The Production Function
A firm is an organization that produces goods or services for sale. - To produce goods or services to sell, a firm must transform inputs into outputs.
A production function is the relationship between the quantity of inputs a firm uses and the quantity of output it produces.
Inputs and Outputs
George and Martha’s farm sits on 10 acres of land—no more, no less because they cannot increase or decrease the size of their land by selling, buying, or leasing. - In this example, land is considered a fixed input—an input whose quantity is fixed for a period of time and cannot be varied.
But, George and Martha are free to decide in how many workers they can hire. - The labor from these workers is considered to be a variable input- an input whose quantity the firm can vary at any time.
Whether or not the quantity of an input is fixed depends on the time horizon. In the long run, all inputs can become varied.
- For e.g. George and Martha can vary the amount of land they farm by buying or selling land.
In the short run, at least one input is fixed.
The total product curve shows how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input.
Although the total product curve slopes upward, it begins to plateau as the quantity of labor increases. This is because of the change in the quantity of output, or the marginal product—the additional quantity of output that is produced by using one more unit of that input.
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The significance of the slope of the total product curve is that it is equal to the marginal product of labor.
In the example for George and Martha’s farm, we can see how the marginal product of labor steadily declines as more workers are hired—each successive worker adds less to output than the previous worker.
In other words, as employment increases, the total product curve gets flatter.
The next curve Don't forget about the age old question of How valid are iq tests?
shows how the
of labor depends
on the number of
on the farm.
In this example, the marginal product of labor falls as the number of workers increases.
There are diminishing returns to an input—when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input.
- Due to the diminishing returns to labor the MPL curve is negatively sloped.
Coming back to George and Martha, if they add more workers without increasing the number of acres of land, the land is farmed more intensively and the number of bushels produced increases.
But, each additional worker is working with a smaller share of the 10 acres in total— the fixed input—than the previous worker.
So, the additional worker cannot produce as much output as the previous worker could. This leads to a fall in the marginal product of the additional worker falls.
The crucial point about diminishing returns is that it is an “other things equal” proposition: each successive unit of an input will raise production by less than the last if the quantity of all other inputs is held fixed.
If the levels of other inputs were allowed to change, the marginal product of each worker would become higher when the fixed cost (the land) would vary (increase in size). Don't forget about the age old question of What is chemoreceptors?
Both curves slope downward because, in each case, the amount of land is fixed, albeit at different levels but the MPL20 lies everywhere above MPL10 which shows the fact that the marginal product of the same worker is higher when he or she has more of the fixed input to work with.
The position of the total product curve of a given input depends on the quantities of other inputs.
If you change the quantity of the other inputs, both of the total product curve and the marginal product curve of the remaining input will shift.
From the Production Function to Cost Curves
A fixed cost is a cost that does not depend on the quantity of output produced. ∙ It is the cost of the fixed input.
A variable cost is a cost that depends on the quantity of output produced. ∙ It is the cost of the variable input.
The total cost of producing a given quantity of output is the sum of the fixed cost and the variable cost of producing that quantity of output.
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The total cost curve slopes upward:
due to the variable cost, the more
output produced, the higher the farm’s
Unlike the total product curve, which
gets flatter as employment rises, the
total cost curve gets steeper.
The slope of the total cost curve is
greater as the amount of output
∙ Marginal cost is the change in total cost generated by producing one more unit of output.
The formula for marginal cost:
∙ The marginal cost curve slopes upward because there are diminishing returns to inputs in the example of Selena and her gourmet salsas. o Marginal cost at Selena’s Gourmet Salsas rise as output increases
In the case of Selena’s Gourmet Salsas, the marginal cost curve slopes upward because there are diminishing returns to inputs.
As output increases, the marginal product of the variable input declines. This implies that more and more of the variable input must be used to produce each additional unit of output as the amount of output already produced rises.
Since each unit of the variable input must be paid for, the additional cost per additional unit of output also rises.
**Recall that the flattening of the total product curve is also due to diminishing returns: the marginal product of an input falls as more of that input is used if the quantities of other inputs are fixed.
The flattening of the total product curve as output increases and the steepening of the total cost curve as the output increases are the same phenomenon.
As output increases, the marginal cost of output also increases because the marginal product of the variable input decreases.
Average Total Cost
∙ The average total cost is the total cost divided by the quantity of output produced—it is equal to total cost/unit of output.
The average total cost is important because it tells the producer how much the average or typical unit of output costs to produce.
In the case of Selena’s Gourmet Salsas, the average total cost curve has a distinctive U-shape that corresponds to how average total cost first falls and then rises as output increases.
U-shaped average total cost curve falls at low levels of output, then rises at higher levels.
The average total cost
curve is U-shaped because
of its underlying
fixed cost and average
Average fixed cost is the
fixed cost per unit of
Average variable cost is
the variable cost per unit
Average total cost is the sum of average fixed cost and average variable cost.
- It has a U-shape because these components move in opposite directions as output rises
Average fixed cost falls as more output is produced because the numerator (the fixed cost) is a fixed number but the denominator increases as more is produced.
As more output is produced, the fixed cost is spread over more units of output; the end result is that the cost per unit of output falls.
Average variable cost rises as output increases.
Reflects diminishing returns to the variable input: each additional unit of output incurs more variable cost to produce than the previous unit.
Increasing output has two opposing effects on average total cost ∙ Spreading effect: The larger the output, the greater the quantity of output over which fixed cost is spread, leading to lower average fixed cost.
o At low levels of output, the spreading effect is powerful because even small increases in output cause large reductions in average fixed cost.
Spreading effect dominates the diminishing returns effect
and causes the average total cost curve to slope
∙ Diminishing returns effect: The larger the output, the greater the amount of variable input required to produce additional units, leading to higher average variable cost.
o Diminishing returns usually grow increasingly important as output rises.
When output is large, the diminishing returns effect
dominates the spreading effect, causing the average total cost curve to slope upward.
The marginal cost curve
slopes upward- the result of
diminishing returns that
make an additional unit of
output costlier to produce
than the one before.
Average variable cost also
slopes upward- again, due to
diminishing returns- but is
flatter than the marginal cost
This is because the
high cost of an
additional unit of
output is averaged
across all units.
Average fixed cost slopes
downward because of the
Minimum Average Total Cost
For a u-shaped average total cost curve, average total cost is at its minimum level at the bottom of the U. This quantity of output corresponds to the minimum average total cost—economists call this the minimum-cost output.
The general principles that are always true about a firm’s marginal cost and average total cost curves are:
1. At the minimum-cost output, average total cost is equal to marginal cost. 2. At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling.
3. At output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost rising.
An example to understand these principles would be to think about how your grade in one course—say it is a 3.0 in Economics- affects your overall grade point average.
If your GPA before receiving that grade was more than 3.0, the new grade will lower your average.
- If marginal cost is less than average total cost, producing that extra unit lowers average total cost.
Does the Marginal Cost Curve Always Slope Upward? Economists believe that marginal cost curves often slope downward as a firm increases its production from zero up to some low level, sloping upward only at higher levels of production.
At low levels of output there are often increasing returns to the variable input due to the benefits of specialization, making the marginal cost curve “swoosh”- shaped: initially sloping downward before sloping upward.
Short Run versus Long-Run Costs
In the long run, firms choose fixed cost according to expected output. Higher fixed cost reduces average total cost when output is high. Lower fixed cost reduces average total cost when output is low.
Long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output.
A firm that has fully adjusted its fixed cost for its output level will operate at a point that lies on both its current short-run and long-run average total cost curves.
A change in output moves the firm along its current short-run average total cost curve. Once it has readjusted its fixed cost, the firm will operate on a new short-run average total cost curve and on the long-run average total cost curve.
Returns to Scale
Increasing returns to scale when long-run average total cost declines as output increases.
- Tend to make firms larger.
Decreasing returns to scale when long-run average total cost increases as output increases.
- Tend to limit the size of firms
Constant returns to scale when long-run average total cost is constant as output increases.
- Tend to have no effect
CHAPTER 12- Perfect Competition and the Supply Curve Perfect Competition
Price-taking producer is a producer whose actions have no effect on the market price of the good or service it sells.
- A price-taking producer considers the marker price as given. When there is enough competition—then ever producer is a price-taker.
Price-taking consumer is a consumer whose actions have no effect on the market price of the good or service he or she buys.
Defining Perfect Competition
In a perfectly competitive market, all market participants, both consumers and producers, are price-takers.
- The market price of the good is not affected by consumption decisions or production decisions.
A perfectly competitive industry is an industry in which producers are price takers.
- Some industries aren’t perfectly competitive.
Two Necessary Conditions for Perfect Competition
First, for an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share.
- A producer’s market share is the fraction of the total industry output accounted for by that producer’s output.
Standardized product, also known as a commodity, is when consumers regard the products of different producers as the same good.
The second necessary condition for a competitive industry is that the industry output is a standardized product.
Free Entry and Exit
All perfectly competitive industries have many producers with small market shares, producing a standardized product.
Most perfectly competitive industries are also characterized by one or more feature: it is easy for new firms to enter the industry or for firms that are currently in the industry to leave. No obstacles in the form of government regulations or limited access to key resources prevent new producers from entering the market. – And no additional costs are associated with shutting down a company and leaving the industry.
Economists refer to the arrival of a new firms into an industry as entry: they refer to the departure of firms from an industry as exit.
Free entry and exit is not strictly necessary for perfect competition. TO SUM UP: Perfect competition depends on two necessary conditions.
1. The industry must contain many producers, each having a small market share.
2. The industry must produce a standardized product.
Perfectly competitive industries are normally characterized by free entry and exit.
Production and Profits
Total Revenue is equal to the market price Profit is equal to total revenue
multiplied by the quantity of output. minus total cost.
Using Marginal Analysis to Choose the Profit-Maximizing Quantity of Output
Marginal revenue is the change in total revenue generated by an additional unit of output.
Optimal output rule: Profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal unit.
- Profit equals marginal cost (P = MC) at the price-taking firm’s optimal quantity of output.
- In the case of a price-taking firm, marginal revenue is equal to the market price. MR = MP
A price-taking firm cannot influence the market price by its actions. It always takes the market price as given because it cannot lower the market price by selling more or raise the market price by selling less.
So, for a price taking firm, the additional revenue generated by producing one more unit is always the market price.
Firms are not price-takers when an industry is not perfectly competitive. Marginal revenue curve shows how marginal revenue varies as output varies.
Note: Whenever a firm
is a price-taker, its
curve is a horizontal
line at the market
price: it can sell as
much as it likes at the
In effect, the
individual firm faces a
elastic demand curve
for its output—an
curve for its output
that is equivalent to
its marginal revenue
When is Production Profitable?
A firm’s decision whether or not to stay in a given business depends on its economic profit—the measure of profit based on the opportunity cost of resources used in the business.
In contrast, accounting profit is profit calculated using only the explicit costs incurred by the firm.
This means that economic profit incorporates the opportunity cost of resources owned by the firm and used in the production of output, while accounting profit does not.
A firm may make positive accounting profit while making zero or even negative economic profit.
A firm’s decision to produce or not, to stay in business or to close down permanently, should be based on economic profit, not accounting profit.
To see how these curves can be
used to decide whether
production is profitable or
unprofitable, recall that
PROFIT = TOTAL REVENUE –
If the firm produces a
quantity at which TR >
TC, the firm is profitable.
If the firm produces a
quantity at which TR =
TC, the firm breaks even.
If the firm produces a
quantity at which TR <
TC, the firm incurs a loss.
We can also express this idea in terms of revenue and cost per unit of output. If we divide profit by the number of units of output, Q.
TR/Q is average revenue, which is the market price. TC/Q is average total cost.
A firm is profitable if the market price for its product is more than the average total cost of the quantity the firm produces; a firm loses money if the market price is less than average total cost of the quantity the firm produces.
If the firm produces a quantity at
which P > ATC, the firm
If the firm produces a
quantity at which P =
ATC, the firm breaks
If the firm produces a
quantity at which P <
ATC, the firm incurs a
Figure 12-3 shows this result,
illustrating how the market price
determines whether a firm is
Each panel shows the marginal cost
curve, MC, and the short-run
average total cost curve, ATC.
Average total cost minimized at
point C. Panel (a) shows the case we
have already analyzed, in which the
market price of trees is $18 per tree.
Panel (b) shows the case in which
the market price of trees is lower,
$10 per tree.
Noelle’s total profit when the market
price is $18 is represented by the
area of the shaded rectangle in
How does a producer know, in general, whether or not its business will be profitable?
- The crucial test lies in a comparison of the market price to the producer’s minimum average total cost.
Whenever the market price exceeds minimum average total cost, the producer can find some output level for which the average total cost is less than the market price; aka, the producer can find a level of output at which the firm makes a profit.
Conversely, whenever the market price exceeds minimum average total cost, the producer can find some output level for which the average total cost is less than the market price.
The minimum average total cost of a price-taking firm is called its break-even price, the price at which it earns zero profit. ~~ Economic profit, that is.
The rule for determining whether a producer of a good is profitable depends on a comparison of the market price of the good to the producer’s breakeven price—its minimum average total cost.
- Whenever the market price exceeds minimum average total cost, the producer is profitable.
- Whenever the market price equals minimum average total cost, the producer breaks even.
- Whenever the market price is less than minimum average total cost, the producer is unprofitable.
The Short-Run Production Decision
If a firm is unprofitable because the market price is below its minimum average total cost, it shouldn’t produce any output… FALSE.
In the short run, sometimes the firm should produce even if price falls below minimum average total cost.
- The reason is that total cost includes fixed cost—cost that does not depend on the amount of output produced and can only be altered in the long run.
In the short run, fixed cost must still be paid, regardless of whether or not a firm produces.
If a producer rents a piece of equipment for the year, the producer has to pay the rent on the equipment regardless of whether the production continues. Since it cannot be changed in the short run, her fixed cost is irrelevant to her decision about whether to produce or shut down in the short run.
Although fixed cost should play no role in the decision about whether to produce in the short run, other costs—variable costs—do matter.
- An example of variable costs is the wages of workers who must be hired to help.
Variable costs can be saved by not producing; so they should play a role in determining whether or not to produce in the short run.
Because the marginal
cost curve has a “swoosh”
shape—falling at first before
rising—the short-run average
variable cost curve is U-shaped:
the initial fall in marginal cost
causes average variable cost to
fall as well, before rising
marginal cost eventually pulls it
When the market price is
below minimum average
variable cost, the price the firm
receives per unit is not covering
its variable cost per unit.
A firm in this situation
should cease production
Because there is no level
of output at which the
firm’s total revenue
covers its variable costs—
the costs it can avoid by
In this case, the firm
maximizes its profits by
not producing at all—by,
in effect, minimizing its
- This means that the minimum average variable cost is equal to the shut down price—the price at which the firm ceases production in the short run.
When the price is greater than minimum average variable cost, however, the firm should produce in the short run. In this case, the firm maximizes profit- or minimizes
loss—by choosing the output quantity at which its marginal cost is equal to the market price.
Short-run individual supply curve shows how an individual producer’s profit maximizing output quantity depends on the market price, taking fixed cost as given.
To sum up:
- Fixed cost is irrelevant to the firm’s optimal short-run production decision. - When price exceeds its shut-down price, minimum average variable cost, the price-taking firm produces the quantity of output at which marginal cost equals price.
- When price is lower than its shut-down price, it ceases production in the short run. This defines the short-run individual supply curve.
Changing Fixed Cost
Over time, fixed cost matters.
If price consistently falls below minimum average total cost, a firm will exit the industry.
If price exceeds minimum average total cost, the firm is profitable and will remain in the industry; other firms will enter the industry in the long run.
Summing Up: The Perfectly Competitive Firm’s Profitability and Production Conditions
The Industry Supply Curve
The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole.
The Short-Run Industry Supply Curve
The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers.
- This is shown as S, in Figure 12-5. This curve shows the quantity that producers will supply at each price, taking the number of producers as given.
The demand curve D in Figure 12-5
crosses the short run industry
supply curve at EMKT
- This point is a short-run
market equilibrium: the
quantity supplied equals the
quantity demanded, taking
the number of producers as
- But in the long-run, farms
may enter or exit the
The Long-Run Industry Supply Curve
Whenever existing producers are making a profit—that is, whenever the market price is above the break-even price, the minimum average total cost of production.
What happens as additional producers enter the
- The quantity
supplied at any
given price will
- The short-run
supply curve will
shift to the right,
which will, in turn,
alter the market
result in a lower
- Existing firms will
respond to the
lower market price
by reducing their
output, but the
total industry output will increase because of the larger number of firms in the industry.
A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.
The long-run industry supply curve shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry.
Regardless of whether the long-run industry supply curve is horizontal or upward sloping or even downward sloping, the long-run price elasticity of supply is higher than the short-run price elasticity whenever there is free entry and exit.
As shown in Figure 12-8, the long-run
industry supply curve is always
flatter than the short-run industry
- The reason is entry and
exit: a high price caused
by an increase in demand
attracts entry by new
producers, resulting in a
rise in industry output and
an eventual fall in price; a
low price caused by a
decrease in demand
induces existing firms to
exit, leading a fall in
industry output and an
eventual increase in price.
The Cost of Production and Efficiency in Long-Run Equilibrium
1. In a perfectly competitive industry in equilibrium, the value of marginal cost is the same for all firms.
a. That’s because all firms produce the quantity of output at which marginal cost equals the market price, and as price-takers they all face the same market price.
2. In a perfectly competitive industry with free entry and exit, each firm will have zero economic profit in long-run equilibrium.
a. Each firm produces the quantity of output that minimizes its average total cost—corresponding to point Z in panel ( c ) of Figure 12-7. b. The exception is an industry with increasing costs across the industry. Given a sufficiently high market price, early entrants make positive economic profits, but the last entrants, as the industry reaches the long-run equilibrium, but not necessarily for the early ones.
So the total cost of production of the industry’s output is minimized in a perfectly competitive industry.
3. The long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go exploited.
a. Recall, all consumers who have a willingness to pay greater than or equal to sellers’ costs actually get the good.
b. We have also learned that when a market is efficient, the market price matches all consumers with a willingness to pay greater than or equal to the market price to all seller who have a cost of producing the good less than or equal to the market price.
In the long-run market equilibrium of a perfectly competitive industry, each firm produces at the same marginal cost, which is equal to the market price, and the total cost of production of the industry’s output is minimized. It’s also considered efficient.
CHAPTER 9- DECISION MAKING BY INDIVIDUALS AND FIRMS
Costs, Benefits, and Profits
When making decisions, it is crucial to think in terms of opportunity cost, because the opportunity cost of an action is often considerably more than the cost of any outlays of money.
Economists use the concepts of explicit costs and implicit costs to compare the relationships between opportunity costs and monetary outlays.
Explicit versus Implicit Costs
An explicit cost is a cost that requires an outlay of money. For e.g. the explicit cost of the additional year of schooling includes tuition.
An implicit cost does not require an outlay of money. It is measure by the value, in dollar terms, of benefits that are forgone. For e.g. the implicit cost of the year spent in school includes the income you would have earned if you had taken a job instead.
A common mistake is to ignore implicit
costs and focus exclusively on explicit
costs. But often, the implicit cost of an
activity is quite substantial—indeed,
sometimes it is much larger than the
In Table 9-1, the forgone salary is the cost
of using your own resources—your time—
in going to school rather than working. The
use of your time for more schooling,
despite the fact that you don’t have to spend any money on it, is still costly to you.
The opportunity cost: in considering the cost of an activity, you should include the cost of using any of your own resources for that activity. You can calculate the cost of using your own resources by determining what they would have earned in their next best use.
Accounting Profit versus Economic Profit
Accounting profit is equal to revenue minus explicit cost.
Economic profit is equal to revenue minus the opportunity cost of resources used. It is usually less than the accounting profit.
In general, the economic profit of a given project will be less than the accounting profit because there are almost always implicit costs in addition to explicit costs.
When economists refer to the term profit, they are referring to economic profit, not accounting profit.
Capital is the total value of assets owned by an individual or firm—physical asset plus financial assets.
- An individual’s capital usually consists of cash in the bank, stocks, bonds, and the ownership value of real estate such as a house.
The implicit cost of capital is the opportunity cost of the use of one’s own capital —the income earned if the capital had been employed in its next best alternative use.
Making “Either-Or” Decisions
An “either-or” decision Is one in which you must choose between two activities.
The best way to make an “either-or” decision, the method that leads to the best possible economic outcome, is the straightforward principle of “either-or” decision making.
- According to this principle, when making an “either-or” choice between two activities, choose the one with the positive economic profit.
Marginal cost of producing a good or service is the additional cost incurred by producing one more unit of that good or service.
Production of a good or service has increasing marginal cost when each additional unit costs more to produce than the previous one.
Marginal cost curve shows how the cost of producing one more unit depends on the quantity that has already been produced.
Production of a good or service has constant marginal cost when each additional unit costs the same to produce as the previous one.
Production of a good or service has decreasing marginal cost when each additional unit costs less to produce than the previous one.
Marginal benefit of a good or service is the additional benefit derived from producing one more unit of that good or service.
Decreasing marginal benefit from an activity when each additional unit of the activity yields less benefit than the previous unit.
- With decreasing marginal benefit, the benefit from producing one more unit of the good or service falls as the quantity already produced rises. - A downward-sloping marginal benefit curve reflects a decreasing marginal benefit.
Marginal benefit curve shows how the benefit from producing one more unit depends on the quantity that has already been produced.
Optimal quantity is the quantity that generates the higher possible total profit.
- With small quantities, the rule for choosing the optimal quantity is: increase the quantity as long as the marginal benefit from one more unit is greater than the marginal cost, but stop before the marginal benefit becomes less than the marginal cost.
Profit-Maximizing Principle of Marginal Analysis—When making a profit maximizing “how much” decision, the optimal quantity is the largest quantity at which marginal benefit is greater than or equal to marginal cost.
A sunk cost is a cost that has already been incurred and is nonrecoverable. A sunk cost should be ignored in decisions about future actions because they have no effect on future costs and benefits.
- Behavioral economics combines economic modeling with insights from human psychology.
Rational, but Human, Too
Rational decision maker chooses the available option that leads to the outcome he or she most prefers.
- Rational behavior leads to the outcome a person most prefers.
Bounded rationality is making a choice that is close to but not exactly the one that leads to the highest possible profit because the effort of finding the best payoff is too costly.
- Bounded rationality is the “good enough” method of decision making.
Risk aversion is the willingness to sacrifice some economic payoff in order to avoid a potential loss.
- Because risk makes most people uncomfortable, it’s rational for them to give up some potential economic gain in order to avoid it.
Irrationality: An Economist’s View
An irrational decision maker chooses an option that leaves him or her worse off than choosing another available option.
Mental accounting is the habit of mentally assigning dollars to different accounts so that some dollars are worth more than others.
Loss aversion is an oversensitivity to loss, leading to unwillingness to recognize a loss and move on.
The status quo bias is the tendency to avoid making a decision and sticking with the status quo.
CHAPTER 13- MONOPOLY
The Meaning of Monopoly
A monopolist is a firm that the only producer of a good that has no close substitutes. An industry controlled by a monopolist is known as a monopoly.
What Monopolists Do
The ability of a monopolist to
raise its price above the
competitive level by reducing
output is known as market
The reason a monopolist
reduces output and raises
prices compared to the
perfectly competitive industry
levels is to increase profit.
Why Do Monopolies Exist?
For a profitable monopoly to persist, something must keep others from going into the same business; that “something” is known as a barrier to entry – there are five principal types.
1. Control of a Scarce Resource or Input – A monopolist that controls a resource or input crucial to an industry can prevent other firms from entering its market.
2. Increasing Returns to Scale—A monopoly created and sustained by increasing returns to scale is called a natural monopoly. For e.g. Local gas supply is an industry in which average total cost falls as output increases.
a. Natural monopoly exists
when increasing returns to
scale provide a large cost
advantage to a single firm
that produces all of an
3. Technological Superiority—A
firm that maintains a consistent
technological advantage over
potential competitors can
establish itself as a monopolist.
4. Network Externality—Network
externality exists when the value of a good or service to an individual is greater when many other people use the good or service as well. a. The earliest form of network externalities arose in transportation, where the value of a road or airport increased as the number of people who had access to it rose. But network externalities are especially prevalent in the technology and communications sectors of the economy.
5. Government-Created Barrier—The most important legally created monopolies today arise from patents and copyrights.
a. Patent—gives an inventor a temporary monopoly in the use or sale of an invention.
b. Copyright—gives the creator of a literary or artistic work sole rights to profit from that work.
The Monopolist’s Demand Curve and Marginal Revenue
A monopolist is the sole supplier of its good. So its demand curve is simply the market demand curve, which slopes downward.
- This downward slope creates a “wedge” between the price of the good and marginal revenue of the good—the change in revenue generated by producing one more unit.
The marginal revenue of a monopolist is composed of a quantity effect (the price received from the additional unit) and a price effect (the reduction in the price at which all units are sold). Because of the price effect, a monopolist’s marginal revenue is always less than the market price, and the marginal revenue curve lies below the demand curve.
At the monopolist’s profit-maximizing output level, marginal cost equals marginal revenue, which is less than market price. MC = MR; < P.
- At the perfectly competitive firm’s profit-maximizing output level, marginal cost equals the market price. MC = P.
o Compared to perfectly competitive industries, monopolies produce less, charge higher prices, and earn profits in both the short run and the long run.
monopolist is a
sole supplier of
its good, its
is simply the
DM in panel (B)
of the figure to
- This downward
slope creates a
between the prices of the good and the marginal revenue of the good—the change in revenue generated by producing one more unit.
An increase in production by a monopolist has two opposing effects on revenue:
- A quantity effect: One more unit is sold, increasing total revenue by the price at which the unit is sold.
- A price effect: In order to sell the last unit, the monopolist must cut the market price on all units sold. This decreases total revenue.
The quantity effect and the price
effect when the monopolist goes from
selling 9 diamonds to 10 diamonds are
illustrated in the two shaded areas in
the figure to the left.
o Increasing diamond sales from 9
to 10 means moving down the
demand curve from A to B,
reducing the price per diamond
from $550 to $500.
o The green shaded area
represents the quantity effect:
The company sells the 10th
diamond at a price of $500.
This is offset, however,
by the price effect
represented by the
In order for the company
to sell that 10th diamond,
it must reduce the price
on all its diamonds from
$550 to $500.
o So, it loses 9 x $50 = $450 in
revenue, the yellow-shaded
o Point C indicates that the total
effect on revenue of selling one
more diamond—the marginal
revenue—derived from an
increase in diamond sales from
9 to 10 is only $50.
Panel (b) reflects the fact that at low
levels of output, the quantity effect is
stronger than the price effect: as the
monopolist sells more, it has to lower
the price on only very few units, so the
price effect is small.
o As output rises beyond 10
diamonds, total revenue
actually falls. This reflects that
at high levels of output, the
price effect is stronger than the
quantity effect: as the
monopolist sells more, it now
has to lower the price on many
units of output, making the
price effect very large.
The Monopolist’s Profit-Maximizing Output and Price
To maximize profit, the monopolist compares marginal cost with marginal revenue. If marginal revenue exceeds marginal cost, the diamond company increases profit by producing more; if marginal revenue is less than marginal cost, the diamond company increases profit by producing less.
So the monopolist maximizes its profit by using the optimal output rule.
The monopolist’s optimal point
is shown on the left. At point A,
the marginal cost curve, MC,
crosses the marginal revenue
curve, MR. The corresponding
output level, 8 diamonds, is the
quantity of output, QM.
The price at which consumers
demand 8 diamonds, is $600, so
the monopolist’s price, is $600
—corresponding to point B. The
average total cost of producing
each diamond is $200, so the
monopolist earns a profit of
$600 - $200 = $400 per
diamond, and total profit is 8 x
$400 = $3,200, as indicated by
the shaded area.
Monopoly versus Perfect Competition
Compared with a competitive industry, a monopolist does the following:
- Produces a smaller quantity: QM < QC
- Charges a higher price: PM > PC
- Earns a profit
Monopoly: The General Picture
The crucial difference between a firm with market power, such as a monopolist, and a firm in a perfectly competitive industry is that perfectly competitive firms are price-takers that face horizontal demand curves, but a firm with market power faces a downward-sloping demand curve.
Due to the price effect of an increase in output, the marginal revenue curve of a firm with market power always lies below its demand curve. So, a profit-maximizing monopolist chooses the output level at which marginal cost is equal to marginal revenue—not to price.
As a result, the monopolist produces less and sells its output at a higher price than a perfectly competitive industry would. It earns profits in the short run and the long run.
Monopoly and Public Policy
Welfare Effects of Monopoly
By reducing output and raising price above marginal cost, a monopolist captures some of the consumer surplus as profit and causes deadweight loss. To avoid deadweight loss, government policy attempts to curtail monopoly behavior.
Policy toward monopoly depends crucially on whether or not the industry in question is a natural monopoly, one in which increasing returns to scale ensure that a bigger producer has lower average total cost.
- If the industry is not a natural monopoly, the best policy is to prevent monopoly from arising or break it up if it already exists.
The De Beers monopoly on diamonds didn’t have to happen. Diamond production is not a natural monopoly: the industry’s costs would be no higher if it consisted of a number of independent, competing producers (as is the case, for example, in gold production).
- So, if the South African government has been worried about how a monopoly would have affected consumers, it could have blocked Cecil Rhodes in his drive to dominate the industry or broken up his monopoly after the fact. Today, governments often try to prevent monopolies from forming and break up existing one.
For complicated historical reasons, it was allowed to remain a monopoly. But over the last century, most similar monopolies have been broken up. The most celebrated example in the US is Standard Oil—founded by John D. Rockefeller in 1870. By 1878, Standard oil controlled almost all us oil refining; but in 1911 a court order broke the company into a number of smaller units, including the companies that later became Exxon and Mobil.
The government policies used to prevent or eliminate monopolies are known as antitrust policies ~
Dealing with Natural Monopoly
What can public policy do about breaking up huge monopolies
1. Public ownership—In public ownership of a monopoly, the good is supplied by the government or by a firm owned by the government.
a. Instead of allowing a private monopolist to control an industry, the government establishes a public agency to provide the good and protect consumers’ interests.
b. Examples of public ownership in the US is Passenger rail service— which is provided by the public company Amtrak; regular mail delivery is provided by the U.S. Postal Service; some cities, including LA, have publicly owned electric power companies.
2. Regulation—Price Regulation limits the price that a monopolist is allowed to charge.
a. Most local utilities like electricity, land line telephone service, natural gas, etc.
b. A price ceiling on a monopolist need not create a shortage—in the absence of a price ceiling, a monopolist would charge a price that is higher than its marginal cost of production.
i. So if even forced to charge a lower price—as long as that price is above MC and the monopolist at least breaks even on total
output—the monopolist still has an incentive to produce the quantity demanded at that price.
When monopolies are “created” rather than natural, governments should act to prevent them from forming and break up existing ones.
Natural monopoly poses a harder policy problem.
- Public Ownership is one answer for policy regulation but publicly owned companies are often poorly run.
- Price regulation is another answer—A price ceiling imposed on a monopolist does not create shortages as long as it is not set too low.
There always remains the option of doing nothing, monopoly is a bad thing, but the cure may be worse than the disease.
A monopsony, when there is only one buyer of a good, also results in deadweight loss. The monopsonist can affect the price of the good it buys; it captures surplus from sellers by reducing how much it purchases and thereby lowers the price.
A single-price monopolist offers its product to all consumers at the same price.
Sellers engage in price discrimination when they charge different prices to different consumers for the same good.
The Logic of Price Discrimination
Price discrimination is profitable when consumers differ in their sensitivity to the price. A monopolist charges higher prices to low-elasticity consumers and lower prices to high-elasticity ones.
Perfect Price Discrimination
A monopolist able to charge each consumer his or her willingness to pay for the good achieves perfect price discrimination and does not cause inefficiency because all mutually beneficial transactions are exploited.
Monopolists do try to move
in the direction of perfect
through a variety of pricing
restrictions: Prices are
lower for those who
purchase well in advance
(or in some cases for
those who purchase at
the last minute).
Volume discounts: Often
the price is lower if you
buy a large quantity. For
a consumer who plans to
consume a lot of good,
the cost of the last unit—
the marginal cost to the
considerably less than
the average price.
- Two-part tariffs: With a two-part tariff, a customer pays a flat fee up-front and then a per-unit fee on each item purchased.
If sales to consumers formerly priced out of the market but now able to purchase the good at a lower price generate enough surplus to offset the loss in surplus to those now facing a higher price and no longer buying the good, then total surplus increases when discrimination is introduced.
- For e.g. a drug that is disproportionately prescribed to senior citizens, who are often on fixed incomes and so are very sensitive to price. A policy that allows a drug company to charge senior citizens a low price and everyone else a high price may indeed increase total surplus compared to a situation in
which everyone is charged the same price.
- But price discrimination that creates serious concerns about equity is likely to be prohibited—for example, an ambulance service that charges patients based on the severity of their emergency.
CHAPTER 14- OLIGOPOLY
The Prevalence of Oligopoly
An oligopoly is an industry with only a small number of producers. A producer in such an industry is known as an oligopolist.
When no one firm has a monopoly, but producers nonetheless realize that they can affect market prices, an industry is characterized by imperfect competition.
Oligopoly is the result of the same factors that sometimes produce monopoly, but in somewhat weaker form.
- The most important source of oligopoly is the existence of increasing returns to scale, which give bigger producers a cost advantage over smaller ones. When these effects are very strong, they lead to monopoly; when they are
not that strong, they lead to an industry with a small number of firms. o For e.g., larger grocery stores typically have lower costs than smaller ones. But the advantages, of large scale taper off once grocery stores are reasonably large, which is why two or three stores often survive in small towns.
A Duopoly Example
We have two firms, ADM and Ajnimoto, producing
lysine—both marginal costs equal zero.
If this were a perfectly competitive industry, each firm would have an incentive to produce more as long as
the market price was above marginal cost. Since the marginal cost is assumed to be zero, this would mean
that at equilibrium lysine would be provided free. Firms
would produce until price equals zero, yielding a total
output of 120 million pounds and zero revenue for both
How much will the two firms produce?
Collusion—the two companies will cooperate to raise their joint profits. The strongest form of collusion is a cartel, an arrangement between producers that determines how much each is allowed to produce.
Collusion and Competition
Suppose that the presidents of ADM and Ajinomoto were to agree that each would produce 30 million pounds of lysine over the next year.
Consider what would happen if Ajinomoto honored its agreement, producing only 30 million pounds, but ADM ignored its promise and produced 40 million pounds. This increase in total output would drive the price down from $6 to $5/lb.—the price at which 70 million pounds are demanded.
The total revenue of the industry would fall from $360 million to $350 million. However, ADM’s revenue would rise, from $180 million to $200 million. Since we are assuming a marginal cost of zero, this would mean a $20 million increase in ADM’s profits.
- But if Ajinomoto’s president might make exactly the same calculation. And if both firms were to produce 40 million pounds of lysine, the price would drop to $4/lb. – So each firm’s profits would fall, from $180 million to $160 million.
So why do individual firms have an incentive to produce more than the quantity that maximizes their joint profits? Because neither firm has as strong an incentive to limit its output as a true monopolist would.
Theory of Monopoly
1. A positive quantity effect: one more unit is sold, increasing total revenue by the price at which that unit is sold.
2. A negative price effect: in order to sell one more unit, the monopolist must cut the market price on all units sold.
The negative price effect is the reason marginal revenue for a monopolist is less than the market price.
- In the case of oligopoly, when considering the effect of increasing production, a firm is concerned only with the price effect on its own units of output, not those of its fellow oligopolists.
o Both ADM and Ajinomoto suffer a negative price effect if ADM decides to produce extra lysine and so drives down the price—But ADM cares only about the negative price effect on the units it produces, not about the loss to Ajinomoto.
o But ADM only cares about the negative price effect on the units it produces, not about the loss to Ajinomoto.
- This tells us that an individual firm in an oligopolistic industry faces a smaller price effect from an additional unit of output than does a monopolist; therefore, the marginal revenue that such a firm calculates is higher.
Noncooperative Behavior-- when firms ignore the effects of their actions on each others’ profits.
Overall, each firm has an incentive to cheat—to produce more than it is supposed to under the cartel agreement. So there are two principal outcomes: successful collusion or behaving noncooperatively by cheating.
The Prisoner’s Dilemma
Game theory deals with any situation in which the reward to any one player—the payoff—depends not only on his or her own actions but also on those of other players in the game.
- In oligopolistic firms, the payoff is simply the firm’s profit.
When there are only two players, as in a duopoly, the interdependence between the players can be represented with a payoff matrix like that shown in Figure 14-1.
Each row corresponds to an action by one
player (in this case; ADM); each column
corresponds to an action by the other (in
this case, Ajinomoto).
Each box, divided by a diagonal line,
shows the payoff to the two firms
that results from a pair of choices;
the number below the diagonal
shows ADM’s profits, the number
above the diagonal shows
These payoffs show what we
concluded from our earlier analysis:
the combined profit of the two firms
that results from a pair of choices; the
number below shows ADM’s profits,
the number above the diagonal shows
The payoffs conclude: The profit of the two firms is maximized if they each produce 30 million pounds.
Either the firm can, however, increase its own profits by producing 40 million pounds while the other produces only 30 million pounds—but if both produce the larger quantity, both will have lower profits than if they had both held their output down.
This situation is known as the prisoner’s dilemma—a type of game in which the payoff matrix implies the following.
- Each player has an incentive , regardless of what the other player does, to cheat—to take an action that benefits it at the other’s expense.
- When both players cheat, both are worse off than they would have been if neither had cheated.
An action is dominant strategy when it is the player’s best action regardless of the action taken by the other player.
In game theory, a Nash equilibrium, also known as a noncooperative equilibrium, results when each player in a game chooses the action that maximizes his or her payoff given the actions of other players, ignoring the effects of his or her action on the payoffs received by those other players.
Overcoming the Prisoner’s Dilemma: Repeated Interaction and Tacit Collusion
A smart firm will engage in strategic behavior, taking account of the effects of the action it chooses today on the future actions of other players in the game.
A strategy of tit for tat involves playing cooperatively at first, then doing whatever the other player did in the previous period.
1. If ADM plays tit for tat and so does
Ajinomoto, both firms will make a profit of
$180 million each year.
2. If ADM plays always cheat but Ajinomoto
plays tit for tat, ADM makes a profit of
$200 million the first year but only $160
million per year thereafter.
3. If ADM plays tit for tat but Ajinomoto
plays always cheat, ADM makes a profit of
only $150 million in the first year, but
$160 million per year thereafter.
4. If ADM plays always cheat and
Adjinomoto does the same, both firms will
make a profit of $160 million each year.
When firms limit production and raise prices in a way that raises one another’s profits, even though they have not made any formal agreement, they are engaged in tacit collusion.
Oligopoly in Practice
Antitrust policies consist of efforts undertaken by the government to prevent oligopolistic industries from becoming or behaving like monopolies.
- One of the most striking early actions of antitrust policy was the breakup of Standard Oil in 1911.
Tacit Collusion and Price Wars
Tacit collusion is limited by a number of factors, including large numbers of firms, complex products and pricing, differences in interests among firms, and bargaining power of buyers.
When collusion breaks down, there is a price war—occurs when tacit collusion breaks down and prices collapse.
Product Differentiation and Price Leadership
To limit competition, oligopolist often engage in product differentiation. When products are differentiated, it is sometimes possible for industry to achieve tacit collusion through price leadership.
Product differentiation is an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry.
- A firm might alter what it actually produces, adding “extras”, or choosing a different design.
o It may also use advertising and marketing campaigns to create a differentiation in the minds of consumers, even though its product is more or less identical to the products of rivals.
Price leadership is when one firm sets its price first, and other firms follow that price.
Nonprice competition is the use of advertising and other means to try to increase their sales.
CHAPTER 15: MONOPOLISTIC COMPETITION AND PRODUCT DIFFERENTIATION
The Meaning of Monopolistic Competition
Monopolistic competition is a market structure in which there are many competing producers in an industry, each producer sells a differentiated product, and there is free entry into and exit from the industry in the long run.
- Each producer has some ability to set the price of their differentiated product. In a monopolistic competitive industry, there are producers.
- Each producer has a product that consumers view as somewhat distinct from the product competing firms; at the same time, though, consumer see these competing products as close substitutes.
Three important forms of product differentiation: differentiation by style or type, differentiation by location, and differentiation by quality.
Differentiation by Style or Type
- The product of different vendors are substitutes, but they aren’t perfect substitutes—they are imperfect substitutes.
Product differentiation is characteristic of most consumer goods—As long as people differ in their tastes, producers find it possible and profitable to produce a range of varieties.
Differentiation by Location
Monopolistically competitive industries supply goods differentiated by location. This is especially true in service industries, from dry cleaners to hairdressers, where customers often choose the seller who is closest rather than cheapest.
Differentiation by Quality
Because consumers vary in what they are willing to pay higher quality, producers can differentiate their products by quality—some offering lower-quality, inexpensive products and others offering higher-quality products at a higher price.
- Competition among sellers: even though sellers of differentiated products are not offering identical goods, they are to some extent competing for a limited market.
o If more businesses enter the market, each will find that it sells less quantity at any given price.
For e.g. if a new gas station opens along a road, each of the existing gas stations will sell a bit less.
- Value in diversity: refers to the gain to consumers from the proliferation of differentiated products.
o For e.g. a food court with eight vendors makes consumers happier than one with only six vendors, even if the prices are the same, because some customers will get a meal that is closer to what they had in mind.
When a product is available in many different qualities, fewer people are forced to pay for more quality than they need or to settle for lower quality than they want. --- There are benefits to consumers from a greater diversity of available products.
Producers compete for the same market, so entry by more producers reduces the quantity each existing producers sells at any given price. In addition, consumers gain from the increased diversity of products.
Monopolistic Competition in the Short Run
The key to whether a firm
with market power is
profitable or unprofitable
in the short run, lies in
the relationship between
its demand curve and its
average total cost curve.
Monopolistic Competition in Long Run
the long run, a
firm makes zero
profit at its profit
In long-run equilibrium, firms in a monopolistically competitive industry sell at a price greater than marginal cost.
They also have excess capacity because they produce less than the minimum-cost output; as a result, they have higher costs than firms in a perfectly competitive industry. Whether or not monopolistic competition is inefficient is ambiguous because consumers value the diversity of products that it creates.
A monopolistically competitive firm will always prefer to make an additional sale at the going price, so it will engage in advertising to increase demand for its produce and enhance its market power.
- Advertising and brand names that provide useful information to consumers are economically valuable.
o But they are economically wasteful when their only purpose is to create market power.
- In reality, advertising and brand names are likely to be some of both: economically valuable and economically wasteful.