6.

0 THEORY OF FIRMS
Pricing decisions depends on environment
in which firm operates. It depends on the
market structure.
Four types of market structure:
1. Perfect Competition
2. Monopoly
3. Monopolistic competition
4. Oligopoly
PERFECT COMPETITION
Characteristics:
a)
Many small sellers and each firm produces a
small unit of output. A firm is a price-taker.
b)
Many small buyers-no buyer is Able to
influence price
c)
Product is standardized.
d)
Easy entry and exit.

Price of a firm is determined by the industry.

Individual firm cannot determine its own
P
price.
S

D=MR
D
Qty

Qty

SHORT RUN EQUILIBRIUM FOR

PERFECT COMPETITIVE FIRM
-To maximize profit: Firm should produce
output at:
MR = MC
Since MR=P for Perfect competitive firm;
Profit maximizing condition is when: P= MC
P

MC
D=AR=MR

Q*

Qty

Three possible conditions in the short run:

a) Supernormal profit
P= MC and
P> AC or TR >TC
Firm experience short run profit
Diagram
b) Normal profit
P= MC and
P= AC or TR =TC
Firm experience zero profit
Diagram
c) Sub-normal profit
i) Loss but can still produce
P= MC and
P< AC or TR < TC
P > AVC
Firm experience short run loss
Diagram
3

ii) Shut Down

P= MC and
P< AC or TR <TC
P< AVC
Firm should shut down the business.
Diagram
Exercise 1:
P=RM 80
TC= 800+ 5Q + 0.5Q2
P= MC
80= 5 +Q
Q =75
Total profit=TR-TC
=RM 2012.5
4

LONG RUN EQUILIBRIUM FOR

PERFECT COMPETITION
Suppose short run profit- entry into the industry
Increase number of sellers
Increase market supply
Reduce price until it
eliminates profit
Zero profit (P= AC) in
long run equilibrium
Diagram
e.g: AC= 1000/Q +200 +2Q
d(AC)/dQ=0 Q=22.4, AC=289.4 P=AC=
289.4