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Chapter 9

ECO100Y1 Chapter 9 Notes

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University of Toronto St. George
Robert Gazzale

ECO100Y1 Textbook Notes Chapter 9 9.1 Market Structure and Firm Behaviour  Market structure: all features of a market that affect the behaviour and performance of firms in that market, such as the number and size of sellers, the extent of knowledge about one another’s actions, the degree of freedom of entry, and the degree of product differentiation.  Market power: the ability of a firm to influence the price of a product or the terms under which it is sold.  A market is said to have a competitive structure when its firms have little or no market power (the more market power, the less competitive the market structure).  Perfectly competitive market structure: each firm has zero market power. There are so many firms in the market that each must accept the price set by the forces of market demand and market supply. o One firm’s ability to sell its product does not depend on the behaviour of any other firm; thus they do not actively compete with each other.  Competitive behaviour: the degree to which individual firms actively vie with one another for business.  Firms that compete actively with each other do no operate in perfectly competitive markets.  The details of market structure determine how we get from the industry demand curve to the demand curve facing any individual firm in that industry.  Market structure plays a central role in determining the behaviour of individual firms and also in the overall efficiency of the market outcomes. 9.2 The Theory of Perfect Competition  Perfect competition: a market structure in which all firms in an industry are price takers and in which there is freedom of entry into and exit from the industry.  The theory of perfect competition is built on a number of assumptions relating to each firm and to the industry as a whole: o All firms in the industry sell an identical product. Economists say that the firms sell a homogeneous product. o Consumers know the nature of the product being sold and the prices charged by each firm. o The level of each firm’s output at which its long-run average cost reaches a minimum is small relative to the industry’s total output (each firm is small relative to the size of the industry). o The industry is characterized by freedom of entry and exit; any new firm is free to enter the industry and start producing if it so wishes, and any existing firm is free to cease production and leave the industry. Existing firms cannot block the entry of new firms, and there are no legal prohibitions or other barriers to entering or exiting the industry.  Price taker: a firm that can alter its rate of production and sales without affecting the market price of its product. o The firm must passively accept whatever happens to be the market price, but can sell as much as it wants.  Degree of market power: the difference between the wheat farmers (perfectly competitive market) and American Express or Visa (not perfectly competitive).  Even though the demand curve for the entire industry is negatively sloped, each firm in a perfectly competitive market faces a horizontal demand curve because variations in the firm’s output have no significant effect on price.  Total revenue (TR): total amount received by the firm from the sale of a product; price x quantity.  Average revenue (AR): the amount of revenue per unit sold; total revenue / quantity.  Marginal revenue (MR): the change in a firm’s total revenue resulting from a change in its sales by one unit.  If the market price is unaffected by variations in the firm’s output (price- taker), the firm’s demand curve, its average revenue curve, and its marginal revenue curve all coincide in the same horizontal line (D = AR = MR = P). 9.3 Short-Run Decisions  Rule 1: A firm should not produce at all if, for all levels of output, the total variable cost of producing that output exceeds the total revenue from selling it. Equivalently, the firm should not produce at all if, for all levels of output, the average variable cost of producing the output exceeds the market price.  Shut-down price: the price that is equal to the minimum of a firm’s AVCs. At prices below this, a profit-maximizing firm will shut down and produce no output.  Rule 2: If it is worthwhile for the firm to produce at all, the firm should produce the output at which marginal revenue equals marginal cost. o If MR > MC more should be produced. o If MR < MC less should be produced.  A profit-maximizing firm that is operating in a perfectly competitive market will produce the output that equates its MC of production with the market price of its product (as long as price > AVC).  The perfectly competitive firm adjusts its level of output in response to changes in the market-determined price.  A competitive firm’s supply curve is given by the portion of its marginal cost curve that is above its average variable cost curve.  The industry’s supply curve is the horizontal sum of the supply curves of each of the firms in the industry (i.e. how much each will supply at a given price added and becomes the quantity in the industries supply curve).  The industry supply curve is sometimes called a short-run supply curve because it is based on the short-run, profit-maximizing behaviour of all the firms in the industry.  The collective actions of all firms in the industry ( as shown by the industry suppl
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