CH 7-11

Chapter 7
Profit
Maximization
© 2004 Thomson Learning/South-Western

2
The Nature of Firms
 While firms are complex institutions, the typical approach

taken by economists is to assume that the firm’s decisions are
made by a single dictatorial manager who rationally pursues
some goal.
 The goal most often used is that the firm maximizes economic
profit.
3
APPLICATION 7.1: Corporate Profits, Taxes,

and Leveraged Buyout Craze
 The U.S. corporate profit tax was levied in 1909, four years
before the personal income tax.
 Some economists believe that this tax seriously distorts the

allocation of resources because
 It fails to use the economic profit definition.
 It taxes corporate income twice.
4
Definition of Profits
 Much of what is defined as corporate profits under the tax laws

is a normal return to shareholders for the equity they have
invested in the corporation.
 Shareholders expect return on their investment whether interest

from bonds or returns on equity.
5
Definition of Profits
 Some portion of corporate profits reflects the owners forgone

earnings by making equity investments.
 If this cost were added to corporate costs, profits would be

substantially reduced.
6
Effects of the Double Tax
• The corporate profits tax is a tax on the equity returns of

corporate shareholders.
• Two effects of this tax.
▫ Corporations find it more attractive to finance new capital

investments through loans and bond offerings whose
interest is tax deductible.
7
Effects of the Double Tax
 Since corporate income is taxed twice--when it is earned

by the corporation and when it is paid to shareholders as
dividends--the total rate of tax applied to corporate
equity capital is much higher than applied to other
capital.
 Investors will be less willing to invest in corporate

business than in other assets that are not taxed at as
high a tax rate.
8
Marginalism
 Firms as profit maximizers will make decisions in a marginal

way.
 The manager looks, for example, at the marginal profit from

producing one more unit of output or the additional profit from
hiring one more unit of labor.
 When the incremental profit of an activity becomes zero,

profits are maximized.
9
The Output Decision
 Economic profits () are defined as

 = TR(q) - TC(q)
 where TR(q) is the total amount of revenues received

and TC(q) are the total economic costs incurred, both
depending upon the level of output (q) produced.
 The firm will choose the level of output that generates

the largest level of profit.
10
Profit Maximization: Marginal Revenue Must Equal

Marginal Cost
Costs (TC)
Figure 7.1
Revenues (R)
Costs,
Revenue
Profits
(a)
0 Output
Profits
0
q1 q* q2 Output
(b) Profits
In Figure 7.1, (TC) is the total cost curve that is drawn consistent with
the discussion in Chapter 6.
11
Profit Maximization: Marginal Revenue Must Equal

Marginal Cost
Costs (TC)
Figure 7.1
Revenues (R)
Costs,
Revenue
Profits
(a)
0 Output
Profits
0
q1 q* q2 Output
(b) Profits
As drawn in the figure, profits reach their maximum at the output level q*.
12
FIG 7.1: Marginal Revenue Must Equal Marginal

Cost for Profit Maximization Costs (TC)
Figure 7.1 Revenues (R)
Costs,
Revenue
Profits
(a)
0 Output
Profits
0
q1 q* q2 Output
(b) Profits
At output levels below q* increasing output causes profits to increase, so

profit maximizing firms would not stop short of q*.
13
FIG 7.1: Marginal Revenue Must Equal Marginal

Cost for Profit Maximization Costs (TC)
Figure 7.1 Revenues (R)
Costs,
Revenue
Profits
(a)
0 Output
Profits
0
q1 q* q2 Output
(b) Profits
Increasing output beyond q* reduces profits, so profit maximizing firms

would not produce more than q*.
14
The Marginal Revenue = Marginal Cost Rule

Figure 7.1
Costs (TC)
Costs,
Revenue Revenues (R)
(a)
0 Output
Profits
0
q1 q* q2 Output
(b) Profits
At q* marginal cost equals marginal revenue, the extra revenue a firm

receives when it sells one more unit of output.
15
The Marginal Revenue/ Marginal Cost Rule
 In order to maximize profits, a firm should produce that

output level for which the marginal revenue from selling one
more unit of output is exactly equal to the marginal cost of
producing that unit of output.
 MR = MC to reach maximum 
16
The Marginal Revenue/Marginal Cost Rule
 At the profit maximizing level of output
Marginal Revenue = Marginal Cost

or
MR = MC
 Firms, starting at zero output, can expand output so long as

marginal revenue exceeds marginal cost, but don’t go beyond the
point where these two are equal.
17
Marginalism in Input Choices
 Both labor and capital should be hired up to the point where

the additional revenue brought in by selling the output
produced by the extra labor or capital equals the increase in
costs brought on by hiring the additional inputs.
18
Marginal Revenue
 A price taker is a firm or individual whose decisions regarding

buying or selling have no effect on the prevailing market price
of a good or service.
 For a price taking firm

MC = P.
19
Marginal Revenue for a Downward-Sloping

Demand Curve
 A firm that is not a price taker faces a downward sloping
demand curve for its product.
 These firms must reduce their selling price in order to sell
more goods or services.
 In this case marginal revenue is less than market price
MR < P.
20
A Numerical Example
 Assume the quantity demanded of tape cassettes from a
particular store per week (Q) is related to the price (P) by
Q = 10 - P.
 Total revenue is (P*Q) and marginal revenue (MR) is the

change in total revenue due to a change in quantity demanded.
MR = D TR > 0
DQ
21
A Numerical Example
 This example demonstrates that MR < P as shown in Table 7.1.

 Total revenue reaches a maximum at q = 5, P = 5.
 For q > 5, total revenues decline causing marginal revenue to be
negative.
22
Total and Marginal Revenue for Cassette Tapes

(Q = 10 - P)
TABLE 7.1:
Price Quantity Total Revenue Marginal Revenue

(P) (q) (P·q) (MR)
$10 0 $0
9 1 9 $9
8 2 16 7
7 3 21 5
6 4 24 3
5 5 25 1
4 6 24 -1
3 7 21 -3
2 8 16 -5
1 9 9 -7
0 10 0 -9
23
A Numerical Example
 This hypothetical demand curve is shown in Figure 7.2.
 When q = 3, P = $7 and total revenue equals $21 which is

shown by the area of the rectangle P*Aq*0.
 If the firm wants to sell four tapes it must reduce the price to
$6.
24
Illustration of Marginal Revenue for the Demand

Curve for Cassette Tapes (Q = 10 - P)
Price
(dollars)
10
 When q = 3, P = $7 and total
revenue equals $21 which is
shown by the area of the
P* = $7 A rectangle P*Aq*0.
Demand
Casette Tapes
0 1 2 3 4 10
q*
 If the firm wants to sell four tapes it must reduce the price to $6.
25
A Numerical Example
• Total revenue is not $24 as illustrated by the area of the

rectangle P**Bq**0.
• The sale of one more tape increases revenue by the price at

which it sells ($6).
• But, to sell the fourth tape, it must reduce its selling price on the
first three tapes from $7 to $6 which reduces revenue by $3,
which is shown in the lightly shaded rectangle.
26
Illustration of Marginal Revenue for the Demand

Curve for Cassette Tapes (Q = 10 - P)
Price
(dollars) FIGURE 7.2
10  Total revenue is not $24 as illustrated by the area
of the rectangle P**Bq**0.
P* = $7 A  The sale of one more tape increases revenue by

P* = $6 B the price at which it sells ($6).
Demand Cassette tapes

per week
0 1 2 3 4 10
q* q**
 But, to sell the fourth tape, it must reduce its selling price on the first three tapes
from $7 to $6 which reduces revenue by $3, which is shown in the lightly shaded
rectangle.
27
A Numerical Example
 The net result of this price decrease is total revenue

increases by only $3 ($6 - $3).
 Thus, the marginal revenue of the fourth tape is $3.
 The sale of the sixth tape, instead of five, results in an

increase in revenue of the price ($4), but a decrease for the
five other tapes (-$5) with a net effect (MR) = -$1.
28
Marginal Revenue and Price Elasticity
 As previously defined in Chapter 4, the price elasticity of

demand for the market is
Percentage change in Q
eq , P  .
Percentage change in P
 This same concept can be defined for a single firm as
Percentage change in q
eq , P  .
Percentage change in P
29
 If demand facing the firm is inelastic
 (0  eq,P > -1), a rise in the price will cause total revenues to
rise.
 If demand is elastic (eq,P < -1), a rise in price will result in

smaller total revenues.
 This relationship between the price elasticity and marginal

revenue is summarized in Table 7.2.
30
TABLE 7.2: Relationship between Marginal

Revenue and Elasticity
Demand Curve Marginal Revenue
Elastic (eq,p < -1) MR > 0
Unit elastic (eq,P = -1) MR = 0
Inelastic (eq,P > -1) MR < 0

31
 It can be shown that all of the relationships in Table 7.2

can be derived from the basic equation
 1 
MR  P 1  
 e 
 q , P 
 For example, if eq,P < -1 (elastic), this equation shows
that MR is positive.
32
• If demand is infinitely elastic (eq,P = -), MR will equal price,

as was shown when the firm is a price taker.
• Suppose a non price taker firm knows elasticity = -2 and its

current price is $10.
• Selling one more product will result in a marginal revenue of

$5 [$10(1+1/-2)], which would be produced only if MC < $5.
33
Marginal Revenue Curve
 It is sometimes useful to think of the demand curve as the

average revenue curve since it shows the revenue per unit
(price).
 The marginal revenue curve is a curve showing the relation

between the quantity a firm sells and the revenue yielded by
the last unit sold. It is derived from the demand curve.
34
Marginal Revenue Curve
 With a downward-sloping demand curve, the marginal revenue

curve will lie below the demand curve since, at any level of
output, marginal revenue is less than price.
 A demand and marginal revenue curve are shown in Fig 7.3.
 For output levels greater than q1, marginal revenue is negative.

35
Shifts in Demand and Marginal Revenue

Curves
 As previously discussed, changes in such factors as income,

other prices, or preferences cause demand curves to shift.
 Since marginal revenue curves are derived from demand

curves, whenever the demand curve shifts, the marginal
revenue curve also shifts.
36
FIGURE 7.3: Marginal Revenue Curve Associated

with a Demand Curve
Price
P1
Demand (Average Revenue)
0 q1 Quantity
per week
Marginal Revenue
37
Short-Run Profit Maximization
 Since the firm has no effect on the price it receives for its
product, the goal of maximizing profits dictates that it should
produce the quantity for which marginal cost equals price.
 At a given price, such as P* in Figure 7.4, the firm’s demand

curve is a horizontal line through P*.
38
FIGURE 7.4: Short-Run Supply Curve for a

Price-Taking Firm
Price SMC
E SAC
P* = MR
0
q* Quantity
per week
39
FIGURE 7.4: Short-Run Supply Curve for a Price-

Taking Firm
Price SMC
P**
SAC
P* = MR E
A
F
P***
P1
0
q1 q*** q* q** Quantity
per week
At P* = MR, the firm maximizes profits by producing q*, since this is

where price equals short-run marginal costs
40

Taking Firm
Price SMC
P**
SAC
P* = MR E
A
F
P***
P1
0
per week
At P* profits are positive since P > SAC, but at a price such as P***, short-
run profits would be negative
41

Taking Firm
Price SMC
P**
P* = MR SAC
E
A
F
P***
P1
0
per week
If price just equaled average cost (and marginal cost), short-run profits
equal zero
42

Taking Firm
Price SMC
P**
SAC
P* = MR E
A
F
P***
P1
0
per week
If , at P* the firm produced less than q*, profits could be increased by

producing more since MR > SMC below q
43

Taking Firm
Price SMC
P**
P* = MR SAC
E
A
F
P***
P1
0
per week
Alternatively, if the firm produced more than q* profits could be

increased by producing less since MR < SMC beyond q*.
44

Taking Firm
Price SMC
P**
SAC
P* = MR E
A
F
P***
P1
0
per week
Total profits are given by the area P*EFA which can be calculated by
multiplying profits per unit (P* - A) times the firm’s chosen output level q*.
45

Taking Firm
Price SMC
P**
SAC
P* = MR E
A
F
P***
P1
0
per week
For this situation to truly be a maximum profit, the marginal cost curve
must also be be increasing (it would be a profit minimum if the marginal
cost curve was decreasing).
46
The Firm’s Short-Run Supply Curve
 The firm’s short-run supply curve is the relationship

between price and quantity supplied by a firm in the short-run.
 For a price-taking firm, this is the positively sloped portion of

the short-run marginal cost curve.
 For all possible prices, the marginal cost curve shows how
much output the firm should supply.
47
The Shutdown Decision
 For very low prices, the firm could also produce zero output.
 Since fixed costs are incurred whether or not the firm
produces any goods, the decision to produce is based on
short-run variable costs.
48
 The firm will opt for q > 0 providing
P  q  SVC
or, dividing by q,
SVC
P .
q
 The price must exceed average variable cost.

49
• The shutdown price is the price below which the firm will
choose to produce no output in the short-run. It is equal to
minimum average variable costs.
• In Figure 7.4, the shutdown price is P1.
• For all P  P1 the firm will follow the P = MC rule, so the

supply curve will be the short-run marginal cost curve.
50
 Notice, the firm will still produce if P < SAC, so long as it can
cover its fixed costs.
 However, if price is less than the shutdown price (P < P1 in

Figure 7.4), the firm will have smaller losses if it shuts down.
 This decision is illustrated by the colored segment 0P1 in

Figure 7.4.
51
FIGURE 7.4: Short-Run Supply Curve for a

Price-Taking Firm
Price SMC
P1
0
Quantity
per week
52
Profit Maximization and Managers’ Incentives
 The principal-agent relationship is an economic actor (the

principal) delegating decision-making authority to another
party (the agent).
 As early as Adam Smith, it was understood that managers of

a company may have different goals than are the goals of the
owners of the company.
53
APPLICATION 7.4: Principals and Agents in

Franchising and Medicine
 Many large business, such as McDonald’s Corporation,

operate their local retail outlets through franchise contracts.
 For example, local McDonalds restaurants are usually

owned by local groups of investors.
 The problem for the parent company is to ensure that their

franchise agents operate in a proper manner.
54

 Various provisions of franchise contracts help to assure

proper behavior.
 With McDonald’s franchises, for example, must meet food-

quality and service standards and must purchase supplies
from firms that meet standards set by the parent company.
 The franchisee, in return, gets some management

assistance and national advertising and gets to keep a
large share of the profits.
55

 Physicians act as agents for patients who often lack

knowledge of their illness or what treatments are warranted.
 There are several reasons why physicians might not chose

exactly what a fully informed patient might choose.
 Unlike the physician, the patient must pay the medical bills.
56

 Since the physician is usually the care provider, he or she

may financially benefit from the services provided.
 Studies find evidence of this physician induced demand,

especially for patients with insurance.
 Doctors are “double agents” with insured patients since they

represent both the patients and the insurance company.
57

 Current controversies, such as the growth of managed care

organizations arise from this dual relationship.
 The rapid escalation of health costs have resulted in

managed care organizations.
 Alternatively, restrictions place by managed care

organizations have resulted in a major backlash among
patients.
58
Incentive Contracts
 Owners, however, could refuse to invest in firms where

managers behave this way.
 Managers would then have two options.
 They could go it alone and finance the company solely with

their funds.
 This would return to the original case and result in *, B*.
 A manger could work out some agreement with potential

investors.
59
Incentive Contracts
 It would likely be too costly for other owners to have

managers completely pay for their benefits.
 But owners could construct contracts that give managers

incentives to economize on benefits and pursue more
profit maximizing goals.
 Incentives include stock options and profit sharing

bonuses.
Chapter 8
Perfect
Competition

Timing of a Supply Response
 A supply response is the change in quantity

of output in response to a change in demand
conditions.
 The pattern of equilibrium prices will be
different depending upon the time period
– In the very short run, quantity is fixed so there is no
supply response
2
Timing of a Supply Response
– In the short run existing firms may change

the quantity they are supplying, but no
firms enter or exit the market.
– In the long run firms can further change
the quantity supplied and new firms may
enter the market.
3
Pricing in the Very Short Run
 The market period (very short run) is a short period of

time during which quantity supplied is fixed.
 In this period, price acts to ration demand as it adjusts
to clear the market.
 This situation is illustrated in Figure 8.1 where supply is
fixed at Q*.
4
FIGURE 8.1: Pricing in the Very
Short Run
When demand is represented by the

Price curve D, P1 is the equilibrium price.
S
The equilibrium price is the price at
which the quantity demanded by buyers of
P1
a good is equal to the quantity supplied by
sellers of the good.
D
0 Q* Quantity
per week
5
Pricing in the Very Short Run
 When demand is represented by the curve D,

P1 is the equilibrium price.
 The equilibrium price is the price at which the
quantity demanded by buyers of a good is
equal to the quantity supplied by sellers of the
good.
6
FIGURE 8.1: Shifts in Demand with
Price as a Rationing Device
Price If demand were to increase, as illustrated

S
by the new demand curve D’ in Figure 8.1,
P2 P1 is no longer the equilibrium price since

the quantity demanded exceeds the
P1
D’ quantity supplied.
D
0 Q* Quantity
per week
7
Short Run
Price The new equilibrium price is now P2

S where price has rationed the good to
those who value it the most.
P2
P1
D’
0 Q* Quantity
per week
8
Short Run
Price
S In the short run, P goes up
because there is only firm
P2
produces the good at Q*
P1
D’
0 Q* Quantity
per week
9
Short-Run Supply
 In the short-run the number of firms is fixed as no firms

are able to enter or leave the market.
 However, existing firms can adjust their quantity in
response to price changes.
 Because of the large number of firms, each firm is
treated as a price taker.
10
Construction of a Short-Run Supply
Curve
 The quantity that is supplied is the sum of the

quantities supplied by each firm.
 The short-run market supply curve is the relationship
between market price and quantity supplied of a good
in the short run.
 In Figure 8.2 it is assumed that there are only two
firms, A and B.
11
FIGURE 8.2: Short-Run Market
Supply Curve
Price Price Price
SA
qA1 Output 0 Output 0 Quantity

0
per week
(a) Firm A (b) Firm B (c) The Market
12
Supply Curve
Price Price Price
SA SB
qA1 Output 0 qB 1 Output 0 Quantity

0
per week

13
Supply Curve
Price Price Price
SA SB S
0 qA1 Output 0 qB 1 Output 0 Q1 Quantity

per week

14
Supply Curve
The market supply curve is the horizontal sum of the two firms are every
price.
Q1 equals the sum of q1A and q1B.
Price Price Price
SA SB S
0 qA1 Output 0 qB1 Output 0 Q1 Quantity

per week
15
FIGURE 8.3: Short-Run Price
Determination
The market equilibrium where the market demand curve D and the
short-run supply curve S intersect at a price of P1 and quantity Q1
Price SMC Price S Price
SAC
P1
D
d
0 q1q2 Output 0 Q1 Q2 Quantity 0 q1 q2 q‘1 Quantity

per week
(a) Typical Firm (b) The Market (c) Typical Person

16
FIGURE 8.3: Short-Run Price
Determination
This equilibrium would persist since what firms supply at P1 is

exactly what people want to buy at that price.
SAC
P2
D’
P1 d’
D
d
q1q2 Output 0 Q1 Q2 Quantity 0 q1 q2 q‘1 Quantity

0 per week
17
Functions of the Equilibrium Price
 The price serves as a signal to producers

about how much should be produced.
– To maximize profit, firms will produce the output
level for which marginal costs equal P1.
– This yields an aggregate production of Q1.
18
Interaction of Many Individuals and Firms
Determine market price in the Short Run
Given the price, utility maximizing individuals will decide how much of their
limited incomes to spend
• At price P1 the total quantity demanded is Q1.
• No other price brings about the balance of quantity demanded and
quantity supplied.
FIGURE 8.3:
SAC
P2
D’
P1 d’
D
d

per week
19 (a) Typical Firm (b) The Market (c) Typical Person

If the typical person’s demand for the good increases from d to d’, the
entire market demand curve will shift to D’ as shown in figure 8.3.
SAC
P2
D’
P1 d’
D
d

per week
20
The new equilibrium is P2, Q2 where a new balance between demand

and supply is established.
SAC
P2
D’
P1 d’
D
d

per week
21
The increase in demand resulted in a higher equilibrium price, P2 and

a greater equilibrium quantity, Q2.
SAC
P2
D’
P1 d’
D
d

per week
22
P2 has rationed the typical person’s demand so that only q2 is

demanded rather than the q’1 that would have been demanded at P1.
SAC
P2
D’
P1 d’
D
d

per week
23
P2 also signals the typical firm to increase production from q1 to q2.
SAC
P2
D’
P1 d’
D
d

per week
24
Shifts in Demand Curves
 Demand will increase, shift outward, because

– Income increases
– The price of a substitute rises
– The price of a complement falls
– Preferences for the good increase
25
Shifts in Demand Curves
 Demand will decrease, shift inward, because

– Income falls
– The price of a substitute falls
– The price of a complement rises
– Preferences for the good diminish
26
Shifts in Supply Curves
 Supply will increase, shift outward, because

– Input prices fall
– Technology improves
 Supply will decrease, shift inward, because

– Input prices rise
27
Table 8.1: Reasons for a Shift in a
Demand or Supply Curve
Demand Supply
Shifts outward () because Shifts outward () because

 Income increases  Input prices fall
 Price of substitute rises  Technology improves
 Price of complement falls
 Preferences for good increase
Shifts inward () because Shifts inward () because

 Income falls  Input prices rise
 Price of substitute falls
 Price of complement rises
 Preferences for good diminish
28
Short-Run Supply Elasticity
 The short-run elasticity of supply is the

percentage change in quantity supplied in the
short run in response to a 1 percent change in
price.
Percentage change in quantity
supplied in short run
Short - run supply elasticity  . [8.1]
Percentage change in price
29
Short-Run Supply Elasticity
 If a 1 percent increase in price causes firms to increase

quantity supplied by more than 1 percent, supply is
elastic.
 If a 1 percent increase in price causes firms to increase

quantity supplied by less than 1 percent, supply is
inelastic.
30
Shits in Supply Curves and the Importance of
the Shape of the Demand Curve
 The effect of a shift in supply upon equilibrium levels

of P and Q depends upon the shape of the demand
curve.
– If demand is elastic, as in Figure 8.4 (a), a decrease in
supply has a small effect on price but a relatively large effect
on quantity.
– If demand is inelastic, as in Figure 8.4 (b), the decrease in
supply has a greater effect on price than on quantity.
31
Effect of a Shift in the Short-Run Supply
Curve on the Shape of the Demand Curve
FIGURE 8.4
Price Price
S
S
D P
P
Quantity Q Quantity
0 Q per week 0
per week
(a) Elastic Demand (b) Inelastic Demand
32
Price S’ Price
S S’
S
P’
P’
D P
P
0 Q’ Q Quantity 0 Q’ Q Quantity
per week per week
The effect of a shift in supply upon equilibrium levels of P and Q

depends upon the shape of the demand curve.
33
Price S’ Price
S S’
S
P’
P’
D P
P
D
Quantity Quantity
per week per week
0 Q’ Q 0 Q’ Q
If demand is elastic, as in Figure If demand is inelastic, as in

8.4 (a), a decrease in supply has Figure 8.4 (b), the decrease in
a small effect on price but a supply has a greater effect on
relatively large effect on quantity. price than on quantity.
34
Shifts in the Demand Curve Depends on the
Shape of the Short-Run Supply Curve
Figure 8.5
S
Price Price
P’ S
P P
D D
0 Q Quantity 0 Q Quantity
per week per week
(a) Inelastic Supply (b) Elastic Supply

35
The Shift in the Demand Curve Depends on
the Shape of the Short-Run Supply Curve
Price S Price
P’ S
P’
P P
D’
D’
D D
Quantity 0 Quantity
0 Q Q’ Q Q’
per week per week
(a) Inelastic Supply (b) Elastic Supply
If supply is inelastic, as in If the supply curve is elastic, as in

Figure 8.5 (a), the effect on Figure 8.5 (b), the effect on price is
price is much greater than relatively smaller than the effect on
on quantity. quantity.
36
A Numerical Illustration
 Suppose the quantity of

cassette tapes
demanded per week (Q)
depends on the price of
the tapes (P) per
equation 8.2, Demand : Q  10  P [8.2]
 Suppose short-run
supply is given by
equation 8.3. Supply : Q  P  2 [8.3]
37
 Figure 8.6 shows the graph for these

equations.
 Since the supply curve intersects the vertical
axis at P = 2, this is the shutdown price.
 The equilibrium price is $6 with people
demanding 4 tapes which equals the amount
supplied by the firms.
38
FIGURE 8.6: Demand and Supply
Curves for Cassette Tapes
Pric
e
S
1
0 Demand : Q  10  P [8.2]
Supply : Q  P  2 [8.3]
6
D
0 4 1
39 0 Tapes
per
Pric
e Since the supply curve intersects
the vertical axis at P = 2, this is the
S
1
shutdown price.
0
6 The equilibrium price is $6 with people

demanding 4 tapes which equals the
amount supplied by the firms.
2
D
0 4 1 Tapes
40 0 per week
Price If the demand increased as

$12
reflected in equation 8.4, the former
S equilibrium price and quantity
10
would no longer hold.
7
As shown in Figure 8.6, the new
6 equilibrium price is $7 where the
5 quantity demanded and supplied of
tapes is 5.
2
D D’
0 3 4 5 6 10 12 Tapes
per week
41
Price
New Demand Curve
Q  12  P [8.4]
$12
S
10
7
6
5
Demand : Q  10  P [8.2]
Old Demand Curve
D D’
0 3 4 5 6 10 12 Tapes
per week
42
Price
• After the increase in demand,
$12
S
there is an excess demand for
10 tapes at the old equilibrium price of
$6.
7 • The increase in price from $6 to $7

6
5
restores equilibrium in the market.
D D’
0 3 4 5 6 10 12 Tapes
per week
43
TABLE 8.2: Supply and Demand Equilibrium in the
Market for Cassette Tapes
Supply Demand
Case 1 Case 2
Q=P-2 Q = 10 – P q = 12 – P
Quantity Supplied Quantity Demanded Quantity Demanded
Price (Tapes per Week) (Tapes per Week) (Tapes per Week)
$10 8 0 2
9 7 1 3
8 6 2 4
7 5 3 5
6 4 4 6
5 3 5 7
4 2 6 8
3 1 7 9
2 0 8 10
1 0 9 11
0 0 10 12
44 New equilibrium Initial equilibrium

The Long Run
 Long run supply responses are much more

flexible than in the short run.
– Long-run cost curves reflect greater input flexibility.
– Firms can enter and exit the market in response to
profit opportunities.
45
Equilibrium Conditions
 In a perfectly competitive equilibrium, no firm

has an incentive to change its behavior.
– Firms must be choosing the profit maximizing level
of output.
– Firms must be content to stay in or out of the
market.
46
Profit Maximization
 It is assumed that the goal of each firm is to

maximize profits.
– Since each firm is a price taker, this implies that
each firm product where price equals long-run
marginal cost.
– This equilibrium condition, P = MC determines the
firm’s output choice and its choice of inputs that
minimize their long-run costs.
47
Entry and Exit
 The perfectly competitive model assumes that

firms entail no special costs when they exit and
enter the market.
– Firms will be enticed to enter the market when
economic profits are positive.
– Firms will leave the market when economic profits
are negative.
48
Entry and Exit
 Entry will cause the short-run market supply

curve to shift outward causing the market
price to fall.
– This will continue until positive economic profits
are no longer available.
 Exit causes the short-run market supply curve

to shift inward causing the market price to
increase, eliminating the economic losses.
49
Long-Run Equilibrium
 For purposes of this chapter, it is assumed that

all firms producing a particular good have
identical cost curves.
 Thus, in the long-run equilibrium all firms earn
zero economic profits.
 Firms will produce at minimum average total
costs where P = MC and P = AC.
50
Long-Run Equilibrium
 P = MC results from the assumption that firm’s

are profit maximizers.
 P = AC results because market forces cause
long run economic profits to equal zero.
 In the long run, firm owners will only earn
normal returns on their investments.
51
FIGURE 8.7: Long-Run Equilibrium for a Perfectly
Competitive Constant Market: Cost Case
Price Price
MC S
AC
P1 = MC = min AC
0 q1 Output Q1 Quantity
0
per week
(a) Typical Firm (b) Total Market
•The constant cost case is a market in which entry or

52 exit has no effect on the cost curves of firms.
Price Price
MC S
AC
P1 = MC = min AC
0
per week
Figure 8.7 demonstrates long-run equilibrium for the

53 constant cost case.
Price Price
MC S
AC
P1 = MC = min AC
0
per week
Figure 8.7 (b) shows that market where the market demand and
supply curves are D and S, respectively, and equilibrium price is P1.
54
Price Price
MC S
AC
P2
P1
D’
D
0 q1 q2 Output Q1 Q Quantity per week

0 2
If demand increases to D’, the short-run price will increase to P2.

55
Price Price
MC S
AC
P2
P1
D’
D
0 q1 q2 Output Q1 Q Quantity per week

0 2
A typical firm will maximize profits by producing q2 which will result

in short-run economic profits (P2 > AC).
56
Price Price
MC S
AC
S’
P2
P1 LS
0 q1 q2 Output Q 1 Q2 Q3 Quantity
0
(a) Typical Firm per week
(b) Total Market
Positive economic profits cause new firms to enter the market until
economic profits again equal zero.
57
Long-Run Supply: The Constant
Cost Case
 The typical firm will produce output level q1

which results in Q1 in the market.
 The typical firm is maximizing profits since
price is equal to long-run marginal cost.
 The typical firm is earning zero economic
profits since price equals long-run average
total costs.
 There is no incentive for exit or entry.
58
A Shift in Demand
 Since costs do no increase with entry, the

typical firm’s costs curves do not change.
 The supply curve shifts to S’ where the
equilibrium price returns to P1 and the typical
firm produces q1 again.
 The new long-run equilibrium output will be Q3
with more firms in the market.
59
FIGURE 8.7: A Shift in Demand
Price Price
MC S
AC
S’
P2
P1 LS
0
(b) Total Market
Since costs do no increase with entry, the typical firm’s costs curves
do not change.
60
Price Price
MC S Entry of the new firm

AC
S’
P2
P1 LS
0
(b) Total Market
The supply curve shifts to S’ where the equilibrium price returns to

P1 and the typical firm produces q1 again.
61
Long-Run Equilibrium for a Perfectly
Price Price
MC S
AC
S’
P2
P1 LS
0
(b) Total Market
The new long-run equilibrium output will be Q3 with more firms in

the market
62
FIGURE 8.7: Long-Run Supply Curve
Price Price
MC S
AC
S’
P2
P LS
1
0 q1 q2 Output 0 Q1 Q2 Q3 Quantity per week

Regardless of the shift in demand, market forces will cause the

63 equilibrium price to return to P1 in the long-run.
Price Price
MC S
AC
S’
P2
P LS
1

The long-run supply curve is horizontal at the low point of the firms
64 long-run average total cost curves.
Price Price
MC S
AC
S’
P2
P LS
1

This long-run supply curve is labeled LS in Figure 8.7 (b)

65
Shape of the Long-Run Supply
Curve: The Increasing Cost Case
 The increasing cost case is a market in

which the entry of firms increases firms’
costs.
– New firms may increase demand for scarce inputs
driving up their prices.
– New firms may impose external costs in the form
of air or water pollution.
– New firms may place strains on public facilities
increasing costs for all firms in the market.
66
FIGURE 8.8: Increasing Costs Result in a
Positively Sloped Long-Run Supply Curve
Price
Price Price
S
MC D
AC
MC P2
AC
P3 P3
P1 P1
Output Quantity
Output Q1 per week
q1 q2 0 q3 0
0
(a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market
This case is shown in Figure 8.8, where the initial equilibrium price is P1
with the typical firm producing q1 with total output Q1.
67 • Economic profits are zero.
Price Price
Price D’ S
MC D
AC
P2 MC P2
AC
P1 P1 2
Quantity
Output Output per week
0 q1 q2 0 q3 0 Q1 Q2 Q3
The increase in demand to D’, with short-run supply curve S, causes

equilibrium price to increase to P2 with the typical firm producing q2
68 resulting in positive profits.
Price
Price Price D’ S S’
MC D
AC LS
P2 MC P2
AC
P3 P3
P1 P1 2
Quantity
0 q1 q2 0 q3 0 Q1 Q2 Q3
The positive profits entice firms to enter which drives up costs.

The typical firm’s new cost curves are shown in Figure 8.8 (b).
69
FIGURE 8.8:The Increasing Cost Case
Price
MC D
AC LS
P2 MC P2
AC
P3 P3
P1 P1 2
Output Output Quantity per week
0 q1 q2 0 q3 0 Q1 Q2 Q3
The new long-run equilibrium price is P3 with market output Q3.

The long-run supply curve, LS, is positively sloped because of the
70 increasing costs.
Price
MC D
AC LS
P2 MC P2
AC
P3 P3
P1 P1 2
0 q1 q2 Output 0 q3 Output 0 Q1 Q2 Q3 Quantity

per week
71
Long-Run Supply Elasticity
 The long-run elasticity of supply is the

percentage change in quantity
supplied in the long run in response to
a 1 percent change in price.
Percentage change in quantity

supplied in the long run
Long - run elasticity of supply  [8.5]
Percentage change in price
72
TABLE 8.3: Estimated Long-Run Supply
Elasticities
Industry Elasticity Estimate

Agriculture
Corn + 0.27
Soybeans + 0.13
Wheat + 0.03
Aluminum Nearly infinite
Coal + 15.0
Medical Care + 0.15 - + 0.60
Natural Gas (U.S.) + 0.50
Crude Oil (U.S.) +0.75
73
The Decreasing Cost Case
 The decreasing cost case is a market in

which the entry of firms decreases firms’
costs.
– Entry may produce a larger pool of trained labor
which reduces the costs of hiring.
– Entry may provide a “critical mass” of
industrialization that permits the development of
more efficient transportation, communications, and
financial networks.
74
The Decreasing Cost Case
 The initial equilibrium is shown as P1, Q1 in Figure

8.9 (c).
 The increase in demand from D to D’ results in the

short-run equilibrium, P2, Q2 where the typical firm
is earning positive economic profits.
 Entry drives down costs for the typical firm, as

shown in Figure 8.9 (b).
75
FIGURE 8.9: Decreasing Costs Result in a
Negatively Sloped Long-Run Supply Curve
Price Price S
Price
D
P2 MC
AC
MC
P1 AC P1 2
0 q1 Output 0 Output 0 Q1 Quantity

(a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Marketper week
The initial equilibrium is shown as P1, Q1 in Figure 8.9 (c).

76
Price Price Price S
D’
D
P2 MC P2
AC
MC
P1 AC P1 2
0 q1 q2 Output 0 Output 0 Q1 Q2 Quantity

(a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Marketper week
The increase in demand from D to D’ results in the short-run equilibrium, P2,

Q2 where the typical firm is earning positive economic profits.
77
Price Price S
Price D’
D
P2 MC P2
AC MC
P1 AC P1 2
Quantity
0 q1 q2 0 0 Q1 Q2
Entry drives down costs for the typical firm, as shown in Figure 8.9 (b).
78
Price D’ S
Price Price
D
P2 MC P2
AC S’
MC
P1 AC P1 2
P3 P3
LS
q1 q2 Output 0 q3 Output 0 Q2 Q3
0 Q1
Quantity
Entry continues until short-run economic profits are eliminated.

The new long-run equilibrium is P3, Q3 as shown in Figure 8.9(c)
79
D’ S
Price Price Price
D
P2 MC P2
AC S’
MC
P1 AC P1 2
P3 P3
LS
0 q1 q2 Output 0 q3 Output 0 Q1 Q2 Q3
(a) Typical Firm before Entry (b) Typical Firm after Entry (c) The Market Quantity
The long-run supply curve is downward sloping due to the decreasing

costs as labeled LS in Figure 8.9 (c).
80
APPLICATION 8.4: How Do Network
Externalities Affect Supply Curves?
 These cause negatively sloped long-run supply curves.

– This can cause lower consumer prices when demand
expands.
 Industries subject to network externalities include

telecommunications, computer software, and the
Internet.
81
 Telecommunications
– Most of the gains in developed countries have been
realized, but remain for less developed.
 Computer Software
– As adoption grows, lower learning costs for users.
– These benefits may explain why software

companies are not too concerned with pirating.
82
 The Internet (Free MP3, Videos, .MPEG)

– Since anything that can be encoded in digital format
can be shared over the network, benefits for
specialized groups can also be realized.
– This, along with the improved storage capacity of

computers, makes it possible to provide specific
types of services that where cost prohibitive before
the Internet.
83
Infant Industries
 Initially the cost of production of a new product may be

very high.
– As the pool of skilled workers grows, costs may decline.
 It is often argued that these “infant” industries must be

protected from lower-cost foreign competition until they
reach the lower cost portion of their supply curves.
84
Chapter 9
Applying the
Competitive
Model

Consumer Surplus
 Consumer surplus is the extra value

individuals receive from consuming a good
over what they pay for it.
 Alternatively, it is what people would be willing
to pay for the right to consume a good at its
current price.
2
FIGURE 9.1: Competitive Equilibrium
and Consumer/Producer Surplus
Price
A
S
In Figure 9.1, the
equilibrium price and
quantity are P* & Q*
P* E
The demand curve, D,
shows what people are
willing to pay for the good.
D
B
Quantity per period

0 Q*
3
FIGURE 9.1: Competitive Equilibrium
and Consumer/Producer Surplus
Price
A
S
The total value of the good

to buyers is given by the
P* E area below the demand
curve from Q = 0 to Q = Q*
(AEQ*0).
D
B
Quantity per period

0 Q*
4
FIGURE 9.1: Competitive Equilibrium and
Consumer/Producer Surplus
Price
A
S
Consumers
P* E
expenditures for Q*
are given by the
area P*EQ*0
D
B
0 Q* Quantity
5 per period
Price
A S
Consumers receive a
“surplus” (total value
P* E less what they pay)
equal to the area AEP*,
which is shaded gray in
Fig 9.1.
D
B
0 Q* Quantity
6 per period
Producer Surplus
 Producer surplus is the extra value producers

get for a good in excess of the opportunity
costs they incur for producing it.
 It can also be defined as what all producers
would pay for the right to sell a good at its
current market price.
7
Producer Surplus
 At the equilibrium shown in Figure 9.1,

producers receive total revenue equal to the
area P*EQ*0.
 If producers sold one unit at a time at the
lowest possible price, producers would have
been willing to produce Q* for the payment of
BEQ*0.
8
Price
A
S
At the equilibrium
shown in Figure 9.1,
P* E producers receive
total revenue equal to
the area P*EQ*0.
D
B
0 Q* Quantity
9
Price
A
S
If producers sold one unit

at a time at the lowest
P*
E possible price, producers
would have been willing to
produce Q* for the
payment of BEQ*0.
D
B
0 Q* Quantity
10
Price
A
S
Thus, producer
surplus the the area
P* E P*EB shaded in
green in Figure 9.1
D
B
0 Q* Quantity
11
Short-Run Producer Surplus
 The positive slope of the short-run supply

curve, S, in Figure 9.1 results from the
diminishing returns to variable inputs that are
encountered as output is increased.
 For production up to Q*, price exceeds
marginal cost, so total short-run profits equal
the area P*EB less fixed costs
12
Short-Run Producer Surplus
 Producer surplus, the area P*EB, reflects the

sum of total short-run profits and short-run
fixed costs.
 Short-run producer surplus is the part of total
profits that is in excess of the profits firms
would have if they chose to produce nothing at
all.
 As such, it is similar to consumer surplus.
13
Long-Run Producer Surplus
 Since long-run economic profits are zero and

there are no fixed costs in the long-run,
producer surplus is much different in the long
run.
 The positive slope of the long-run supply curve
reflects increasing input costs as output is
expanded.
14
Long-Run Producer Surplus
 Consider the area P*EB in Figure 9.1 as long-

run producer surplus.
 It measures all of the increased payments
relative to the situation in which the industry
produces no output.
 The inputs would have received lower prices if
this industry had not produced output.
15
Ricardian Rent
 Ricardian rent is the long-run profits earned

by owners of low-cost firms.
 It may be capitalized into the prices of these
firms’ inputs.
 Assume there are many parcels of land on
which tomatoes might be grown.
 These farms range from very fertile land (low
cost) to poor, dry land (high cost).
16
Ricardian Rent
 At low prices, only the most fertile land is used.

 As output increases, higher-cost plots of land
are brought into production because higher
prices make this land profitable.
 The long-run supply curve is positively sloped
because of the increasing costs associated
with using less fertile land.
17
Ricardian Rent
 The market equilibrium price and quantity, P*,

Q*, are shown in Figure 9.2 (d).
 Low-cost farms, Figure 9.2 (a) and medium-
cost farms, Figure 9.2 (b), earn long-run
economic profits.
 Marginal farms, Figure 9.2 (c) earn zero
economic profits
18
FIGURE 9.2 (d): The Market
Price
P* E
Q* Q per
period
19
FIGURE 9.2 (a): Low-Cost Farm
Price
MC
AC
P*
q* q per
period
20
FIGURE 9.2 (b): Medium-Cost Farm
Price MC
AC
P*
q* q per
period
21
FIGURE 9.2 (c): Marginal Farm
Price
MC AC
P*
q* q per
period
22
FIGURE 9.2: Ricardian Rent
Price Price
MC AC
MC AC
P* P*
q* q per q* q per
period period
(a) Low-Cost Farm (b) Medium-Cost Farm
Price Price
MC AC
S
P* P* E
D
B
q* q per Q* Q per
period period
(c) Marginal Farm (d) The Market
23
Ricardian Rent
 Profits earned by the intramarginal farms can

persist in the long run because they reflect the
returns to a scarce resource, low-cost land.
 Entry can not erode these profits because of
the scarcity of the low-cost land.
 The sum of these long run profits (P*EB) is the
producer surplus ( Ricardian rent).
24
Economic Efficiency
 The competitive equilibrium is efficient in that it

produces the largest surplus equal to
the sum of producer and consumer
surplus.
25
Price
A
S
In Figure 9.1, an
P1 F output level of Q1
results in a loss of
P* E surplus equal to
P2
the area FEG
G
D
B
0 Q1 Q* Quantity
26 per period
Price
A
S
F Consumers would be
P1
willing to pay P1 for a
P* E good that producers
are willing to produce
P2
G
for P2, so mutually
beneficial transactions
D exist.
B
0 Q1 Q* Quantity
27 per period
APPLICATION 9.1: Does Buying Things
on the Internet Improve Welfare?
 Transaction costs associated with conducting

business on the internet have been reduced
due to
– Technical innovations
– significant network externalities.
 Prior to this, transaction costs exceed the
difference between consumers’ willingness to
pay and producers costs.
28
 Some early evidence

– Electronic retailing directly to consumers totaled
about $20 billion in 2001.
– Business to business sales represented another
$50 to $75 billion.
– Most sales are in travel-related goods, on-line
financial services, and some narrow categories of
consumer goods such as books.
29
 Retailers as Infomediaries
– The role for retailing “middlemen” on the internet is
to provide information to the consumer.
 Internet automobile sellers provide comparative information
about the features of cars and point to dealers with the best
price.
 Internet airline services search for the lowest price or most
convenient departure.
30
A Numerical Example
Demand : Q  10  P
Supply : Q  P  2
31
FIGURE 9.3: Efficiency in Tape Sales
Price
10
 The market
6 E equilibrium is P* = $6
and Q* = 4.
1 2 3 4 5 Tapes
32 per period
Price
10
 The equilibrium is
shown as point E
6 E in Figure 9.3.
1 2 3 4 5 Tapes
33 per period
Price
10
At point E in Fig 9.3,

6 E
consumer surplus is
$8 (= ½·$4·4).
1 2 3 4 5 Tapes
34 per period
Price
10
Producers also
6 E gain a producer
surplus of $8 at
point E
D
1 2 3 4 5 Tapes
35 per period
Price
10
Total consumer
6 E and producer
surplus is $16.
D
1 2 3 4 5 Tapes
36 per period
Price
10
If price stays at $6
6 E but output falls to
3, total surplus
(CS + PS) falls to
D
$15
2
1 2 3 4 5 Tapes per period

37
A Numerical Example
 For any output level, total surplus is the area

between the demand and supply curves out to
that level of output.
 Once output is specified, the price affects the
distribution of the surplus between producers
and consumers, but does not affect the total
amount of the surplus.
38
A Numerical Example
• If output < 4 tapes per period with P = $6, total

surplus is less than $16.
▫ At Q = 5, consumer surplus falls to $7.50.
 $8 for four tapes less $.50 because the fifth tapes sells for
more than people want to pay for the fifth tape.
 Producer surplus also equals $7.50 reflecting the loss of $.50
on the production of the fifth tape.
▫ Total surplus is $15 for Q = 3 tapes per week.
39
Tax Incidence
 The study of the final burden of a tax after

considering all market reactions to it is tax
incidence theory.
 The incidence of a “specific tax” of a fixed
amount per unit of output that is imposed on all
firms in a constant cost industry is illustrated in
Figure 9.5
40
FIGURE 9.5: Effect of the Imposition of a Specific Tax
on a Perfectly Competitive Constant Cost Industry
Price Price S’
S
SMC MC P4
AC P3
P1 LS
P2
Tax D
D’
0 q2 q 1 Output 0 Q3 Q2 Q1 Quantity
per week
(a) Typical Firm (b) The Market
41
Tax Incidence
• Since for any price, P, consumers pay the

firm gets to keep P - t (where t is the per unit
tax), the effect of the tax on firms can be
shown as a decrease in demand.
▫ The vertical distance between the demand curves
is t.
• It creates a wedge between the consumers’
price, P, and the price firms receive.
42
Short-Run Tax Incidence
 The short-run effect is to decrease output from

Q1 to Q2, where firms receive P2 and
consumers pay P3 (P3 - P2 = t).
 So long as P2 is above minimum variable
costs, the firm continues to produce and the
tax incidence is shared by consumers, whose
price increased to P3, and by firm’s who now
receive only P2 rather than P1.
43
Long-Run Tax Incidence
 Firms will not operate at a loss in the long run,

so exit will take place shifting the short-run
supply curve back to S’.
 In the new long-run equilibrium, output will
return to Q3 where the firm’s will receive P1
again and consumers will pay P4.
 The long-run tax incidence is all on the
consumer although the firms pays the tax.
44
Long-Run Incidence with
Increasing Costs
 When the long-run supply curve has a positive

slope, both consumers and firms pay a portion
of the tax.
 The imposition of the tax shifts the long-run
demand curve inward to D’ (as shown in Figure
9.6) which causes the price to fall from P1 to P2
as some firms exit and input prices fall.
45
FIGURE 9.6: Tax Incidence in an
Increasing Cost Industry
Price LS
A
P3
P1 B E1
P2
E2
Tax
D
D’
Q2 Q1 Quantity
46 per period
FIGURE 9.6: Long-Run Incidence with
Increasing Costs
Price LS
Consumers pay a portion of

A
P3 the tax since the gross price
P1 E1 of P3 exceeds the pre-tax
B
P2 price.
E2 Total tax collection is the
Tax gray area P3ARE2P2.
D
D’
Quantity
Q2 Q1
47
FIGURE 9.6: Long-Run Incidence with
Increasing Costs
Price LS
The inputs to the firm pay

A
P3 the remainder of the tax as
P1 E1 they are not paid based on a
B
P2 lower net price of P2.
E2
Tax
D
D’
Quantity
Q2 Q1
48
Long-Run Incidence with
Increasing Costs
 Consumers pay a portion of the tax since the

gross price of P3 exceeds the pre-tax price.
 Total tax collection is the gray area
P3ARE2P2.
 The inputs to the firm pay the remainder of
the tax as they are not paid based on a lower
net price of P2.
49
Incidence and Elasticity
 The economic actor who has the most elastic

curve will be able to avoid more of the tax
leaving the actor with the more inelastic curve
to pay most of the tax.
– If demand is relatively inelastic and supply is elastic,
demanders will pay most of the tax.
– If supply is relatively inelastic and demand is elastic,
suppliers will pay most of the tax.
50
Taxation and Efficiency
 Taxes reduce output of the taxed commodities

and a reallocation of production to other areas.
 Reallocation means that some mutually
beneficial transactions will be foregone so
economic welfare will decline.
51
FIGURE 9.6: Taxation and Efficiency
Price LS
In Figure 9.6, the total loss of

A
P3 consumer surplus is the area
P1 E1 P3AE1P1.
B
P2 The area P3ABP1 is transferred
E2 into tax revenue and the area
Tax AE1B is simply lost.
D
D’
Quantity
Q2 Q1
52
FIGURE 9.6:Taxation and Efficiency
Price LS
A The loss in producer surplus

P3
P1 E1
is P1E1E2P2 of which
B
P2 P1BE2P2 is tax revenue and
E2
BE1E2 lost.
Tax
D
D’
Quantity
Q2 Q1
53
Taxation and Efficiency
 The effect of the transfer into tax revenue on welfare

is ambiguous since consumers and producers may
benefit from government expenditures.
 However, the deadweight loss is the losses of
consumer and producer surplus that are not
transferred to other parties.
 This is also called the “excess burden” of a tax.
54
 Using the supply-demand equilibrium in the market for

cassette tapes, suppose the government implements a
$2 per tape tax that retailers add to the sales price of
each tape sold.
The supply function remains

Supply : Q  P  2
where P is the net price received by the seller.
55
 Demanders, on the other hand, must pay P + t

for each tape so the demand function
becomes:
Demand : Q  10  ( P  t )
Q  10  ( P  2)  8  P
56
Equilibrium requires supply equal demand.

Supply  P  2  Demand  8  P
 or P* = 5, Q* =3.
 Consumers pay $7 for each tape and total tax
collections are $6 per week.
 Total consumer and producer surplus is decreased by
$6 of tax revenue and the excess burden is $1.
57
Transactions Costs
 Transaction costs, such as a real estate broker

fee, also cause a wedge between buyers’ and
sellers’ prices.
 To the extent that transaction costs are on a
per-unit basis, the same analysis as with a tax
applies, so both parties bear some of the cost
and output will be reduced.
58
Transactions Costs
 If the wedge is a lump-sum amount per

transaction, such as the cost of driving to the
supermarket to buy groceries, the individual
will seek to reduce the number of transactions.
 While prices will not change significantly,
persons will hold larger inventories to reduce
their transaction costs.
59
Appendix to
Chapter 9
General
Equilibrium

General Equilibrium
 This appendix deals with a system of many

competitive markets do deal with the issue of
allocating resources efficiently.
 A primary purpose of the chapter is to
investigate Adam Smith’s idea of an “invisible
hand” that guides resources to their best use.
2
General Equilibrium Model
 An economic model of a complete system of

markets.
 A partial equilibrium model is an economic
model of a single market.
3
Perfectly Competitive Price System
 A perfectly competitive price system is an

economic model in which individuals
maximize utility, firms maximize profits, there
is perfect information about prices, and every
economic actor is a price taker.
– There is a large number of homogeneous goods,
including factors of production.
4
Perfectly Competitive Price System
– Demand and supply determine the equilibrium price

for each good.
– At this set of equilibrium prices, every market is
cleared in that quantity supplied equals quantity
demanded.
– There are no transaction or transportation charges.
– Individuals and firms are fully informed about all
prices.
5
Efficient Markets
 Efficient Consumption: MRS = price ratio
 Efficient Production:
MRTS = price ratio of inputs
 Efficient Product Mix

MRS = cost ratio of outputs
 Where is Social Justice?

- fair distribution of wealth
6
Efficiency of Perfect Competition
 Competitive markets will lead firms to choose

an economically efficient output combination.
7
Fundamental Theorem of Welfare
Economics
 A perfectly competitive price system will bring about an
economically efficient allocation of resources.
 This “theorem” is simply a generalization of the

efficiency result described in Chapter 9.
 You cannot make one person better off without making

the other worse off
 Nothing is wasted
8
Efficiency in Output Mix
 Profit maximizing firms will equate the rate at

which they can trade X for Y in production to
the equilibrium price ratio.
 Utility maximizing people will equate their MRS

to the equilibrium price ratio.
9
Prices, Efficiency, and Laissez-
Faire Economics
 It has been shown that a perfectly competitive

price system, by relying on the self-interests of
people and of firms, and by utilizing the
information carried by equilibrium prices, can
arrive at an economically efficient allocation of
resources.
10
Prices, Efficiency, and Laissez-
Faire Economics
 This provides “scientific” support for the

laissez-faire position taken by such economists
as Adam Smith.
 As noted by Smith, the baker provides bread
for the public because of his or her self interest
responding to market signals (Smith’s invisible
hand) rather than because of public spirit.
11
APPLICATION 9A.1: Modern Resistance
to Trade
 In the U.S. exports tend to be intensive in their use of

skilled labor while imports tend to be intensive in
unskilled labor.
 Unions representing skilled workers (for example,

machinists) tend to favor free trade.
 Unions representing unskilled workers (textile workers,

for example) tend to be against free trade.
12
APPLICATION 9A.1: Adjustment Costs
 In addition, a movement toward free trade would

require that factors of production be transferred out of
import production an into export production.
 Such reallocation may impose costs (moving, search,

and education) on workers.
 Even though society as a whole gains, many workers

may have their utility decreased.
13
Why Markets Fail to Achieve
Economic Efficiency
 Imperfect competition
 Externalities
 Public goods
 Imperfect information
14
Imperfect Competition
 Imperfect competition is a market situation in

which buyers or sellers have some influence
on the prices of goods or services.
 In this case, the firm is not a price taker so
marginal revenue does not equal price.
 Relative prices do not reflect relative marginal
costs, and inefficiency can result (for
example, monopoly dead-weight loss).
15
Externalities
 An externality is when the effect of one party’s

economic activities on another party that is not
taken into account by the price system.
– A common case is when a firm pollutes the air.
 The prices of the resources the firm uses
represent the opportunity costs involved in
production, if there are no externalities.
16
Externalities
 Externalities represent additional costs--those

that arise from the external damage.
 The firm, however, only responds to private
input costs, it disregards the social costs of
pollution.
 This results in a gap between market price and
social marginal cost, which leads to a
misallocation of resources.
17
Public Goods
 Public goods are goods that provide

nonexclusive benefits to everyone in a group
and that can be provided to one more user at
zero marginal cost.
– For example national defense and pest control.
 Once the goods are produced, it is impossible
to exclude anyone from benefiting from them.
18
Public Goods
 Price cannot equal marginal cost (which is

zero), since the fixed cost of providing the good
would not be covered.
 The incentive is for people to refuse to pay for
the good hoping others will purchase, and thus
provide the good.
 This causes society to not allocate enough
resources to public goods.
19
Imperfect Information
 It has been assumed that economic actors are

fully informed, especially about equilibrium
market prices.
 Without this information, the “invisible hand”
results do not hold.
 Without perfect information, a consumer would
have problems (costs) finding quality and the
prices charged by different firms.
20
Efficiency and Equity
 Equity is the fairness of the distribution of

goods or utility.
 A primary problem with this concept is
developing an accepted definition of “fair” or
“unfair” allocations of resources.
 Opinions vary from, an allocation is fair if no
laws are broken in obtaining it to a fair
allocation requires all people share equally.
21
Equity and Competitive Markets
 As shown in the appendix to this chapter,

voluntary transactions among people may not
achieve a “fair” allocation.
– For example, if people start with an unequal
distribution of goods, voluntary trading cannot
necessarily erase that inequality.
 Adopting coercive methods (such as taxes) to
achieve equity may create problems.
22
Pareto Efficient Allocation
 A Pareto efficient allocation is an allocation

of available resources in which no mutually
beneficial trading opportunities are unexploited.
That is, an allocation in which no one person
can be made better-off without someone else
being made worse off.
23
Chapter 10
Monopoly

Monopoly
 A market is described as a monopoly if there

is only one producer.
– This single firm faces the entire market demand
curve.
– The monopoly must make the decision of how
much to produce.
 The monopoly’s output decision will
completely determine the good’s price.
2
Causes of Monopoly
 Barriers to entry which are factors that

prevent new firms from entering a market are
the source of all monopoly power.
 There are two general types of barriers to

entry
– Technical barriers
– Legal barriers
3
Technical Barriers to Entry
 A primary technical barrier is when the firm is a natural

monopoly because it exhibits diminishing average
cost over a broad range of output levels.
– Hence, a large-scale firm is more efficient than a small scale
firm.
– Utilities, Transportation and Communication
 A large firm could drive out competitors by price

cutting.
4
Technical Barriers to Entry
 Other technical barriers to entry.

– Special knowledge of a low-cost method of
production.
– Ownership of a unique resource.
– Possession of unique managerial talents.
– Patents
5
Legal Barriers to Entry
 Pure monopolies can be created by law.

– The basic technology for a product can be assigned
to only one firm through a patent.
 The rational is that it makes innovation profitable and
encourages technical advancement.
 Medicine costs so much due to patenting
– The government can award an exclusive franchise

or license to serve a market.
 This may make it possible to ensure quality standards
6
Profit Maximization
 To maximize profits, a monopoly will chose the

output at which marginal revenue equals
marginal costs.
 The demand curve is downward-sloping so

marginal revenue is less than price.
– To sell more, the firm must lower its price on all
units to be sold in order to generate the extra
demand.
7
A Graphic Treatment
 A monopoly will produce an output level in

which price exceeds marginal cost.
P > MC
8
FIGURE 10.1: Profit Maximization and Price
Determination in a Monopoly Market
MC
Price
AC QC is the profit
PM
E maximizing output
level in Fig 10.1
A PC = min AC
PC
MR
0 QM Quantity
QC
9
MC
Price
AC QC is the profit
PM
E maximizing output
level in Fig 10.1
A PC = min AC
PC
MR
0 QM Quantity
QC
10
MC
Price
AC
Profits are
E maximized when
PM
MR = MC
A
PC
MR
0 QM Quantity
QC
11
MC
Price
AC
Given output level
E QC, the firm
PM
chooses PC on the
demand curve
A because that is
PC
what consumers
D are willing to pay
for PC.
MR
0 QM Quantity
QC
12
MC
Price
AC
With a fixed
E market demand
PM
curve, the supply
“curve” for a
A monopoly is the
PC
one point where
D MR = MC
MR
0 QM Quantity
QC
13
MC
Price
AC
At QM, output
E produced is even
PM
less than the
output provided
A by perfect
PC
competition,
D
QM < QC
MR
0 QM Quantity
QC
14
MC
Price
AC
The monopolist’s
E profits is given by
PM
the area PMEAPC
Monopoly
profits A
PC
MR
0 QM Quantity
QC
15
Monopoly ProfitsBB
 Profits equal (P - AC)Q*,

– If price exceeds average cost at Q* > 0, profits
will be positive.
– Since entry is prohibited, these profits can exist in
the long run.
16
Monopoly Rents
 Monopoly rents are the profits a monopolist

earns in the long run.
– These profits are a return to the factor that forms the
basis of the monopoly.
 Patent, favorable location, license, etc..
 Others might be willing to pay up to the amount

of this rent to operate the monopoly to obtain
its profits.
17
What’s Wrong with Monopoly?
 Profitability
– Monopoly power is the ability to raise
price above marginal cost.
– Profits are the difference between price and
average cost.
 In Figure 10.2, one firm earns positive

economic profits (a) while the other (b) earns
zero economic profits.
18
FIGURE 10.2: Monopoly Profits Depend on the Relationship
between the Demand and Average Cost Curves
Price Price
MC AC
MC AC
PM
PM= min AC
AC
D
D
MR MR
0 QM Quantity 0 QM Quantity
per week per week
(a) Monopoly with Large Profits (b) Zero-Profit Monopoly
19
What’s Wrong with Monopoly?
– If monopoly rents accrue to inputs, the monopoly

may appear to not earn a profit.
 People may also be concerned that

economic profits go to the
wealthy.
– However, as with the Navajo blanket monopoly,
the profits of the low-income Navajo are coming
from the more wealthy tourists.
20
What’s Wrong with Monopoly
 Distortion of Resource Allocation

– Monopolists restrict their production to
maximize profits.
 Since price exceeds marginal cost, consumers are willing to

pay more for extra output than it costs to produce it.
– From societies point of view, output is too

low as some mutually beneficial transactions
are missed.
21
What’s Wrong with Monopoly
 Distortion of Resource Allocation

– I don’t care what people demand,
because all I care about is
maximizing my profits
22
Distortion of Resource Allocation
 In Figure 10.3 the monopolist is assumed to

produce under conditions of constant
marginal cost.
 Further, it is assumed that if the good where
produced by a perfectly competitive industry,
the long-run cost curve would be the same
as the monopolist’s.
23
FIGURE 10.3: Allocational and
Distributional Effects of Monopoly
D MR
Price The competitive output
level (QC in Figure 10.3)
is produced at price PC.
PM B
E
PC MC ( =AC)
A
24 0 QC
QM Quantity per week
D MR
Price
At perfect competition,
the consumer surplus is
PM B DEPC.
E
PC MC ( =AC)
A
25 0 QC
Price D
MR
A monopolist produces
at QM where marginal
revenue equals
PM B
marginal cost.
MC ( =AC)
A
26 0
QM Quantity
D MR
Price The restriction in
output (QM - QC) is a
measure of the harm
PM B
done by a monopoly
E
PC MC ( =AC)
A
27 0 QC
D MR
Price Consumer surplus is
reduced by the area
DBPM.
PM B
E
PC MC ( =AC)
A
28 0 QC
Price
D MR
The loss of consumer
surplus is BEA which is
often called the
PM B
deadweight loss from
monopoly.
E
PC MC ( =AC)
A
29 0 QC
Price
D MR
Monopoly profits equal
the area PMBAPC
PM B
E
PC MC ( =AC)
A
30 0 QC
D MR This would be consumer

Price
surplus under perfect
competition.
PM B
It does not necessarily
represent a loss of
social welfare.
E
PC MC ( =AC)
A
31 0 QC
Distributional Effects
 This is the redistributional effects of

monopoly that may or may not be
desirable.
32
Price D
MR
P** B
Transfer
from
consumers
to firm
E
P* MC ( =AC)
A
33 0
Q** Q* Quantity per week
Price D MR
P** B
Transfer
from
consumers Deadweight
to firm loss
E
P* MC ( =AC)
A Value of
transferred
inputs
34 0
Q** Q* Quantity per week
Monopolists’ Costs
 Monopolists costs may be higher due to:

– Resources spent to achieve monopoly profits
such as ways to erect barriers to entry.
– Monopolists may expend resources for lobbying

or legal fees to seek special favors from the
government such as restrictions on entry through
licensing or favorable treatment from regulatory
agencies.
35
Monopolists’ Costs
 The possibility that costs may be higher for

monopolists complicates the comparison of
monopoly with perfect competition.
 Studies that have attempted to measure

welfare losses from monopoly find estimates
are sensitive to assumptions.
– Estimates range from as little as 0.5 percent of
GDP to as much as 5 percent of GDP.
36
A Numerical Illustration of
Deadweight Loss
 Suppose we have a demand curve,

P = 10 – Q
and we have a long run supply curve such that
MC = AC = 3.
Find PC and PM
Find QC and QM
What is CSC and CSM
How much is the DWL?
37
TABLE 10.1: Effects of Monopolization on
the Market for Cassette Tapes
Demand Conditions Consumer Surplus

Quantity Average Under
(Tapes and Perfect
per Total Marginal Marginal Compe- Under Monopoly
Price Week) Revenue Revenue Cost tition Monopoly Profits
$9 1 $9 $9 $3 $6 $3 $3
8 2 16 7 3 5 2 3
7 3 21 5 3 4 1 3
6.5 3.5 24 3 3 3 0 3
5 5 25 1 3 2 -- --
4 6 24 -1 3 1 -- --
3 7 21 -3 3 0 -- --
2 8 16 -5 3 -- -- --
1 9 9 -7 3 -- -- --
0 10 0 -9 3 -- -- --
Totals $21 $6 $12
38
Competitive Equilibrium: (P = MC) Monopoly equilibrium: (MR = MC)
Price Discrimination
 Price discrimination occurs if identical units

of output are sold at different prices.
 If the monopolist could sell its product at
different prices to different customers, new
opportunities exits as shown in Figure 10.4.
– Some consumer surplus still exists (area DBP**).
– The possibility of mutually beneficial trades exist as
represented by the area BEA.
39
FIGURE 10.4: Targets for Price
Discrimination
Price D
MR
B
P**
E MC ( =AC)
P*
A
40 0 Q** Q* Quantity
per week
Perfect Price Discrimination
 Perfect price discrimination is selling each

unit of output for the highest price obtainable.
– The firm would sell the first unit at slightly below
0D (Figure 10.4), the next for slightly less, and so
on until the firm reaches Q*, where a lower price
would result in less profit.
– All consumer surplus (area P*DE) would be
monopoly profit.
41
FIGURE 10.4: Perfect Price
Discrimination
Price
PMAX MR The firm would sell the first

unit at slightly below PMAX the
next for slightly less, and so
on until the firm reaches Q*,
B where a lower price would
P**
result in less profit.
MC ( =AC)
P* A E
D
MR
per week
Discrimination
Price
PMAX MR
If the firm charges at the
maximum price, PMAX, all
consumer surplus (area
B P*DE) would be monopoly
P**
profit.
MC ( =AC)
P* A E
D
MR
per week
Perfect Price Discrimination
 Since the monopolist would produce and sell

Q* units of output, which is the competitive
equilibrium.
 This pricing scheme requires a way to
determine what each consumer would be
willing to pay, and
 The monopolist must be able to stop
consumers from selling to each other.
44
Quantity Discounts:
 Quantity discounts allow some sales at the

monopolist’s price and sales beyond
monopolist output at a lower price which
increases profits.
– Examples include a second pizza for a lower price

and supermarket coupons.
45
Quantity Discounts:
 It’s basically producing and selling to rip

consumers off while keeping your market
share (your ripped off consumers) intact
 The monopolist must keep customers who

buy at lower prices to sell to customers at a
price less than P**.
46
FIGURE 10.4i: Quantity Discount
Price
PMAX MR Quantity discounts allow some

sales at the monopolist’s price (P**
in Figure 10.4), and sales beyond
Q** at a lower price which
B increases profits.
P**
MC ( =AC)
P* A E
D
MR
per week
FIGURE 10.4i: Quantity Discount
Price
PMAX MR
Different prices for different
markets/ consumers
Market 1
B Selective Price Discrimination
P**
Market 2
MC ( =AC)
P* A E
D
MR
per week
Discrimination
Price
PMAX MR
B
P**
MC ( =AC)
P* A E
D
MR
per week
Two-Part Tariffs
 In this pricing scheme, customers must pay

an entry fee for the right to purchase a good.
 A classic example is the pricing of movie
popcorn.
– The entry fee, which should be set to obtain as
much of the consumer surplus as possible, is the
price of movie itself.
– Popcorn is then priced to maximize admission so
long as the price exceeds cost.
50
Market Separation
 If the market can be separated into two or

more categories may be able to charged
different prices.
 Figure 10.5 shows the separation into two

markets.
– The profit-maximizing decision is to sell Q1* in the
first market and Q2* in the second market where,
in both cases, MR = MC.
51
FIGURE 10.5: Separated Markets Raise the
Possibility of Price Discrimination
Price
P1
P2
MC1
D1 D2
MR1 MR2
Q1* 0 Q2*
Quantity in market 1 Quantity in market 2
The profit-maximizing decision is to sell Q1* in the first market

and Q2* in the second market where, in both cases, MR = MC.
52
Price
P1
P2
MC1
D1 D2
MR1 MR2
Q1* 0 Q2*
The two market prices will be P1and P2 respectively.
53
Price
P1
P2
MC1
D1 D2
MR1 MR2
Q1* 0 Q2*
As shown in Figure 10.5, the price-discriminating monopolist will

charge a higher price in the market with the more inelastic demand.
54
Price
P1
P2
MC1
D1 D2
MR1 MR2
Q1* 0 Q2*
Examples of this kind of discrimination include book publishers

charging higher prices in the U.S. or charging different prices for a
movie in the day than at night.
55
Pricing for Multiproduct
Monopolies
 If a firm has pricing power in markets for

several related products, other strategies can
be used.
– Firms can require users of one product to also
buy a related product such as coffee filters bought
with coffee machines.
 Firms can also create pricing bundles such

as option packages on cars or computers.
56
Chapter 11
Imperfect
Competition

 Pricing in these markets falls between perfect

competition and monopoly.
 Three topics considered:
– Pricing of homogeneous goods in markets with few
firms.
– Product differentiation in these markets.
– How entry and exit affect long-run outcomes in
imperfectly competitive markets.
2
Pricing of Homogeneous Goods
 In this market a relatively few firms produce a

single homogeneous good.
– Assume demanders are price takers.
– Assume there are no transactions or informational
costs.
 These assumptions result in a single
equilibrium price for the good.
 Initially, assume a fixed, small number of
identical firms.
3
Quasi-Competitive Model
 A model of oligopoly pricing in which each firm

acts as a price taker even though there may be
few firms is a quasi-competitive model.
 As a price taker, a firm will produce where
price equals long-run marginal costs.
 This equilibrium will resemble the perfectly
competitive solution, even with few firms.
4
Quasi-Competitive Model
 In Figure 11.1, the quasi-competitive

equilibrium is PC (= MC), QC.
 This equilibrium represents the highest quantity
and lowest price that can prevail in the long run
given the demand curve D.
– A lower price would not be sustainable in the long
run because it would not cover average costs.
5
FIGURE 11.1: Pricing under
Price
C
P MC
C
MR
0 Q Quantity
6 C per week
Cartel Model
 A model of pricing in which firms coordinate

their decisions to act as a multiplant monopoly
is the cartel model.
7
FIGURE 11.1: Pricing under
Price
Assuming marginal costs are constant
and equal across firms, the cartel
output is point M (the monopoly
P M
M output) in Figure 11.1
P A
A
C
P MC The plan would
C
require a certain
output by each firm
D and how to share
the monopoly profits
MR
0 Q Q Q Quantity
M A C
8 per week
Cartel Model
 Maintaining this cartel solution poses three

problems:
– Cartel formations may be illegal, as it is in the U.S.
by Section I of the Sherman Act of 1890.
– It requires a considerable amount of costly
information be available to the cartel.
 The market demand function.
 Each firm’s marginal cost function.
9
Cartel Model
– The cartel solution may be fundamentally unstable.

 Each member produces an output level for which
price exceeds marginal cost.
 Each member could increase its own profits by
producing more output than allocated by the
cartel.
 If the cartel directors are not able to enforce their
policies, the cartel my collapse.
10
The Cournot ModelBB
 The Cournot model of duopoly is one in which

each firm assumes the other firm’s output
will not change if it changes its own output
level.
 Assume
– A single owner of a costless spring.
– A downward sloping demand curve for water has
the equation Q = 120 - P.
11
The Cournot Model
 As shown in Figure 11.2, the monpolist would

maximize profit by producing Q = 60 with a
price = $60 and profits (revenue) = $3600.
– Note, this output equals one-half of the quantity that
would be demanded at a price of zero.
 Assume a second spring is discovered.
12
FIGURE 11.2: Spring Monopolist’s
Output Choice
Price
120
60
MR D
Output
13 0 60 120
per week
Duopoly Model
 Cournot assumed that firm A, say, chooses its output

level (qA) assuming the output of firm B (qB) is fixed
and will not adjust to A’s actions.
 The total market output is given by
Q  q A  qB  120  P
Assuming q B is fixed, A' s demand curve is
q A  (120  qB )  P.
14
Duopoly Model
 If the demand curve is linear, the marginal

revenue curve will bisect the horizontal axis
between the price axis and the demand curve.
 Thus, the profit maximizing point is given by
120  q B
qA  . [11.4]
2
15
Duopoly Model
 If firm B chooses to produce 60 units, firm A

would choose 30 [=(120 - 60)  2].
 Equation 11.4 is called a reaction function
which, in the Cournot model, is a function or
graph that shows how much one firm will
produce given what the other firm produces.
16
FIGURE 11.3: Cournot Reaction
Functions in a Duopoly Market
120
Output of
firm B(qB)
Firm A’s reactions
Output of
17 0 60 120
firm A(qA)
Duopoly Model
 Firm A’s reaction function is shown in Figure 11.3.

 Firm B’s reaction function is given below and also
shown in Figure 11.3
120  q A
qB  [11.5]
2
18
120
Output of
firm B(qB) Firm B’s reactions
60
Equilibrium
Firm A’s reactions
Output of
19 0 60 120 firm A(qA)
Cournot Equilibrium
 The actions of the two firms are consistent with

each other only at the point where the two lines
intersect.
 The point of intersection is the Cournot
equilibrium, a solution to the Cournot model in
which each firm makes the correct assumption
about what the other firm will produce.
20
120
Output of
firm B(qB) Firm A’s reactions
60
Equilibrium
40 Firm B’s reactions
Output of
21 0 40 60 120
firm A(qA)
Cournot Equilibrium
 In this Cournot equilibrium each firm produces 40 units

of output.
q A  40 qB  40.
 Total industry profit is $3,200, $1600 for each firm).
 Because the firms do not fully coordinate their actions,
their profits are less than the cartel profit ($3,600) but
much greater than the competitive solution where P =
MC = 0.
22
Price Leadership Model
 A model in which one dominant firm takes

reactions of all other firms into account in its
output and pricing decisions is the price
leadership model.
 A formal model assumes the industry is
composed of a single price-setting leader and
a competitive fringe which is a group of firms
that act as price takers.
23
FIGURE 11.4: Formal Model of Price
Leadership Model
Price
SC
• This model is shown in

Figure 11.4.
• The demand curve D

represents the total demand
curve for the industry’s
product.
Quantity D
per week
24 0
Leadership Model
Price
SC
 The supply curve SC

represents the supply
decisions of all the firms in
the competitive fringe.
Quantity D
per week
25 0
Leadership Model
Price
SC
 The supply curve SC

represents the supply
decisions of all the firms in
the competitive fringe.
Quantity D
per week
26 0
Leadership Model
Price
SC
The demand curve (D’) for the

dominant firm is derived as follows:
P1
• For a price of P1 or above the
D’
smaller firms will supply the entire
market.
P
2
0 Quantity
27 per week
Leadership Model
Price
SC
P1: small firms will all
produce the Q demanded
P1 P= below P2: no small firms

produce 0 output
D’
P= below P2: with 0 output
P from small firms, the leader
2
can start producing for the
D market
0 Quantity
28 per week
Leadership Model
Price
SC
For a price of P2 or below,

the dominant firm will
P1 supply the entire market.
D’ Between P2 and P1 the

curve D’ is constructed by
P subtracting what the fringe
2
will supply from the total
market demand.
D
0 Quantity
29 per week
Leadership Model
Price
SC
Given D’, the leader’s marginal

revenue curve is MR’ which
P1 equals the leader’s marginal
cost (MC) at the profit
D’ maximizing level QL
P
L
P
2
MC
MR’ D
0 Q Q Q Quantity
30 C L T per week
Leadership Model
Price
SC
• Market price is PL and

equilibrium output is QT (=QC +
P1 QL).
D’ • The model does not explain

P
L how the leader is chosen
P
2
MC
MR’ D
0 Q Q Q Quantity
31 C L T per week
Product Differentiation: Market
Definition and Firms Choices
 A product group is a set of differentiated

products that are highly substitutable for one
another.
 Assume few firms in each product group.
 Firms will incur additional costs to differentiate
their product up to the point where the
additional revenue from this activity equals the
marginal cost.
32
Product Differentiation: Market
Equilibrium
 The demand curve for each firm depends on

the prices and product differentiation activities
of its competitors.
 The firm’s demand curve may shift frequently,
and its position at any point in time may only
be partially understood.
– Each firm must make assumptions about its
competitors’ actions, and whatever one firm
decides may affect its competitor’s actions.
33
Product Differentiation: Entry by
New Firms
 The degree to which firms can enter the market

plays an important role.
 Even with few firms, to the extent that entry is
possible, long-run profits are constrained.
 If entry is completely costless, long-run
economic profits will be zero (as in the
competitive case).
34
Monopolistic Competition
 If firms are price takers, P = MR = MC for profit

maximization.
 Since P = AC, if entry is to result in zero profits,
production will take place where MC = AC (at
minimum average cost).
 If, say through product differentiation, firms
have some control over price, each firm faces
a downward sloping demand curve.
35
Monopolistic Competition
 Entry still may reduce profits to zero, but

production at minimum cost is not assured.
 Monopolistic competition is a market in
which each firm faces a negatively sloped
demand curve and there are no barriers to
entry.
36
Sustainability of Monopolistic
Competition
 Monopolistic competition focuses only on the

behavior of actual entrants but ignores the
effects of potential entrants.
 A broader perspective of the “ invisible hand” is
the distinction between competition in the
market and competition for the market.
37
Barriers to Entry
 The existence of barriers to entry change the

type of analysis.
 In addition to those previously discussed,
barriers include brand loyalty and strategic
pricing.
– Firms may drive out potential entrants with low
prices followed later by price increases or they may
buy up smaller firms.
38

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Chapter 7

© 2004 Thomson Learning/South-Western

The Nature of Firms

 While firms are complex institutions, the typical approach

APPLICATION 7.1: Corporate Profits, Taxes,

 Some economists believe that this tax seriously distorts the

 Much of what is defined as corporate profits under the tax laws

 Shareholders expect return on their investment whether interest

 Some portion of corporate profits reflects the owners forgone

 If this cost were added to corporate costs, profits would be

Effects of the Double Tax

• The corporate profits tax is a tax on the equity returns of

• Two effects of this tax.

▫ Corporations find it more attractive to finance new capital

Effects of the Double Tax

 Since corporate income is taxed twice--when it is earned

 Investors will be less willing to invest in corporate

 Firms as profit maximizers will make decisions in a marginal

 The manager looks, for example, at the marginal profit from

 When the incremental profit of an activity becomes zero,

The Output Decision

 Economic profits () are defined as

 where TR(q) is the total amount of revenues received

 The firm will choose the level of output that generates

Profit Maximization: Marginal Revenue Must Equal

Profit Maximization: Marginal Revenue Must Equal

FIG 7.1: Marginal Revenue Must Equal Marginal

At output levels below q* increasing output causes profits to increase, so

FIG 7.1: Marginal Revenue Must Equal Marginal

Increasing output beyond q* reduces profits, so profit maximizing firms

The Marginal Revenue = Marginal Cost Rule

At q* marginal cost equals marginal revenue, the extra revenue a firm

The Marginal Revenue/ Marginal Cost Rule

 In order to maximize profits, a firm should produce that

The Marginal Revenue/Marginal Cost Rule

 At the profit maximizing level of output

Marginal Revenue = Marginal Cost

 Firms, starting at zero output, can expand output so long as

Marginalism in Input Choices

 Both labor and capital should be hired up to the point where

 A price taker is a firm or individual whose decisions regarding

 For a price taking firm

Marginal Revenue for a Downward-Sloping

 Total revenue is (P*Q) and marginal revenue (MR) is the

 This example demonstrates that MR < P as shown in Table 7.1.

Total and Marginal Revenue for Cassette Tapes

Price Quantity Total Revenue Marginal Revenue

 This hypothetical demand curve is shown in Figure 7.2.

 When q = 3, P = $7 and total revenue equals $21 which is

Illustration of Marginal Revenue for the Demand

• Total revenue is not $24 as illustrated by the area of the

• The sale of one more tape increases revenue by the price at

Illustration of Marginal Revenue for the Demand

P* = $7 A  The sale of one more tape increases revenue by

Demand Cassette tapes

 The net result of this price decrease is total revenue

 Thus, the marginal revenue of the fourth tape is $3.

 The sale of the sixth tape, instead of five, results in an

Marginal Revenue and Price Elasticity