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Chapters 6, 13, 14, 15, and 16 Notes

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Chapters 6, 13, 14, 15, and 16 Notes Econ 202

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This is a bundle of notes to assist with understanding the second half of the class material. In these notes you will find both chapter notes and lecture notes. The chapter notes are created by me ...
Principles of Microeconomics
Dr. Karki
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Date Created: 02/13/16
Chapter 6: Supply, Demand, and Government Policies 6-1: Controls on Prices Aprice ceiling is a legal maximum on the price of which a good can be sold. Price ceilings benefit the consumer. • The price ceiling is binding if the market price is higher than the price ceiling. • The price ceiling is non-binding when the market price is lower than the price ceiling. • Ashortage occurs because firms do not want to supply as much at the price ceiling but households demand rises. • The shortage can be calcualted by suprtacting the quantity supplied at the price ceiling from the quantity demanded at the price ceiling. In the graph the shortage is 20 units. Aprice floor is a legal minimum on the price which a good can be sold. Price floors benefit the producer. • Asurplus occures because firms are required to charge or pay (if minimum wage) which changes the quantity supplied. Households change their quantity demanded based on the price that they are required to pay for a good or in the case of minimum wage they supply more workers. • Surplus can be calcualted the same way as shortage. In the graph the surplus is 20 units. 6-2: Taxes Tax incidence refers to how the burden of a tax is distributed amoung the various people who make up the economy. • The graph represents a tax on sellers of $0.50. Because cost goes up the supplied quantity goes down. This is shown with the yellow line. • The tax is divided between the seller and the consumer. The consumer pays $4.30 for the product but the supplier only makes $3.80 after taking out $.30 of the that the price paid by customer and then paying an additional $0.20 to make up the full tax amount. • We can say that the tax discourages market activity. ◦ Quantity sold after tax < before. ◦ Buyer and sellers pay higher price. ◦ Tax Revenue is used to reallocate resources. Chapter 13: The Cost of Production 13.1 What Are Costs? Factor of Production: Land, Labour, Capital, and Technology Total Revenue, Total Cost, and Profit Economists normally assume that the goal of a firm is to maximize profit.Afirm's profit is the amount that firm receives for the sales of its output – total revenue-- minus the total cost which is the inputs that the firm buys to create output. The following equation below shows how profit is calculated. Profit = Revenue – Cost Costs as Opportunity Costs If you recall from Chapter 1 : The Ten Principles of Economics, the opportunity cost is the cost of something is what you give up to get it. When economists speak of a firm's cost of production, they include all the opportunity costs of making its output of goods and services. However, a firm's opportunity cost can be split into two – explicit cost and implicit cost. Explicit cost the opportunity cost that require firms to pay out some money. Implicit costs are inputs that do not require a firm to pay. An example of explicit cost is flour. Whereas, an example of implicit cost is the opportunity to make $100 per hour as a programmer instead of being a baker. Because economists are interested in studying how firms make production and pricing discussions, you can say that the total cost of a firm is the sum of the explicit and implicit costs. Whereas, accountants will not count the opportunity cost when calculating a firm's profit. Economic Profit versus Accounting Profit An economist measures a firm's economic profit as the firm's revenue minus all the opportunity costs (explicit and implicit) of producing the goods and services sold.An accountant measures the firm's accounting profit as the firm's total revenue minus only the firm's explicit costs. The following illustration shows the differences between economic profit and accounting profit. As you can see the economic profit is smaller than the accounting profit. Economic profit is an important concept because it is what motivates the firms that supply good and services. If the firm is making a positive profit or zero economic profit it will stay in business. Whereas, a firm that is making negative profit will eventually close down and exit the industry if conditions do not change. 13.2 Production and Costs Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. In this section, we examine the link between a firm’s production process and its total cost. The Production Function The production function is the relationship between quantity of inputs used to make a good and quantity of output produced. The following table shows the quantity of cookies produced per hour at a cookie factory. Number of Workers Output Marginal Cost of Factory Cost of Total Cost Product of (Fixed Cost) Workers Labour (Variable Cost) 0 0 - $30 $0 $30 1 50 50 30 8 38 2 90 40 30 16 46 3 120 30 30 24 54 4 140 20 30 32 62 As you can see in the first two columns, if there are no workers in the factory, the factory produces no cookies. When there is 1 worker, it produces 50 cookies. When there are 2 workers, it produces 90 cookies and so on. The following figure presents a graph of these two columns of numbers. The number of workers is on the horizontal axis, and the number of cookies produced is on the vertical axis. This relationship between the quantity of inputs and quantity of out puts is called the production function. The production function in panel (a) shows the relationship between the number of workers hired and the quantity of output produced. Here the number of workers hired (on the horizontal axis) is the first column in the table above, and the quantity of output produced (on the vertical axis) is the second column. The production function gets flatter as the number of workers increases, reflecting diminishing marginal product. The total-cost curve in panel (b) shows the relationship between the quantity of output produced and the total cost of production. The quantity of output produced is on the horizontal axis and the total cost is on the vertical axis. The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product. Marginal product is the increase in output that arises from an additional unit of input. Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. 13.3 The Various Measures of Cost From data on a firm's cost, we can derive several related measures of cost, which will be useful when analyzing production and pricing decisions in future chapters. The following table presents cost data on a neighbouring coffee shop. Fixed and Variable Costs The coffee shop's total cost can be divided into two types – fixed costs and variable costs. Fixed costs do not vary with the quantity of output produced. Fixed costs can include rent for a building or rent for equipment. Variable costs are costs that vary with the quantity of output produced. These costs can include cost of coffee beans, milk, sugar, and paper-cups.As you can see in the third column of the graph above the fixed cost of the coffee shop is $3.00 no matter how much coffee is produced. The variable cost, which is in the fourth column, varies with the amount of coffee produced. The total cost is found by adding the fixed cost and variable cost, which is seen in column 2. Average and Marginal Cost Firms use average total cost and marginal cost to decide how much to produce. We can calculate the average total cost with the following equation: Average Total Cost = Change in Total Cost/Quantity For example if the firm produces 2 cups of coffee per hour, its total cost is $3.80, and the cost of the typical cup is $3.80/2 or $1.90. However, total cost is the sum of fixed and variable costs, average total cost can be expressed as the sum of average fixed cost and average variable cost.Average fixed cost can be calculated by the following equation: Average Fixed Cost = Fixed Cost / Quantity Produced And the Variable Fixed cost can be found by the following equation: Average Variable Cost = Variable Cost / Quantity Produced Average total cost tells us the cost of the typical unit, but it does not tell us how much total cost will change as the firm alters its level of production. The last column of the table shows that the total cost rises when the firm increases production by 1 unit of output. This number is called marginal cost. Marginal cost can be found by the following equation: Marginal Cost = Change in Total Cost / Change in quantity Cost Curves and Their Shapes Just as in previous chapters we found graphs of supply and demand useful when analyzing the behaviour of markets, we will find graphs of average and marginal cost useful when analyzing the behaviour of firms. The following Figure graphs the costs of the coffee shop. The horizontal axis measures the quantity the firm produces, and the vertical axis measures marginal and average costs. The graph shows four curves: average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC). The cost curves show three features that are typical of many firms: 1. Marginal cost rises with the quantity of output. 2. The average total cost curve is U-shaped. • The bottom of the U-shape occurs at the quantity that minimizes average total cost and this is sometimes called the efficient scale. 3. The marginal cost curve crosses the average total cost curve at the minimum of average total cost. 13.4 Costs in the Short Run and in the Long Run Afirm's costs might depend on the time horizon when determine if they are going to stay in business. The Relationship between Short-Run and Long-Run Average Total Cost In the short-run you are keeping at least one input constant. Variable cost is used to make decisions of shutting down or staying in business. In the long-run all inputs are varying and total cost is used to make the decision of staying in business or shutting down. The graph shows how short-run and long-run costs are related. The long-run average total cost curve is a much flatter U-shape than the short-run average total cost. In addition, all the short-run curves lie on or above the long-run curve. Economies and Diseconomies of Scale When long-run average total cost declines as output increases, there are said to be economies of scale. When the long-run average total cost rises as output increases, there are said to be diseconomies of scale. When the long-run average total cost does not vary with the level of output, it is said to be constant returns to scale. 13.5 Summary The following table provides a summary of the different types of cost and how to calculate them. Chapter Summary • The goal of firms is to maximize profits, which equals total revenue minus total cost. • When analyzing a firm's behaviour, it is important to include all the opportunity costs of production. Some of the opportunity costs, such as the wages a firm pays its workers, are explicit. Other opportunity costs, such as the wages the firms owner gives up by working at the firm rather than taking another job, are implicit. Economic profit takes both explicit and implicit costs into account, whereas accounting profit considers only explicit costs. • Afirm's cost reflect its production process.Atypical firm's production function gets flatter as the quantity of an input increases, displaying the property of diminishing marginal product.As a result, a firm's total-cost curve gets steeper as the quantity produced rises. • Afirm’s total costs can be divided between fixed costs and variable costs. Fixed costs are costs that do not change when the firm alters the quantity of output produced. Variable costs are costs that change when the firm alters the quantity of output produced. • From a firm's total-cost, two related measures of cost are derived.Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost rises if output increases by 1 unit. • When analyzing firm behaviour, it is often useful to graph average total cost and marginal cost. For a typical firm, marginal cost rises with the quantity of output.Average total cost first falls as output increases and then rises as output increases further. The marginal-cost curve always crosses the average total cost curve at the minimum of average total cost. • Afirm's costs often depend on the time horizon considered. In particular, many costs are fixed in the short run but variable in the long run.As a result, when the firm changes its level of production, average total cost may rise more in the short run than in the long run. Chapter 14: Firms in Competitive Market 14.1 What is a Competitive Market? Acompetitive market is a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.Aperfectly competitive market has the following three characteristics: • There are many buyers and many sellers in the market. • The goods offered by the various sellers are largely the same. • Firms can freely enter or exit the market. As a result of these conditions, the actions of any single buyer or seller in the market have a negligible impact on the market price. The Revenue of a Competitive Firm Afirm in a competitive market, like most other firms in the economy, tries to maximize profit.Afirm's total revenue is found by multiplying Price and Quantity. The following table illustrates the total revenue, average revenue, and marginal revenue of a dairy farm. Quantity Price Total Revenue Average Revenue Marginal Revenue (Q) (P) ( TR = P X Q) (AR = TR/Q) (MR = ∆TR/∆Q) 1 gallon $6 $6 $6 - 2 6 12 6 $6 3 6 18 6 6 4 6 24 6 6 5 6 30 6 6 6 6 36 6 6 The total revenue doubles as the dairy farm increases the quantity output but the price stays the same. As a result, total revenue is proportional to the amount of output. The fourth column in the table shows average revenue, which is the total revenue divided by the quantity sold. The average revenue tells us how much revenue a firm receives for a typical unit sold. The fifth column shows marginal revenue, which is the change in total revenue from the sale of each additional unit of output. For comparative firms, marginal revenue equals the price of a good. 14.2 Profit Maximization and the Competitive Firm's Supply Curve The goal of a firm is to maximize profit, which equals total revenue minus total cost. A Simple Example of Profit Maximization We begin our analysis of the firm's supply decision with the example in the table below. In the first column of the table is the number of gallons of milk that the dairy farm produces. The second column shows the farm's total cost. Total cost includes fixed costs, which are $3 in this example, and variable costs, which depend on the quantity produced. The fourth column shows the farm's profit, which is computed by subtracting total cost from total revenue. If the farm produces nothing, it has a loss of $3 (its fixed cost). If it produces 1 gallon, it has a profit of $1. If it produces 2 gallons, it has a profit of $4 and so on. However, the firm's goal is maximize profit. To do this the firm chooses to produce the quantity of milk that makes profit as large as possible. In this example, profit is maximized when the farm produces either 4 or 5 gallons of milk for a profit of $7. Another way to look at it is to find the profit-maximizing quantity by comparing the marginal revenue and the marginal cost from each unit produced. The fifth and sixth columns in the table compute the marginal revenue and marginal cost from the changes in total revenue and total cost, the last column shows the change in profit for each additional unit produced..As long as marginal revenue exceeds marginal cost, increasing the quantity produced rises profit. Once the marginal cost exceeds the marginal revenue, the firm would not produce beyond the additional unit that has marginal revenue exceeding marginal cost. By thinking at the margin and making incremental adjustments to the level of production, the firm will end up producing the profit-maximizing quantity. The Marginal-Cost Curve and the Firm's Supply Decision To extend our analysis of profit maximization, consider the cost curves in the following figure. These cost curves have the three features that was discussed in the previous chapter. The marginal-cost curve (MC) is upward sloping, the average-total-cost curve (ATC) is U-shaped, and then marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. The figure also shows a horizontal line at the market price (P). The price line is horizontal because a competitive firm is a price taker: The price of the firm's output is the same regardless of the quantity that the firm decides to produce. This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average- variable-cost curve (AVC). The market price (P) for a competitive firm equals both marginal revenue (MR) and average revenue (AR).At Q1, marginal revenue (MR1) exceeds marginal cost (MC1), so rising production increases profit.At Q2, the marginal cost (MC2) is above marginal revenue (MR2), so reducing production increases profit. The profit-maximizing quantity, Qmax, is found where the horizontal line representing the price intersects the marginal-cost curve. This analysis yields three general rules for profit maximization: • If marginal revenue is greater than marginal cost, the firm should increase its output. • If marginal cost is greater than marginal revenue, the firm should decrease its output. • At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal. These rules are key to rational decision making by any profit-maximizing firm and apply not only to competitive firms. The Firm's Short-Run Decision to Shut Down Ashutdown refers to a short-run decision not to produce anything during a specific period of time because the current market conditions. Exit refers to a long-run decision to leave the market. The short- run and long-run decisions differ because most firms cannot avoid their fixed costs in the short-run but can do in the long-run. That is, a firm that shut downs temporarily will have to pay its fixed costs, but the firm that exits the market does not have to pay any costs. Afirm shuts down if the revenue that it would earn from producing is less than its variable costs of production. Thus the firm's decision can be written as: Shut down if TR < VC. The firm shuts down if total revenue is less than variable cost. By dividing both sides of this inequality by quantity, we can write it as Shut down if TR/Q < VC/Q Since the left side of the inequality, TR/Q, is total revenue (P x Q ) divided by quantity, which is average revenue, this can be expressed as the good's price. The right side of the inequality, VC/Q, is average variable cost,AVC. Therefore, the firm's shutdown rule can be restarted as Shut down if P <AVC The following figure displays how if the price falls below average variable cost, the firm is better off shutting down temporarily. The Firm's Long-Run Decision to Exit or Enter a Market Afirm will exit the market if the revenue it would get from producing is less than its total costs. We can write this as: Exit if P <ATC Afirm will enter the market if the revenue it would get from producing is greater than its total costs. We can write this as: Enter if P >ATC Now we can describe a competitive firm's long-run profit-maximizing strategy as if the firm produces anything, it will choose the quantity at which marginal cost equals the price of the good. However, of the price is less than the average total cost at that quantity, the firm chooses to exit (or not enter) the market. These results are illustrated in the following figure. Measuring Profit in Our Graph for the Competitive Firm We can find a firm's profit with the following equation: Profit = (P –ATC) X Q This way of expressing the firm's profit allows us to measure profit in our graphs. Panel (a) of the Figure below shows a firm earning positive profit.As we have already learned, the firm maximizes profit by producing the quantity at which price equals marginal cost. Looking at the shaded rectangle, we can see that the height of the rectangle is P-ATC, the difference between price and average total cost. The width of the rectangle is Q, the quantity produced. Therefore, the area of the rectangle is (P- ATC) x Q, which is the firm's profit. If the price is above average total cost, the firm has a positive profit. However, if the price is less than average total cost, the firm incurs a loss. This is seen in Panel (a) and (b) in the Figure above. 14.3 The Supply Curve in a Competitive Market In this section, we will discuss the supply curve for a market. There are two cases to consider. First, a market with a fixed number of firms. Second, a market in which the number of firms can change as old firms exit the market and new firms enter. Both cases are important, for each applies to a specific time horizon. Over short periods of time, it is often difficult for firms to enter and exit, so the assumption of a fixed number of firms is appropriate. But other long periods of time, the number of firms can adjust to changing market conditions. The Short Run: Market Supply with a Fixed Number of Firms Consider first a market with 1,000 identical firms. For any given price, each firm supplies a quantity of output so that its marginal cost equals the price, as shown in panel (a) of the Figure below. That is, as long as price is above average variable cost, each firm's marginal-cost curve is its supply curve. The quantity of output supplied to the market equals the sum of the quantities supplied by each of the 1,000 individual firms. Thus, to derive the market supply curve, we add the quantity supplied by each firm in the market.As panel (b) of the Figure below shows, because the firms are identical, the quantity supplied to the market is 1,000 times the quantity supplied each firm. In the short run, the number of firms in the market is fixed.As a result, the market supply curve, shown in panel (b), reflects the individual firm's marginal-cost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the quantity supplied by each firm. The Long Run: Market Supply with Entry and Exit Now consider what happens is firms are able to enter or exit the market. Suppose that everyone has access to the same technology for producing the good and access to the same markets to buy the inputs for production. Therefore, all current and potential firms have the same cost curves. Decisions about entry and exit in a market of this type depend on the incentives facing the owners of existing firms and the entrepreneurs who could start new firms. The following can be used as a guide for these decisions: • If firms in the market are profitable, then new firms will enter the market. • If firms in the market are making losses, then some firms will exit the market. The causes of new firms entering the market are an increase of the quantity of the good supplied and drive prices and profits downward. When firms exit the market, they decrease the quantity of a good supplied and drive prices and profits upward. At the end of this process of entry and exit, firms that remain in the market make zero economic profit.At zero economic profit price equals average-total- cost. So for this analysis has a surprising implication. We noted earlier in the chapter that competitive firms maximize profits by choosing a quantity at which price equals marginal cost. We just noted that free entry and exit force price to equal average total cost. But if price is equal to both marginal cost and average total cost, these two measures of cost must equal each other. Marginal cost and average total cost are equal, however, only when the firm s operating at the minimum of average total cost. This is called a firm's efficient scale. Thus, we can say that in the long-run equilibrium of a competitive market with free entry and exit, firms must be operating at their efficient scale. Panel (a) of the following Figure shows a firm in such a long-run equilibrium. In this figure, price P equals marginal cost MC, so the firm is maximizing profit. Price is also equal to average total cost ATC, so the profit is zero. At this point new firms have no incentive to enter the market, and existing firms have no incentive to leave the market. In the long run, firms will enter or exit the market until profit is driven to zero.As a result, price equals the minimum of average total cost, as shown in panel (a). The number of firms adjusts to ensure that all demand is satisfied at this price. The long-run market supply curve is horizontal at this price, as shown in panel (b). Any price above this would generate profit, leading to entry and an increase in total quantity supplied.Any price below this level would generate losses, leading to exit and a decrease in the total quantity supplied. Eventually, the number of firms in the market adjusts so that price equals the minimum of average total cost and there are enough firms to satisfy the demand at this price. Why Do Competitive Firms Stay in Business If They Make Zero Profit? Competitive firms stay in business when making zero economic profit because profit equals total revenue minus total cost and total cost includes all the opportunity costs of the firm. A Shift in Demand in the Short Run and Long Run Now that we have a more complete understanding of how firms make supply decisions, we can better explain how markets respond to changes in demand. Because firms can enter or exit in the long run but not in the short run, the response of a market to a change in demand depends on the time horizon. To see this, lets trace the effects of a shift in demand over time. Suppose the market for milk begins in a long-run equilibrium. Firms are earning zero profit, so price equals the minimum of average total cost. Panel (a) in the following figure shows this situation. The long-run equilibrium is pointA, the quantity sold in the market is Q1, and the price is P1. The market starts in a long-run equilibrium, shown as pointAin panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost. Panel (b) shows what happens in the short run when demand rises from D1 to D2. The equilibrium goes from pointAto point B, price rises from P1 to P2, and quantity sold in the market rises from Q1 to Q2. Because price now exceeds average total cost, each firm now makes a profit, which over time encourages new forms to enter the market. This entry of new firms shifts the short-run supply curve to the right from S1 to S2, shown in Panel (c) In the new long-run equilibrium, point C, price has returned to P1 but the quantity sold has increased to Q3. Profits are again zero, and price is back to the minimum of average total cost, but the market has more firms to satisfy the greater demand. Chapter Review • Because a competitive firm is a price taker, its revenue is proportional to the amount of output it produces. The price of the good equals both the firm's average revenue and its marginal revenue. • To maximize profit, a firm chooses a quantity of output such that marginal revenue equals marginal cost. Because marginal revenue for a competitive firm equals the market price, the firm chooses quantity so that price equals marginal cost. Thus, the firm's marginal-cost curve is its supply curve. • In the short run when a firm cannot recover its fixed costs, the firm will choose to shut down temporarily if the price of the good is less than average variable cost. In the long run when the firm can recover both fixed and variable costs, it will choose to exit if the price is less than average total cost. • In a market with free entry and exit, profit is driven to zero in the long run. In this long-run equilibrium, all firms produce at the efficient scale, price equals the minimum of average total cost, and the number of firms adjusts to satisfy the quantity demanded at this price. • Changes in demand have different effects over different time horizons. In the short run, an increase in demand raises prices and leads to profits, and a decrease in demand lowers prices and leads to losses. But if firms can freely enter and exit the market, then in the long run, the number of firms adjusts to drive the market back to the zero-profit equilibrium. Chapter 15: Monopoly 15.1 Why Monopolies Arise Afirm is a monopoly of it is the sole seller of its products and if its product does not have close substitutes. The fundamental cause of monopoly is restricted entry:Amonopoly remains the only seller in its market because other firms cannot enter the market and compete with it. These restrictions have three main sources: • Monopoly resources:Akey resource required for production is owned by a single firm. • Government relegation: The government gives a single firm the exclusive rights to produce some good or service. • The production process:Asingle firm can produce output at a lower cost than can a larger number of firms. These are called natural monopolies. 15.2 How Monopolies Make Production and Pricing Decisions The key differences between a competitive firm and a monopoly is the monopoly's ability to influence the price of its output. It can alter the price of its good by adjusting the quantity it supplies to the market. This difference can be seen when looking at the demand curve of a competitive market and a monopoly. The following figure displays the competitive market's demand curve in panel (a) and the monopoly's demand curve in panel (b). Because competitive firms are price takers, they in effect face horizontal demand curves, as in panel (a). Because a monopoly firm is the sole producer in its market, it faces a downward-sloping market demand curve as in panel (b).As a result, the monopoly has to accept the lower price if it wants to sell more output. The market demand curve provides a constraint on a monopoly's ability to profit from its market power because it can choose any point on the demand curve, but it cannot choose a point off the demand curve. A Monopoly's Revenue Consider a town with a single producer of water. The table below shows how the monopoly's revenue might depend on the amount of water produced. If you graph the first two columns (quantity of water and price) you would get the monopoly's downward-sloping demand curve. The last column is the firm's marginal revenue that it receives for each additional unit of output. This table shows a result that is important for understanding monopoly behaviour: A monopolist's marginal revenue is always less than the price of its good. Marginal revenue for monopolies is very different from marginal revenue for competitive firms. When a monopoly increases the amount it sells, this action has two effects on total revenue: • The output effect: More output sold, so Q is higher, which tends to increase total revenue. • The price effect: The price falls, so P is lower, which tends to decrease total revenue. The following Figure graphs the demand curve and the marginal-revenue curve for a monopoly firm. You can see in the Figure above that marginal revenue can become negative. Marginal revenue is negative when the price effect on revenue is greater than the output effect. Profit Maximization The figure below graphs the demand curve, the marginal-revenue curve, and the cost curves for a monopoly form. The curves contain all the information we need to determine the level of output that a profit-maximizing monopolist will choose. Amonopoly maximizes profit by choosing the quantity at which marginal revenue equals marginal cost (pointA) It then uses the demand curve to find the price that will induce consumers to buy that quantity (point B). Suppose, first, that the firm is producing at a low level of output, such as Q1. In this case, marginal cost is less than marginal revenue. If the firm increased production by 1 unit, the additional revenue would exceed the additional costs, and profit would rise. Thus, when the marginal cost is less than the marginal revenue, the firm can increase profit by producing more units. The similar argument applies at high levels of output, such as Q2. In this case, the marginal cost is greater than marginal revenue. If the firm reduced production by 1 unit, the costs saved would exceed the revenue lost. Thus, if marginal cost is greater than marginal revenue, the firm can raise profit by reducing production. In the end, the firm adjusts its level of production until the quantity reaches Qmax, at which marginal revenue equals marginal cost. Thus, the monopolist's profit-maximizing quantity of output is determined by the intersection of marginal-revenue curve and the marginal-cost curve. At this point you might recall from the previous chapter that competitive firms also choose the quantity of output at which marginal revenue equals marginal costs. In following this rule for profit maximization, competitive firms and monopolies are alike. But there is an important difference between these types of firms: The marginal revenue of a competitive firm equals its price, whereas the marginal revenue of a monopoly is less than its price. That is, For a competitive firm: P = MR = MC For a monopoly firm: P > MR = MC At this point we can see a key difference between markets with competitive firms and markets with a monopoly firm. These differences are crucial to understanding the social cost of monopoly. A Monopoly's Profit We can find a monopoly's profit with the same equation as a competitive market: Profit = (P –ATC) X Q Consider the shaded box in the following figure. The area of the box BCDE equals the profit of the monopoly firm. The height of the box (BC) is price minus average total cost, which equals profit per unit sold. The width of the box (DC) is the number of units sold. 15.3 The Welfare Cost of Monopolies The Deadweight Loss We begin by considering what the monopoly form would do if it were run by a benevolent social planner. The social planner cares not only about the profit earned by the firm's owners but also about the benefits received by the firm's consumers. The planner tries to maximize total surplus, which equals producer surplus plus consumer surplus. The following figure analyzes how a benevolent social planner would choose the monopoly's level of output. The demand curve reflects the value of the good to consumers, as measured by their willingness to pay for it. The marginal-cost curve reflects the cost of the monopolist. Thus, the socially efficient quantity is found where the demand curve and the marginal-cost curve intersect. Below this quantity, the value of an extra unit to consumers exceeds the cost of providing it, so increasing output would raise total surplus.Above this quantity, the cost of producing an extra unit exceeds the value of that unit to consumers so decreasing output would rise total surplus. We can evaluate the welfare effects of monopoly by comparing the level of output that the monopolist chooses to the level of output that a social planner would choose.As we have seen, the monopolist chooses to produce and sell the quantity of output at which the marginal-revenue and marginal-cost curve interest. The following figure shows the comparison. The monopolist produces less than the socially efficient quantity of output. The deadweight loss is presented by the area of the triangle between the demand curve and the marginal-cost curve. The inefficiency of monopoly can be measured with a deadweight loss triangle. 15.4 Price Discrimination Price discrimination is a business practice of selling the same good at different prices to different customers. Price discrimination is a rational strategy for a profit-maximizing monopolist. That is, by charging different prices to customers, a monopolist can increase its profit. The following figure displays how price discrimination increases profit, raises total surplus, and lowers consumer surplus. Panel (a) shows a monopoly that charges the same price to all customers. Total surplus in this market equals the sum of profit (producer surplus) and consumer surplus. Panel (b) shows a monopoly that can perfectly price discriminate. Because consumer surplus equals zero, total surplus now equals the firm's profit. Chapter 16: Monopolistic Competition 16.1 Between Monopoly and Perfect Competition In chapter 14 we discussed perfectly competitive firms and saw that the price is always equals the marginal cost of production. In chapter 15 we discussed markets with a single monopoly firm and saw that the firm can use their market power to keep prices above marginal cost, leading to a positive economic profit and a deadweight loss for society. These two firms are extreme forms of market structure. However, not all markets fall into these two firms. In this chapter we will be learning about monopolistic competitive markets. Then in the next chapter we will learn about oligopoly. These two firms are often called imperfect competition. Monopolistic competition is a market structure in which there are many firms selling products that are similar but not identical. Monopolistic competition describes a market with the following attributes: • Many sellers: There are many firms competing for the same group of customers. • Product differentiation: Each firm produces a product that is at least slightly different from those of other firms. Thus, rather than being a price taker, each firm faces a downward-sloping demand curve. • Free entry and exit: Firms can enter or exit the market without restriction. Thus, the number of firms in the market adjusts until economic profits are driven to zero. The following figure can assist with understanding how economists divide markets into four types – monopoly, oligopoly, monopolist competition, and perfect competition. 16.2 Competition with Differentiated Products The Monopolistically Competitive Firm in the Short Run Monopolistic competitors, like monopolists, maximize profit by producing the quantity at which marginal revenue equals marginal cost. The firm in panel (a) makes a profit because, at this quantity, price is above average total cost. The firm in panel (b) makes losses because, at this quantity, price is less than average total cost. These two panels should seem familiar.Amonopolistically competitive firm chooses its quantity and price just as a monopoly does. In the short run, these two types of market structure are similar. The Long-Run Equilibrium In a monopolistically competitive market, if firms are making profits, new firms enter, and the demand curves for the existing firms shift to the left. Similarly, if firms are making losses, some of the firms in the market exit and the demand curves of the remaining firms shift to the right. Because of thes shifts in demand, monopolistically competitive firms eventually find themselves in the long-run equilibrium shown below. In this long-run equilibrium, price equals average total cost and each firm earns zero profit. The demand curve above just barely touches the average-total-cost curve. We can say that these two curves are tangent to each other. These two curves must be tangent once entry and exit have driven profit to zero. Because profit per unit sold is the difference between price and average total cost, the maximum profit is zero only if these two curves touch each other without crossing.Also note that this point of tangency occurs at the same quantity where marginal revenue equals marginal cost. These two points line up is not a coincidence: It is required because this particular quantity maximizes profit and the maximum profit is exactly zero in the long run. Monopolistic versus Perfect Competition Panel (a) shows the long-run equilibrium in a monopolistically competitive market, and panel (b) shows the long-run equilibrium in a perfectly competitive market. Two differences are notable. 1. The perfectly competitive firm produces at the efficient scale, where average total cost is minimized. By contrast, the monopolistically competitive firm produces at less than the efficient scale. 2. Price equals marginal cost under perfect competition, but price is above marginal cost under monopolistic competition. The quantity that minimizes average total cost is called the efficient scale of the firm. In the long run, perfectly competitive firms produce at the efficient scale, whereas monopolistically competitive firms produce below this level. Firms are said to have excess capacity under monopolistic competition because it is more profitable for a monopolistic competitor to operate this way. Monopolistic Competition and the Welfare of Society Because of monopolistic competition the following are created: • The product-variety externality: Because consumers get some consumer surplus from the introduction of a new product, entry of a new firm conveys a positive externality on consumers. • The business-stealing externality: Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms. Chapter Summary • Amonopolistically competitive market is characterized by three attributes: many firms, differentiated products, and free entry. • The long-run equilibrium in monopolistically competitive market differ from that in a perfectly competitive market in two related ways. First, each firm in a monopolistically competitive market has excess capacity. That is, it chooses a quantity that puts it on the downward-sloping portion of the average-total-cost curve. Second, each firm charges a price above marginal cost. • Monopolistic competition does not have all desirable properties of perfect competition. There is a standard deadweight loss of monopoly caused by the markup of price over marginal cost. In addition, the number of firms (and thud the variety of products) can be too large or too small. In practice, the ability of policymakers to correct these inefficiencies is limited.


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