2.11.5 Degrees of market power

Interpreting Figure 1

Figure 1 illustrates three firms in perfect competition markets in the short-run:

1. One making normal profits.
2. One making abnormal profits.
3. One making losses.

The axis

1. The x axis represents:
   1. Quantity demanded.
   2. Quantity produced (sold).
2. This is because all those measures are expressed in terms of quantity.
3. The y axis represents:
   1. Price.
   2. Revenue.
   3. Cost.
4. This is because all those measures are expressed in terms of currency.

The demand curve

The demand curve is horizontal because in perfect competition markets firms take the price determined by the market.

1. Imagine a local market where there are 20 fruit stores that sell oranges of the exact same quality (undifferentiated).
2. The supply and demand forces of the market agree on the equilibrium price, and the firms in the perfect competition market must sell at this price (Figure 2).
3. If a firm sells oranges at a higher price than the rest, no one will buy them (assuming rational consumer behaviour).
4. If a firms lowers its output prices, they lose profits.

Therefore, the demand a firm faces in a perfect competition market is perfectly elastic, and equals its output price, marginal revenue, and average revenue (to understand why $D=P=MR=AR$, see Table 4 in 2.11.4).

Abnormal profit

1. Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
2. However, at this $Q_{max}$, $AR > AC_1$, and so the firm is making abnormal profit.
3. The average profit per unit equals the difference, at $Q_{max}$ between the average revenue (equal to $P_{e}$) and the average cost ($AC_1$).
4. The total profit equal the average profit ($P_{e}-AC_1$) times the units produced ($Q_{max}$):

$$(P_{e}-AC_1) \times Q_{max}$$

This is visualised by the red box.

Normal profit

1. Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
2. At this $Q_{max}$, $AR = AC_2$, and so the firm is making normal profit.
3. The average profit per unit equals the difference between the average revenue (equal to $P_{e}$) and the average cost ($AC_2$).
4. Since $P_{e}=AC_2$ in this case, the firm is making normal (zero) profit.

Losses

1. Firms always produce at $Q_{max}$, where profit maximisation occurs. This point is when $MR=MC$, so when the MR and MC curves intersect.
2. However, at this $Q_{max}$, $AR < AC_3$, and so the firm is making losses.
3. The average profit per unit equals the difference between the average revenue (equal to $P_{e}$) and the average cost (AC_3).
4. The total profit equal the average profit ($P_{e}-AC_3$) times the units produced ($Q_{max}$):

$$(P_{e}-AC_3) \times Q_{max}$$

However, since $AC>P_{max}$, the total profit is negative, the firm is making losses. These total losses are visualised by the red box.