the Kinked Curve)
This model recognizes that demand for a firm’s product is determined both by the market
demand for a product as well as by rival firm’s behavior. Firms compete for consumers.
The demand curve has two distinct parts that are relatively elastic and relatively inelastic.
The firm sells Q0 at P0. If the firm were to increase price above P0, other firms will not
respond cause the firm to loose a substantial amount of its market share. But if the firm
were to decrease it price below P0 then other firms would do the same in order for them
not to loose their market share. This would lead to small increases in output along the
inelastic segment of the demand curve.
The Kinked Curve
The non-collusive firm and MC and MR
The MR will have a kink at Q0 which corresponds to the point where the demand curve
is kinked. The profit maximization point is Q0 where the MC cuts the MR anywhere
within the break or gap. Although the cost level changes that is MC1 moves from MC0 to
MC the market price of the commodity remains the same. Therefore oligopolists are
characterized by price stickiness and therefore are more likely to engage in non-price
competition rather than compete on the basis of price.
Game Theory applied to oligopoly
Firms consider their rival when making policy decisions. Game theory is useful in
Concentration ratio – the proportion of market share accounted for by top X number
E.g. 5 firm concentration ratio of 80% - means top 5 five firms account for
80% of market share
3 firm CR of 72% - top 3 firms account for 72% of market share
e.g. The music industry has a 5-firm concentration ratio of 75%. Independents make up
25% of the market but there could be many thousands of firms that make up this
An oligopolistic market structure therefore may have many firms in the industry
but it is dominated by a few large sellers.
Barriers to entry and
Control over the
entry and exit
No firm has
market and price
sets the price.
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and set prices
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are a large
firms. In the
in the long
but similar to
Nature of the goods
Price is at AR
etc. has to
is based on
reduce cost to
Number of buyers
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of buyer and
profit in both
profits only in
profit in the
the short run
the short run
short run and
made but in
and the long
as in the long
the long run
run new firms
to normal i.e
the short run.
the short run.
efficient as it
capacity in the
produce at the
long run as
the long run
bottom of the
as output is
efficient as it
An industry in which the firm produces enough to meet the entire demand at a lower cost
than two or more other firms. Left unregulated it produces where P=AR; regulated it
produces where P=MC
3 approaches to determine pricing
1. Do nothing - the firm produces the monopoly output and charges the monopoly price
2. P=MC – efficiency as a larger output is available at a lower price. However the firm
cannot cover its cost of production and will have to be subsidized.
3. P=AC the firm breaks even but efficiency is not achieved.
Concentration Ratio and Herfindahl Hirschman Index (HHI)
Concentration Ratio is usually used to show the extent of market control of the largest
firms in the industry. It is the combined production of the leading 4 or 8 firms in the
The percentage of sales of the 4 or 8 largest firms in the industry.
Formula: Sum of the market share of the leading firms/Total market share X 100%
Procedure for calculating concentration ratio
Total the amount of production/sales for the entire market
Find the share of the market each firm has
Add up the market share of the 4 or 8 firms
Interpretation – 0 -40% low concentration (perfect competition)
40 – 60% medium/moderate concentration (monopolistic competition)
60 -100% high concentration (oligopoly, monopoly)
Herfindahl Hirschman Index (HHI)
The square of the percentage market share of each firm summed over all the firms
Steps – 1. Square the market share of each firm
2. Sum the squared market share of the firms
Interpretation – 0 -1000 or 0.01 low concentration (perfect competition)
1000 ( 0.01) – 1800 (0.18) medium/moderate concentration (monopolistic
1800 (0.18) or more high concentration (oligopoly, monopoly)
In the traditional model of oligopoly it is assumed that there are barriers to entry; in
reality it is likely that other firms can enter the market ie it is possible for competition to
increase within them and this puts pressure on existing firms to behave efficiently.
Firms may act in a competitive manner even when producers are few if the market is easy
to enter. High profits will attract new firms to the industry therefore existing firms must
1. freedom of entry and exit
2. The number of firms competing will vary eg. It may be a monopoly at one time
and then there may be many other firms competing at other times
3. firms compete
For contestable markets, abnormal profits are earned in the short run which attracts other
firms to the market and in the long run only normal profits are earned.
A perfectly contestable market is one in which the costs of entry and exit is zero. Firms
must be competitive; abnormal profit will attract more firms to the industry leading to
lower prices, better quality service, more choice and higher output. Eg banking, in
particular internet banking.
Sunk cost deters entry into the market and make it less contestable.
Hit and run - when firms enter a market and target a particular niche (segment) rather
than compete throughout the market.