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CHAPTER VI. PRODUCTION AND COSTS
OBJECTIVES
At the end of the lesson, the student will be able to
1. Distinguish, discuss, and explain the different classifications of costs and their
effects on profit and revenue.
2. Explain the interaction of the different classes of costs and their effect on
productivity.
3. Discuss the differences of short-run and of the long-run costs and their effect
on production.
TOPICS FOR DISCUSSION
1. Explicit and implicit costs
2. Economic and normal profit
3. Increasing and diminishing returns
4. Short-run costs
5. Long-run costs
6. Economies and diseconomies of scale
KEY WORDS AND TERMS
Costs Implicit costs Accounting profit
Explicit costs Revenue Profit
Economic profit Long-run Inputs
Short-run Marginal product Marginal cost
Production function Economies of scale Planning curve/envelope curve
Returns to scale
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COSTS
When we use the resources of others we pay the owners approximately the opportunity
cost – the possible earning of the resource had they been employed for the other best
alternative. Were we to use our own resources, a building, for example, we still incur
opportunity cost even if we do not pay the rent. That is because, the building can be used to
earn profit by being rented to others.
Explicit costs – Payment for resources secured or bought from non-owners of the
business firm. Among these are wages for labor, cost of utilities (water, light and power,
telephone services), materials, medical services, and others. These resources are owned by
persons and organizations outside the firm and thus payments (or out-of-the-pocket expenses)
are made to “outsiders” (Tucker, 2008).
Implicit costs
Implicit Costs – These costs refers to the opportunity costs that business owners give up
for using the resources of the business firm. A person who decides to put up a business and
runs it gives up the opportunity cost of earning salaries as an employee. If he uses his own land
and building to house his business, he gives up the opportunity to earn rent from outsiders
(Tucker).
There is no actual payment of these costs because what is actually lost is the
opportunity from an alternative choice. No outlay of money is required for implicit costs.
PROFITS
Accounting profits refer to the profits recorded by accountants and are based on total
revenues and explicit costs. The implicit costs are not included. Accounting profit is expressed
by the formula:
Accounting profit = total revenue – total explicit cost
Economic profit, on the other hand, is total revenue minus explicit and implicit costs.
Instead of accounting profits, economists use the concept of economic profits because
economic decisions involve explicit as well as implicit costs. It is expressed in the formula:
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Economic profits = total revenue – total opportunity costs, or
Economic profits = total revenue – (explicit costs + implicit costs)
Exhibit 6.1. Comparison of Economic Profit and Accounting Profit
ITEM ACCOUNTING
PROFIT
ECONOMIC
PROFIT
Total revenue Php 400,000 Php 400,000
Less explicit costs:
Salaries and wages 300,000 300,000
Supplies and materials 30,000 30,000
Interests expense 6,000 6,000
Miscellaneous Exp. 4,000 4,000
Less implicit costs:
Foregone salary 0 40,000
Foregone rent 0 12,000
Foregone interest 0 4,000
Profit Php 60,000 Php 4,000
Reference: Tucker, Irvin B. (2008). Economics for Today, USA: Thomson South-Western, 164.
COSTS, PROFITS, AND REVENUE
At production level q, profits constitute the revenue, R(q) minus costs, C(q):
∏(q) = R(q) – C(q)
On the other hand, revenue is simply price times quantity, R(q) = p(q) (Economides, 2010).
COST OF PRODUCTION
Cost and production decisions are distinguished by economists between the short-run
and the long-run. However, for economists, short-run and long-run do not refer to number of
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days or months or years. Instead, they refer to the “ability to vary the quantity of inputs or
resources used in production” (Tucker, 2008, 165).
Exhibit 6.2.
Short-run refers to a period that is too short or too brief for some inputs to be varied. A
firm cannot secure equipment in a day or two nor make immediate alteration on the size of its
plant.
Long-run refers to a period during which a firm can make adjustments on all its inputs.
Note that in the long-run, all inputs are variable. They change as output changes.
TWO TYPES OF INPUTS
Fixed inputs are resources the quantity of which cannot be changed in the short-run.
They do not change with output. An example of fixed inputs is heavy machineries, the
production capacity of which cannot be changed in a short period of time. Another example is
the size of the plant.
Economic Profits
Implicit Costs
Explicit Costs
Accounting
Profits
Explicit Costs
Total
Revenue
Economic
Costs
Accounting Costs
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Variable inputs are resources “for which the quantity can change during the period of
time under consideration” (Tucker, 2008, 165).
PRODUCTION FUNCTION
N. Gregory Mankiw states that “the production function shows the relationship
between quantity of inputs used to make a good and the quantity of output of that good.” It is
the relationship between the maximum amount of outputs a firm can produce at various
quantities of inputs.
In Exhibit 6.3, assume that technology and factors of production, except labor, are held
constant and that labor is the only input where the skills of workers are the same. Exhibit 6.3
below shows the concept of production function, marginal productivity, and total output.
MARGINAL PRODUCT
As more inputs are applied, at any given additional unit of input there will be an
increase in output. This additional output arising from each unit of additional input is the
marginal product of labor (MPL) defined by the formula:
MPL = ∆Q/∆L
Exhibit 6.3. Total, Marginal, and Average Products of Labor
Quantity of Labor Total Product Marginal Product of Labor Average Product of Labor
1 worker 10baskets 10 baskets per worker 10 baskets per worker
2 25 15 12.50
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 77 2 11
8 77 0 9.62
9 75 -2 8.33
Exhibit 6.4. Total, Marginal, and Average Product Curves
a) Total Product Curve
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b) Marginal Product and Average Product Curves
0
5
40
35
30
25
10
15
20
45
50
55
60
65
70
75
Tota
l pro
duct
80
Labor per day87654321 9
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Exhibits 6.3 and 6.4a and 6.4b, with the first three workers the firm experienced an
increasing marginal returns. From the 4th worker the law of diminishing marginal returns
came into effect as each additional worker contributed less than the one it followed until on the
9th worker the contribution is negative.
The law of diminishing marginal returns states that “the extra production obtained
from increases in a variable input will eventually decline as more of the variable input is used
together with the fixed inputs” (Hyman, 1994).
Total product (TP) is the quantity of output a firm produces in a given time period. As
can be seen from the above exhibit, it depends upon the number of laborers (inputs) the firm
takes in subject to the law of diminishing marginal returns.
Average product is the total product divided by the number or workers (inputs).
0
1 2 3 4 5 6 7 8 9
25
20
15
10
5
Labor per day
Mar
gina
l pro
duce
(uni
ts p
er d
ay)
Increasing MR Decreasing but
positive MR
Negative MRMarginal Product (MP)
Average Product
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THE AVERAGE-MARGINAL RULE OF PRODUCTION
The average-marginal rule shows the relationship between the average product and
marginal product (Exhibit 6.3).
1. When the marginal product of a laborer (an input) is greater than the average product,
adding that laborer (input) increases the average product.
2. When the marginal product of a laborer (an input) is less than the average product,
adding that laborer (input) causes the average product to fall.
MEASURES OF COSTS
Production costs are divided into fixed costs and variable costs (Mankiw).
Fixed Costs, sometimes called set up costs are costs which do not vary with the
level of production. These are the costs that must be paid even if there is no output.
Among these are property taxes, rent, insurance, and interest on loans.
Variable costs are the costs that vary with the level of output or production.
These costs are not incurred when there is no production. Among these are raw
materials, wages of workers, and electricity.
SHORT-RUN COSTS
Total cost is the sum of the total variable cost and fixed cost at every level of output. It
is defined by the formula:
TC =TFC + TVC
Average cost is the cost of each unit of product. It is obtained or determined by dividing
the total cost (whether fixed cost or variable cost) by the number of units of output. Thus
Average fixed cost: AFC = TFC/Q,
Average variable cost: AVC = TVC/Q
Average total cost: ATC = TC/Q
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Marginal Costs or Incremental Costs (MC) is the measure of the increase in total cost
arising from an extra unit of production. It is the cost associated with the last unit of
product of an activity. It is derived by the formula
MC = Change in Total Cost/Change in Quantity = ∆TC/∆Q.
Extra production does not affect fixed cost, therefore the increase in total cost is
equal to or the same as the increase in variable cost, such that
MC = ∆TC/∆Q = ∆TVC/∆Q
MARGINAL-AVERAGE RULE OF COST
“The marginal-average rule states that when marginal cost is below average cost,
average cost falls. When marginal cost is above average cost, average cost rises” (Tucker, 2008,
173). This rule which applies to any average figure such as grades and weights is shown in the
intersection of the marginal cost (MC) curve with the AVC curve and the ATC curve at their
minimum points.
Exhibit 6.5 shows the cost schedule of a theoretical firm while Exhibit 6.6 shows its total
cost, total variable cost, fixed cost, and marginal cost curves.
Exhibit 6.5. Short-Run Cost Schedule.
(1) (2) (3) (4) (5) (6) (7) (8)
Total Product
(Units per hour
Total Fixed
Cost
Total
Variable
Cost
Total Cost Marginal
Cost
Average Fixed
Cost
Average
Variable
Cost
Average
Total Cost
(Q) (TFC) (TVC) (TC) (MC) (AFC) (AVC) (ATC)
0 2.00 0 2.00 - - - -
1.00
1 2.00 1.00 3.00 2.00 1.00 3.00
0.80
2 2.00 1.80 3.80 1.00 0.90 1.90
0.60
3 2.00 2.40 4.40 0.67 0.80 1.47
0.40
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4 2.00 2.80 4.80 0.50 0.70 1.20
0.40
5 2.00 3.20 5.20 0.40 0.64 1.04
0.60
6 2.00 3.80 5.80 0.33 0.63 0.96
0.80
7 2.00 4.60 6.60 0.29 0.66 0.94
1.00
8 2.00 5.60 7.60 0.25 0.7 0.95
1.20
9 2.00 6.80 8.80 0.22 0.75 0.98
1.40
10 2.00 8.20 10.20 0.20 0.82 1.02
1.60
11 2.00 9.80 11.80 0.18 0.89 1.07
1.80
12 2.00 11.60 13.60 0.17 0.97 1.13
2.00
13 2.00 13.60 15.60 0.15 1.05 1.20
2.20
14 2.00 15.80 17.80 0.14 1.13 1.27
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
Exhibit 6.6. Total Cost, Total Variable Cost, Fixed Cost, and Marginal Cost Curves.
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0 1
181716151413121110
987654321
141312111098765432
Product per unit (Quantity)
Cost
per
uni
t
per
unit
FC
TC
TVC
MC
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RELATIONSHIP BETWEEN MARGINAL COSTS AND AVERAGE COSTS
Exhibit 6.7 shows the relationships of the different measures of cost where the following
can be observed (Mankiw).
1. At first the marginal cost curve (MC) declines and will subsequently goes up at a
certain point and intersect the average total cost and the average variable cost
curves at their minimum points.
2. The average variable cost (AVC) curve will go down not as steep as the marginal
cost curve and then will rise. This will not go up as fast and as steep as the marginal
cost curve.
3. As additional units of output are produced, the average fixed cost (AFC) curve will
decline with each unit produced.
4. The average total cost (ATC) curve will initially decline as fixed costs are spread over
a larger number of units. It will go up subsequently as marginal costs increase due to
the law of diminishing returns.
Exhibit 6.7. Relationship Between Marginal Costs And Average Costs.
2.40
2.20
2.00
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
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RELATIONSHIP
BETWEEN MARGINAL PRODUCT AND MARGINAL COST
A definite relationship exists between marginal cost and marginal product. Assuming
that labor is the only variable input, as a firm adds more workers, the marginal product of that
labor will tend to rise. This rising marginal product will result to a decreasing marginal cost
because each additional worker will add more to the total product than the previous worker
(Sexton).
Exhibit 6.8.Relationship Between Marginal Cost and Marginal Product.
MC
ATC
AVC
AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13
OUTPUT (Units per period of time)
Mar
gina
l Pro
duct
Uni
ts p
er h
our
0 Number of WorkersMar
gina
l Cos
t
(Pes
os)
0 Quantity of Output
Marginal Product (MP)
Marginal Cost (MC)
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When the marginal product begins to decline, marginal cost begins to rise because
each additional worker will add less to the total output than the previous worker. This inverse
relationship between marginal product and marginal cost is shown in Exhibit 6.8. Ceteris
paribus, as the marginal product (MP) curve rises, the marginal cost (MC) curve falls. As the MP
curve reaches its maximum, MC curve is at its minimum. When diminishing marginal returns
sets in the MP curve falls and the MC curve rises.
LONG-RUN COSTS
Long-run, for a firm, is a period during which all quantities of resources utilized (inputs)
in production, including plant capacity, can be adjusted. It is thus a period during which all
inputs, the choice of input combinations, are variable or flexible. It is, therefore, a period where
no resource or costs are fixed (Tucker).
Long-run Average Total Cost
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Long-run operation results from a firm’s successful operation and expanding larger plant
sizes with larger output capacities. As shown in exhibit 6.9, the adjustment of the firm, from a
single plant size to varying plant sizes in the long-run reflects the average total cost curve (ATC).
Exhibit 6.9 shows the short-run plant sizes. The long-run average cost (LRAC) curve shows
the lowest average short-run average total cost (SRATC) at which any output can be produced
after the firm was able to make all necessary adjustments in plant size. By connecting the points
on the short-run average cost curves representing the lowest per unit cost for each output
level, a long run average cost curve can be created .
In Exhibit 6.10 the long-run average total cost (LRATC) curve is a smooth curve
representing large possible plant sizes. The resulting long-run average cost curve is called the
“planning curve,” or “envelope curve” of the firm (McConnell et al).
Exhibit 6.9. Short-run Average Total Cost Curve in Five possible Plant Sizes
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Exhibit 6.10. Long-Run Average Cost Curve In An Unlimited Number Of Plant Sizes
0 2 4 6 8 10 12 14 16Quantity of output per period
2
4
6
8
10
12
Aver
age
tota
l cos
t (p
esos
)
SRATC1 SRATC2
SRATC3
SRATC4 SRATC5
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Economies of Scale
While in the short-run, ATC is primarily determined by the law of diminishing marginal
returns, presuming one resources as fixed in supply, in the long-run all resource inputs are
variable. As the size of a plant increases and output expands, average cost of production
decreases. The firm, thus, experiences economies of scale or economies of mass production.
Economies of scale exists when the long-run average total cost declines as output increases
(Exhibit 6.11).
0 2 4 6 8 10 12 14 16Quantity of output per period
2
4
6
8
10
12
Cost
per
uni
t (p
esos
)
Long-run average cost curve
Short-run average total cost curves
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Exhibit 6.11.
Reference: Tucker, Irvin B. (2008). Economics for Today, USA: Thomson South-Western, 17
Constant Returns to Scale (CRS)
Returns to scale is constant when a certain increase in input produces the same
increase in output. In this, the marginal cost is equal to average cost. The same amount of labor
needs to be put in for every unit, particularly in handmade products (Economides).
Decreasing Returns to Scale (DRS)
Decreasing returns to scale is a production function where increasing input by a certain
amount results to a lesser amount of output. This is usually the case in traditional
Increasing returns to scale
(Economies of Scale)
Constant returns to
scale
Decreasing returns to
scale (Diseconomies of
scale)
Cost
per
uni
t (Pe
sos)
Quantity of output0 Q1 Q2
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manufacturing where initially, the incremental costs decreases but later on increases
(Economides).
NOTE: Diminishing marginal product or diminishing marginal returns should not be confused
with decreasing returns to scale. The concepts are different in two ways:
1. Diminishing marginal returns (DMR) is a short-run concept which describes the effect
on output when one input is increased, ceteris paribus.
Decreasing returns to scale (DRS) is a long-term concept. It describes the effect on
output when all inputs are increased in the same proportion.
2. Diminishing marginal returns (DMR) deals with marginal quantities and decreasing
returns to scale (DRS) deals with total and average quantities (Lansburg, 166).
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STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus).
1. Define cost and cite some examples.
2. When are explicit costs incurred?
3. When are implicit costs incurred?
4. Differentiate accounting profits and economic profits.
5. Explain the short-run and long-run concept of production.
6. Give examples of fixed inputs and variable inputs. Why are they classified as such?
7. Explain the concept of marginal product and give an example.
8. Explain the relationship between total product, marginal product and average product.
9. What causes marginal product to decline as more and more of a given input is added
into the production process?
10. Explain the different categories or kinds of costs and give examples.
11. Explain and illustrate the marginal average rule of costs.
12. Explain the relationship between marginal cost and marginal product.
13. Differentiate economies of scale, constant returns to scale, and diseconomies of scale.
14. Differentiate diminishing marginal returns and decreasing returns to scale.
TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the
statement is false. Assume that other things are held constant. If your answer is false,
explain why.
____ 1. When we acquire and pay for resources purchased or secured from others
the payment represents the possible earnings they will earn had they used
the resources for other endeavor. The payment we make in this case is for
opportunity cost.
____ 2. Payment for laborers, utilities, supplies and materials that go into
production is implicit cost.
____ 3. An engineer who gives up his salary in order to engage in business incurs an
implicit cost.
____ 4. No money outlay is necessary for the payment of explicit costs.
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____ 5. Profits derived from the difference between explicit costs and total revenue
are accounting profits.
____ 6. During certain short-term periods of production some resources are either
increased or decreased. These inputs are called variable inputs.
____ 7. The period in production that is too short to vary some production inputs is
called the short-term period.
____ 8. Assuming that labor is the only input, by dividing change in quantity byt the
change in labor will give us the marginal productivity of labor.
____ 9. At the point where total revenue begins to decrease, average product is
zero.
____ 10. Profits which cover both explicit and implicit costs are accounting profits.
____ 11. Marginal product declines or decreases faster than average product.
____ 12. The period when all inputs, whether variable or fixed input, are variable is
the short-term period.
____ 13. Assuming that labor is the only input, when the marginal product is less
than the average product, an additional unit of labor will cause the average
product curve to rise.
____ 14. When the average cost is higher than the marginal cost the average cost will
fall.
____ 15. When the marginal cost is above average cost average cost will rise.
____ 16. Economies of scale exists when the long-run average total cost declines as
output increases
____ 17. When an increase input results to a decrease in output the firm experiences
an increasing returns to scale.
____ 18. Diminishing marginal product means decreasing returns to scale.
____ 19. In the manufacture of hand-made products the same amount of labor is put
into the production of every unit. This is an example of a constant returns to
scale.
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____ 20. Economies of scale is economies of mass production.
FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that
complete each statement. Assume that all other things are held constant.
_______________ 1. When a business firm pay others or outsiders for inputs secured
or purchased from the latter, such payments are called
__________ costs.
_______________ 2. The cost for which there are no cash disbursements in the
present or in the future but are nevertheless incurred because
of missed opportunity to use them for other alternative
economic choices are called __________ costs.
_______________ 3. Profit over and above explicit and implicit costs is __________.
_______________ 4. Profit over and above explicit cost is __________.
_______________ 5. Building, plants, machinery are __________ inputs.
_______________ 6. Raw materials and supplies are __________ inputs.
_______________ 7. When more and more inputs are put into production, the
output for every unit of additional input is called __________.
_______________ 8. The law of __________ exhibits the decreasing output for every
additional variable output added with the fixed input in
production.
_______________ 9. The relationship between the marginal product and marginal
cost is the basis for the __________ relationship between the
two.
_______________ 10. Set-up costs do not vary with production. They are called
__________ costs.
_______________ 11. There are costs that are not incurred when there is no
production. They rise or fall with the level of production. These
are __________ costs.
_______________ 12. At every level of production, the sum of the variable cost and
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fixed cost is __________ cost.
_______________ 13. The increase total cost associated with an additional unit of
production is __________ cost.
_______________ 14. By dividing change in total cost by change in quantity,
__________ cost is obtained.
_______________ 15. The relationship between marginal cost and average cost is the
basis for the __________ rule.
_______________ 16. As marginal cost increases marginal product __________.
ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris
paribus).
1. Hypothetical table of production and costs. Quantity of labor (QL) and Production
(Q/day) are in units. Costs are in pesos.
QL Q/day FC VC TC MC
0 400
1 6 120 20
2 12 210 610 15
3 16 686
4 19 358 758 24
5 21 25
a. Fill the blank boxes on the table with the correct amounts.
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b. What is the marginal cost for the 3rd unit of labor?
c. What is the average total cost when the output is 21 units?
d. Graph the FC, VC, TC, and MC.
2. Romeo rented a stall in front of SPCT for Php72,000 annually to put up an internet shop
and offer other computer services. He hired an assistant for Php36,000 a year. He spends
Php60,000 a year for utilities, supplies and materials, and other miscellaneous expenses.
He turned down a job offer that will pay him Php60,000 a year as computer programmer.
He estimates his talent to be Php12,000 a year. He expects an annual revenue of
Php185,000. Compute for the accounting profit and accounting profit of Romeo.
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PART 2. MARKET STRUCTURES, PRICING, AND, MARKET POWER
CHAPTER VII. PERFECT COMPETITION
OBJECTIVES
This lesson which explores the perfectly competitive market will enable the
student to
1. Understand and explain the features that determine the classification
markets.
2. Enumerate and discuss the characteristics of a perfectly competitive market.
3. Evaluate how a perfectly competitive firm can generate revenue and
maximize profits.
4. Evaluate how a perfectly competitive firm can minimize losses, when to shut
down or exit from the industry.
TOPICS FOR DISCUSSION
1. Market structures
2. Price taker
3. Marginal revenue
4. Golden rule of profit maximization
5. Loss minimization
6. Firm’s short-run supply curve
7. Competition and efficiency
8. Producer surplus.
KEY WORDS AND TERMS
Industry Perfectly competitive market Price taker
Revenue Profit maximization Zero economic profit
Shutdown point Exit point
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INDUSTRY AND MARKET
An industry is a collection of firms, all firms, supplying products or output to a particular
market, such as the lumber market, oil market, grains market.
The terms market and industry are used interchangeably (McEachern).
MARKET STRUCTURE
Market structure refers to the features that characterize a market (McEachern). Among
these are
1. The number of firms. (Many or few?)
2. The degree of uniformity of their products? (Are their products similar (uniform) or
different?)
3. The ease of entry into the market (Is there free or easy entry? Is entry blocked by
natural or artificial, such as government imposed barriers?)
4. The forms or types of competition among the firms in industry or market. (Does
competition among the firms involve only pricing? Are there other means of
competition such as advertising, branding, product differentiation?)
PERFECTLY COMPETITIVE MARKET
A perfectly competitive market is a market structure with the following characteristics
(Sexton):
There are many sellers and buyers in the market. Each buyer or seller buys or sells only a
fraction of the amount of goods sold or exchanged in the market.
Products produced by the firms and sold in the market are standardized (homogeneous).
Buyers and sellers are fully informed about the prevailing prices and availability of the
products.
Firms can enter into or exit from the market freely. There are no artificial or natural barriers
and no obstacles to exit.
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As a result of its characteristics, the perfectly competitive market has the following
outcomes (Sexton):
A competitive market has many buyers and sellers trading identical products so that
each buyer and seller is a price taker.
No single seller or buyer can significantly influence the price.
The market price is considered by every buyer and seller as a given factor.
Buyers and sellers must accept the price determined by the market.
Exhibit 7.1. A Firm’s Demand Curve and Market Equilibrium in Perfect Competition.
DEMAND UNDER PERFECT COMPETITION
0 0Quantity per
period
Quantity per
period
DS
Pric
e pe
r uni
t
P10
100,000
a. Firm’s demand b. Market equilibrium
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1. Under a perfectly competitive market, price is determined by the equilibrium of the
market price and quantity. At this point, a firm can sell as much of the good as he
wants (Sexton).
2. Since the firm’s demand curve is horizontal, perfectly elastic, it cannot charge a price
higher than the market price. Otherwise, buyers will go to other suppliers who are
selling identical products (Exhibit 7.1a and Exhibit 7.1b).
3. It is for that reason that a firm in a perfectly competitive market is called a price taker.
It is usually said that “In perfect competition there is no competition.” That is because
although firms are selling identical product, each of them supplies only an insignificant amount
in the market, insufficient to influence the market.
REVENUE OF A COMPETITIVE FIRM
Total revenue for a competitive firm is derived by multiplying the selling price by the
quantity sold.
TR = (P ´ Q)
Therefore, total revenue is proportional to the amount of output.
Average revenue is the amount of revenue that a firm receives from each unit sold.
Average revenue is derived by dividing total revenue by the quantity sold.
Therefore average revenue in a perfect competition equals the price of the good.
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Marginal revenue is the change in total revenue derived from the sale of an additional
unit. It is derived from the formula: MR =DTR/DQ
Marginal revenue is the price of the good sold by a competitive firm.
Exhibit 7.2. Competitive Firm’s Total, Average, and Marginal Revenue
Quantity
(units)
Price Total Revenue
(TR = PxQ)
Average Revenue
(AR = TR/Q
Marginal Revenue
(MR = ΔTR/ΔQ)
1 8 8 8 8
2 8 16 8 8
3 8 24 8 8
4 8 32 8 8
5 8 40 8 8
6 8 48 8 8
7 8 56 8 8
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8 8 64 8 8
PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
1. Profit maximization is the objective or goal of a competitive firm.
2. It is concerned with the production of the quantity from which it gets the maximum
difference between total revenue and total cost (Total revenue minus total cost).
Exhibits 7.3 show an example of schedule showing the short-run costs, revenue, and
profit in a profit maximizing firm.
PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM’S SUPPLY CURVE
Another way of maximizing profit is through the “golden rule of profit maximization.”
Profit maximization is attained at the quantity where marginal revenue is equal to marginal
cost (Exhibit 7.4). At this level of output, they are getting what economists call the “normal rate
of return on the resources they invested on the firm.” Such profit-maximizing output generates
zero economic profit because it does not provide for the opportunity cost (Sexton, 2003, 209).
Exhibit 7.3. Profit Maximization: Short-run Costs, Revenue and Profit.
Quantity
(units)
(Q)
Marginal
Revenue
(MR =
ΔTR/ΔQ)
Total
Revenue
(TR)
Total
Cost (TC)
Marginal
Cost
(MC =
(ΔTC/ΔQ
Average Total
Cost
(ATC= TC/Q
Profit
(or Loss) (TR –
TC)
0 4 ∞ -4
1 8 8 6 2 6 2
2 8 16 9 3 4.5 7
3 8 24 13 4 4.33 11
4 8 32 18 5 4.5 14
5 8 40 24 6 4.8 16
6 8 48 31 7 5.17 17
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31
7 8 56 39 8 5.57 17
8 8 64 48 9 6 16
Exhibit 7.4. Profit Maximization. Revenue and Average Costs Curves.
HOW A FIRM CAN MAXIMIZE PROFIT
When marginal revenue is greater than marginal cost (MR > MC) quantity should be
increased.
When marginal revenue is less than marginal cost (MR < MC)quantity should be
decreased.
When marginal revenue equals marginal cost (MR = MC) profit is maximized.
From the foregoing, it can be seen that to attain maximized profits, a firm’s supply curve
should be identical to the part of the marginal cost curve that lie above the average cost
curve as shown in Exhibit 7.5 (Mankiw, 2003).
Exhibit 7.5. Marginal Cost is the Competitive Firm’s Supply Curve
MC
ATC
P=AR=MRAVC
MC1
P
MC2
Costs
And
Revenue
0 Q1 QMAX Q2 Quantity
Profit maximizing quantity
(MC = MR)
MC
ATC
AVCP1
P2
Price
0 Q1 Q2 Quantity
Competitive firm’s
supply curve
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32
Short-Run Profits And Losses
In order to determine the viability of going on with the operation, a firm has to
determine if it is generating economic profits, economic loses, or zero economic profits.
It has to be noted that the cost curves include not only the explicit costs but also the
implicit costs.
Economic Profit
A firm is generating economic profits if the total revenue (TR) is greater than
total costs at a certain quantity of output (q): TR > TC (Sexton,2005). In contrast with
profit-maximizing output where the firm derives zero economic profits (MR = MC), to
attain economic profit, the price should be more than the average total cost (P > ATC) at
a certain level of output Q (Exhibit 7.6).
Exhibit 7.6. Economic Profit (Profit-Maximizing Output)
MC
ATC
Price
0 Quantity
P=AR=MR
Q
P Total
ProfitATC
P > ATC at Q
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33
Economic Loss (Loss-Minimizing Output)
A firm incurs economic losses when total revenue (TR) is less than total cost(TC) at a
given output Q (TR < TC). In this situation, price is less than the average total cost at that given
output Q (P < ATC) (Sexton, 2005). However, to minimize the losses, the firm should produce at
a level of output where the price equals marginal cost such that P = MR = AR (Exhibit 7.7).
Exhibit 7.7. Economic Loss (Loss-Minimizing Output)
Exhibit 7.8. Zero Economic Profit
MC
ATC
Price
0 Quantity
P=AR=MR
Q
Total Loss
P < ATC at Q
ATC
P
MC
ATC
Price
0 Quantity
P=AR=MR
Q
P = ATC at Q
P = ATC
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34
Zero Economic Profit
A firm is generating zero economic profits if it is not able to cover the implicit
costs, the opportunity cost. Recall that opportunity cost is “the highest or foregone
opportunity resulting from a decision” (Sexton, 2005, 29). For a firm operating at a level
where it generates zero economic profit, the price is just equal to average total cost (P
= ATC) at that level of output (Exhibit 7.8 and Exhibit 7.6). It is able to recover
accounting costs but not opportunity costs.
SHUT DOWN AND EXIT POINTS IN THE SHORT RUN
Losses Short of Shutting Down
A shutdown is a short-run decision during a certain period when a firm should
not produce anything because of prevailing market conditions.
If each unit produced cannot cover the variable cost per unit because the price is
below the minimum point on the average variable cost curve (AVC) continuing the
operation will increase the firm’s losses. It will be better for the firm to shut down and
produce zero output. While hoping for higher prices in the near future it can keep its
plant, pay fixed cost (Tucker, 2008).
In a shutdown decision, the fixed costs do not figure because the firm pays for
them whether it operates or not.
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35
However, if the price is higher than the average variable cost, it is still better to
operate.
Thus, a firm may operate if
TR – TC > FC
Substituting TC = FC – VC:
TR – (FC – VC) > FC
Therefore: TR > VC
Since TR = P x Q,
P x Q > VC
By dividing each side of the equation by Q,
P = AVC.
In this situation the firm should decide against shutting down (Exhibit 7.9) because it
can afford to pay the variable cost and the point of shutting down is precisely to avoid paying
variable costs (Lansburg, 2005). On the contrary however, Sexton states that to decide against
shutting down while incurring some losses, the price should be higher than average variable
cost (P > AVC)and lower than average total cost (P < ATC).
Exhibit 7.9. Short-run Losses Short of Shutting Down
MC
ATC
AVC
Price
0 Quantity
P
Q
P = MR =AR
P = AVC. Firm does not
shutdown
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36
Shutdown Point
On the other hand, a firm may decide to shut down (Exhibit 7.10) if the revenue
it gets from producing is less than the variable cost of production (Mankiw, 2003):
if TR < VC
if TR/Q < VC/Q
P < AVC
In this situation (Exhibit 7.10), the price at all levels of output is less than the average
cost. It is therefore necessary that the firm shuts down to cut its losses.
Exhibit 7.10. Short-Run Losses and Shutdown Point
LONG-RUN EXIT POINT
Exit is a long-run decision to leave the market. When a firm incurs negative economic
profits, it has to exit the industry. This is because it is unable to recover accounting costs as
well as opportunity costs (Sexton).
MC
ATC
AVC
Price
0 Quantity
P = MR = ARP
P < AVC. Firm has to shut
down.
Shutdown Point
Short-run supply curve
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37
Sunk costs are costs that have been incurred and can never be recovered. Thus, they are
not considered; they are irrelevant in making decisions (McEachern).
Thus a firm will decide to exit when
TR < TC
TR/Q < TC/Q
P < ATC
In the long-run, a firm will enter the industry if
TR > TC
TR/Q > TC/Q
P > ATC
Exhibit 7.11. A Competitive Firm’s Long-Run Supply Curve
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
The competitive firm’s long-run supply curve (Exhibit 7.11) is the portion of its marginal-
cost curve that lies above average total cost. Note that in the short-run, a competitive firm’s
MC
ATC
Costs
0 Quantity
Along the
portion where
P<ATC a firm
will exit the
industry.
When P>ATC
a firm may
enter the
industry.
Long run supply
curve
Page 38
PricePrice
P1
P2
10 100 20 200 Quantity(firm) Quantity(market)
MC Supply
P2
P1
38
supply curve is the portion of the marginal-cost curve that lies above average variable cost
curve (Exhibit 7.10) (Mankiw, 2003).
THE SUPPLY CURVE IN A COMPETITIVE MARKET
The short-run supply curve in a competitive market is “the summation of individual
firms’ supply curves in the market” (Exhibit 7.12). It is the portion of the firms’ marginal costs
(MC) above the average variable costs (AVC). (Sexton, 2005, 211-212)
The long-run supply curve is the portion of the marginal cost (MC) curve above the
minimum point of its average total cost (ATC) curve (Exhibit 7.11).
Exhibit 7.12. Market Supply in a Competitive Market
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39
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
Exhibit 7.13a. An Increase in Demand in the Short Run and Long Run
PricePrice
P1
Quantity(firm)
MC
ATC
Q1
A
Short run supply,
S1
Demand D1
FIRM MARKET
Quantity(market)
Long-run Supply
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40
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
Exhibit 7.13a shows a theoretical initial condition of a firm operating in a market. It’s ATC is
equal to price, thus, is operating at a profit-maximizing output (See also Exhibit 7.6).
An increase in demand (Exhibit 7.13b) generates an increase in price.
Exhibit 7.13b Short-run Response
As the information about the profitability of the theoretical firm gets out, more
suppliers will respond by entering the market thereby increasing the supply or shifting the
supply curve to the right as shown in Exhibit 7.13c.
Exhibit 7.13c Long-run Response
PricePrice
P1
Quantity(firm) Quantity(market)
MC
Long-run
supply
ATC
Q1
A
D1 D2
S1
Q2
P2P2
P1
Profit
PricePrice
P1
Quantity(firm)) Quantity(market)
MC
Long-run
supply
ATC
Q1
A
D1 D2
S1
Q2
P2 P2
P1
Profit
S2
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
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41
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
If the supply response pushes the price of the commodity down, the firm will revert to
the situation (Exhibit 7.13a) where he will be making zero economic profit (P1 = ATC) from
market’s short-run response (Exhibit 7.13b) where he was producing profit-maximizing output
and making economic profit (P2 > ATC)
THE COMPETITIVE FIRM’S LONG-RUN EQUILIBRIUM
Exhibit 7.14. Long-Run Competitive Equilibrium.
Note that the long-run average total cost and the short-run average total cost are equal
at the equilibrium point “e” where marginal cost (MC) equals marginal revenue (MR). The
equilibrium point is at the lowest point on the average total cost curve. This is because the
marginal cost (MC) curve must intersect the average total cost (ATC) curve at the lowest point
of the latter (Exhibit 7.13a). This point (equilibrium) in the long-run requires each firm to
produce at an output level that keeps the average total cost at a minimum or what is called
minimum efficient scale.
MC
SRATC
LRATC
P = MR = AR
Q
P
0
e
Page 42
42
At this point, there is no incentive for new firms to enter the industry and no existing
firm has the inducement to exit. (Sexton, 2005).
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43
STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus).
1. Enumerate the characteristics of a market structure.
2. Enumerate and explain the characteristics of a perfectly competitive market.
3. Explain why a seller in a perfectly competitive market is a price taker.
4. Why is it not possible for a firm in a perfectly competitive market to charge a price other
than the market price?
5. Explain and illustrate the “golden rule of profit maximization.”
6. When should a firm in a perfectly competitive market increase its output in relation to
marginal cost and marginal revenue?
7. When should a firm in a perfectly competitive market decrease its output in relation to
marginal cost and marginal revenue?
8. Explain how a firm in a perfectly competitive market can generate economic profit.
9. How can a firm in a perfectly competitive market minimize its losses? Illustrate your
answer.
10. At what point in its operation should a firm in a perfectly competitive market shut
down?
11. At what point in its operation should a firm in a perfectly competitive market exit the
industry or market?
12.Explain the concept of minimum efficient scale.
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44
TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the
statement is false. Assume that other things are held constant. If your answer is false, explain
why.
____ 1. A group of firms supplying the same products and/or services to a particular
market is an industry. Therefore, the term industry cannot be used to signify a
market.
____ 2. A market where there are many sellers and the price is considered as a given
factor by both sellers and sellers is a perfectly competitive market.
____ 3. No single seller or buyer can influence the price in a perfectly competitive
market.
____ 4. The individual demand for the product of a firm in a perfectly competitive
market is perfectly elastic.
____ 5. The demand for the product in a perfectly competitive market is inelastic.
____ 6. Products in a perfectly competitive market are homogeneous.
____ 7. The marginal revenue is the price of the good sold by a competitive firm.
____ 8. When marginal revenue is equal to marginal cost in a competitive firm, it is
getting or earning normal rate of return but not economic profit.
____ 9. When a firm earns a normal rate of return it is able to recover only what it
invests in the business.
____ 10. When the marginal revenue of a competitive firm is more than its marginal
cost, it must decrease its production.
____ 11. When the marginal revenue of a competitive firm is less than marginal cost its
output should be decreased.
____ 12. To be able to attain economic profit, a competitive firm’s price for the product
should be more than its average total cost (ATC).
____ 13. When the total revenue (TR) is less than total cost (TC) or the price is less than
the average total cost (ATC) the firm is incurring economic loss.
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45
____ 14. It is better for the firm to shut down than to operate when the price is below
the lowest point on the average cost curve.
____ 15. In a shut down decision, fixed costs should also be taken into consideration
because they are incurred whether they operate or not.
____ 16. When a firm is not able to recover economic costs and implicit costs, it has to
exit the industry.
____ 17. A competitive firm may earn incur profit in the short-run. In the long run, as
other firms get to know about it they contribute to the increase in supply
bringing back the original firm to its previous situation.
____ 18. To be able to achieve maximum efficient scale in the long-run, a competitive
firm must produce at the point where the marginal cost (MC) intersects the
average total cost (ATC) at its lowest point.
FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that
complete each statement. Assume that all other things are held constant.
_______________ 1. A group of firms supplying products to a market of a specific
commodity is a/an __________.
_______________ 2. In a perfectly competitive market products are standardized or
_________.
_______________ 3. Since the price in a perfectly competitive market is considered
by both sellers and buyers as a given factor, such buyers and
sellers are __________ takers.
_______________ 4. Price in a perfectly competitive market is determined by the
__________ of the market price and quantity.
_______________ 5. The demand curve of a firm in a perfectly competitive market is
__________ due to the price elasticity of the demand.
_______________ 6. Price times quantity equals _________ in a competitive market.
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46
_______________ 7. Total revenue divided by quantity or price times quantity
divided by quantity is equal to __________
_______________ 8. or __________
_______________ 9. The production quantity where marginal revenue is equal to
marginal cost is the means by which a competitive firm can
maximize profit. This is the __________ of profit maximization
for a firm under perfectly competitive market.
_______________ 10. __________ does not include economic profit because this just
represents the recovery of the resources invested in the firm.
_______________ 11. When marginal cost is more than marginal revenue, quantity
sold should be __________.
_______________ 12. When marginal revenue is less than marginal cost, quantity sold
should be __________.
_______________ 13. When marginal cost is less than marginal revenue quantity
produced or sold should be__________.
_______________ 14. When marginal revenue is more than marginal cost, quantity
sold or produced should be __________.
_______________ 15. A shut down decision is another way of waiting for better
market conditions and better prices in the future. Output is zero
but the firm has to pay for __________ costs.
_______________ 16. When the total revenue from production is less than the
variable cost of production it is better to __________.
_______________ 17. When the firm is unable to recover both accounting and implicit
costs it should __________.
_______________ 18. There is no incentive for new firms to enter the industry and no
existing firm has he motivation to exit when the output level
keeps the total average cost at a minimum. This is the
__________.
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ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris
paribus).
1. Cost data in the short-run for a perfectly competitive firm (in pesos).
a. To maximize profit in the short-run, how many units must the firm produce at the price
of Php300.00?
b. How many units of output should the firm produce to break even?
c. Fill the blank boxes on the table and specify the economic profit or loss.
2. A short-run graph for a perfectly competitive firm.
MR1
AVC
MC
Units of output per hour
MR2
Pric
e pe
r uni
t
MR3
ATC
Output (Q)
(units)
Total Fixed
Cost (TFC)
Total
Variable
Cost (TVC)
Total Cost
(TC)
Total
Revenue
(TR)
PROFIT
1 200 240
2 200 400
3 200 580
4 200 860
5 200 1,180
Page 48
48
a. With MR3 as the firm’s demand curve, does the firm incur a loss or earn and economic
profit?
b. Indicate or identify the firm’s short-run supply curve.
c. With which demand curve should the firm shut down?
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49
CHAPTER VIII. MONOPOLY
OBJECTIVES:
After taking this lesson the student will understand and be able to
1. Explain the characteristics of a monopoly.
2. Compare monopoly with a perfectly competitive firm.
3. Discuss monopoly pricing and its profit maximization.
4. Appreciate and explain the justification and impact of patents and copyrights
on consumers, producers and the society.
5. Analyze the arguments for and against monopoly.
6. Analyze and evaluate monopoly practices and their impact on consumers and
society.
7. Explain government policies governing monopolies.
TOPICS FOR DISCUSSION
1. Barriers to entry
2. Price elasticity and marginal revenue
3. Economic profit in the short-run and in the long-run
4. Welfare cost of monopoly
5. Price discrimination
KEY WORDS AND TERMS
Monopoly Barriers to entry Natural monopoly
Output effect Price effect Patent
Copyright Price discrimination
Page 50
50
MONOPOLY
When there is only one seller of a product that has no substitutes and there are natural
and/or legal barriers to entry in the industry, there is a true or pure monopoly .
Unlike firms in a perfectly competitive market which are price takers, monopolists are
price makers that can and try to pick or set the price that will maximize their profits (Sexton).
BARRIERS TO ENTRY
Barriers to entry are the principal causes for the existence of monopoly (Tucker). These
barriers are the results of
1. Government impositions that prevent the entry of other firms in the monopoly
firm’s market. Among government impositions that give rise to monopolies are
o Franchises
o Licensing
o Patents
o Copyrights
Government impose licenses, patents, copyrights and other restrictions to protect
public interest.
2. Control or ownership of a key resource or the entire supply of an input resource. In
practice, monopolies barely arise because of control or ownership of a resource.
3. Large scale operations which have cost advantages, such as economies of scale.
NATURAL MONOPOLIES
When a single firm is capable of supplying a good or service to an entire market at a
lower cost than two or more firms, the industry is a natural monopoly (Tucker).
The presence of economies of scale over the relevant range of output gives rise to a
natural monopoly.
Exhibit 8.1. Economies of Scale: Cost Comparison of a Small and a Large Firm
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51
Exhibit 8.1 shows a large firm with economies of scale over a range of output with
declining costs. The small firm has higher costs and thus will be driven out of the market
resulting to a natural monopoly by the large firm (Sexton).
MONOPOLY COMPARED WITH A COMPETITIVE FIRM (Mankiw)
A monopoly (Exhibit 8.2b)
o Is the sole producer of a product or service.
o Is a price maker because it can dictate the price of its product
o Reduces price to increase its sales
o Faces a downward-sloping demand curve
Competitive Firm (Exhibit8.2a)
o Is only one of many producers
o Is a price taker because it has no control over the market price
Cost
ATC
0Quantity (small firm)
CSF
CLF
Quantity (large firm)
Page 52
52
o Sells as much or as little at same price which is dictated by market forces such as
supply and demand.
o Faces a horizontal demand curve because demand is perfectly elastic and sensitive
to even a slight change in price.
Exhibit 8.2. Demand Curves for Competitive and Monopoly Firms
REVENUE OF A MONOPOLY ( Exhibit 8.3 and 8.4)
Total Revenue of a monopoly is equal to price times the quantity:
P ´ Q = TR
Its average revenue is equal to total revenue divided by quantity. Average revenue is
also equal to its price.
TR/Q = AR = P
A monopoly’s marginal revenue is derived by dividing the change in total revenue by
the change in quantity:
∆TR/∆Q = MR
Quantity of Output
Demand
0 0
Demand
Price Price
Quantity of Output
a) Competitive firm b)Monopoly
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53
Marginal Revenue of a Monopoly
1. The demand curve for the product of a monopoly is downward sloping because the
demand curve for its products declines as more are placed on the market
(McEachern).
Exhibit 8.3. Revenues of a Monopoly
Quantity
Price =
Ave. Revenue Total Revenue Average Revenue Marginal Revenue
(Q) (P) (TR = PxQ) (AR = TR/Q) (MR= ∆TR/∆Q)
0 8.75 0.00 0.00 0.00
1 8.50 8.50 8.50 7.50
2 8.25 16.50 8.25 8.00
3 8.00 24.00 8.00 7.50
4 7.75 31.00 7.75 7.00
5 7.50 37.50 7.50 6.50
6 7.25 43.50 7.25 6.00
7 7.00 49.00 7.00 5.50
8 6.75 54.00 6.75 5.00
9 6.50 58.50 6.50 4.50
10 6.25 62.50 6.25 4.00
11 6.00 66.00 6.00 3.50
12 5.75 69.00 5.75 3.00
13 5.50 71.50 5.50 2.50
14 5.25 73.50 5.25 2.00
15 5.00 75.00 5.00 1.50
16 4.75 76.00 4.75 1.00
17 4.50 76.50 4.50 0.50
18 4.25 76.50 4.25 0.00
19 4.00 76.00 4.00 -0.50
20 3.75 75.00 3.75 -1.00
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54
2. Dropping the price to sell one more unit, the revenue received from previously sold
units also decreases.
3. The marginal revenue of a monopoly is always less than the price of its good, thus,
the marginal revenue curve will always lie below the demand curve.
4. Increasing the amount a monopoly sells has two effects on total revenue (P ´ Q):
The output effect which results to more quantity sold or a higher Q
The price effect which results to a reduction in price or a lower P.
These effects of increasing the amount to be sold is due to the downward sloping
demand for the monopoly’s products.
Exhibit 8.4. A Monopoly’s Demand and Marginal Revenue Curve.
Exhibit 8.5. Short-run Costs and Revenue for a Monopoly
18MR
4.25
0
D = AR = P
8.75
Quantity per period
Peso
s pe
r uni
t
34
Page 55
55
Quantity
Price =
Ave.
Revenue
Total
Revenue
Marginal
Revenue
Total
Cost
Marginal
Cost
Average
Total
Cost
Total
Profit or
Loss
(Q) (P) (TR = PxQ) (MR =
∆TR/∆Q)
(TC) (MC =
ΔTC/ΔQ)
(ATC =
TC/Q
(TR-TC)
0 8.75 0.00 _ 16.00 _ _ -16.00
1 8.50 8.50 7.50 20.75 4.75 20.75 -12.25
2 8.25 16.50 8.00 24.50 3.75 12.25 -8.00
3 8.00 24.00 7.50 27.50 3.00 9.17 -3.5
4 7.75 31.00 7.00 30.00 2.50 7.50 1.00
5 7.50 37.50 6.50 32.00 2.00 6.40 5.50
6 7.25 43.50 6.00 33.50 1.50 5.58 10.50
7 7.00 49.00 5.50 34.75 1.25 4.96 14.25
8 6.75 54.00 5.00 36.25 1.50 4.53 19.75
9 6.50 58.50 4.50 38.25 2.00 4.25 20.25
10 6.25 62.50 4.00 41.00 2.75 4.10 21.25
11 6.00 66.00 3.50 44.25 3.25 4.02 21.75
12 5.75 69.00 3.00 49.00 4.75 4.08 20.00
13 5.50 71.50 2.50 55.50 6.50 4.27 16.00
14 5.25 73.50 2.00 65.00 9.50 4.64 8.50
15 5.00 75.00 1.50 78.50 13.5 5.23 -3.50
16 4.75 76.00 1.00 97.00 18.5 6.06 -21.00
17 4.50 76.50 0.50 122.00 25.00 7.18 -45.50
18 4.25 76.50 0.00 150.50 28.50 8.36 -74.00
19 4.00 76.00 -0.50 182.50 32.00 9.60 -106.00
20 3.75 75.00 -1.00 219.00 36.50 10.95 -144.00
PROFIT MAXIMIZATION
A monopoly maximizes profits in two ways, by the Total Revenue-Total Cost Method
and the Marginal Revenue Equals Marginal Cost Method (Tucker).
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56
1. Total revenue-total cost method. This is done by producing the quantity where the
vertical distance between the total revenue curve and the total cost curve is widest
(Exhibit 8.6).
Exhibit 8.6. Profit Maximization: Total Revenue-Total Cost Method.
Exhibit 8.7. Profit Maximization: Marginal Revenue = Marginal Cost.
TC
Output:
maximum
profit
Maximum
Profit
0
44.25
66.00
MC
A
B
C
D
MR
ATC
A
Peso
per
uni
t
Quantity of output per period
Quantity of output per period
D = Marginal revenue
11 24
TR
11 24
Tota
l rev
enue
and
tota
l cos
t
4.02
6.00
0
Page 57
57
2. Marginal Revenue = Marginal Cost Method. With this method, the firm produces
the quantity where the marginal cost curve and the marginal revenue curve
intersect. It then uses the demand curve to find the price and quantity that is
higher than the average total cost curve Exhibit 8.6). In Exhibit 8.7 area ABCD
represents the monopoly’s profit.
LOSS MINIMIZATION
A monopoly minimizes loss through the Marginal Revenue = Marginal Cost Method.
Exhibit 8.8 shows how a monopoly whose demand (demand curve) lie below the average
total cost (ATC) curve minimizes its losses. At the level of output where marginal revenue
equals marginal cost and equals quantity demanded (MR = MC = Q) such that revenue is
equal to price times quantity but more than average cost and less than average total costs
(R = P x Q > AVC < ATC), the firm is able to minimizes its losses because it is able to pay for
the VC and part of FC. Area ABCD represents the monopoly’s loss (Tucker).
Exhibit 8.8. LOSS MINIMIZATION OF A MONOPOLY
ATC
MC
AVC
A
B
D
MR
Pric
e an
d co
st p
er u
nit
C
D
Quantity of output(units per time period)0 Q
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0
B
C
A
D
Monopoly’s profit
MC
ATC
D
MR
Cost and
Revenue
Monopoly
Price
Average total
cost
QuantityMaximum Q
58
PROFIT MAXIMIZATION: MONOPOLY VS A COMPETITIVE FIRM
A competitive firm maximizes profit when P = MR = MC (Exhibit 7.6 and 7.7).
On the other hand, a monopoly maximizes profits when P > MR = MC. (Exhibit 8.6 and
8.7)
A monopoly’s profit equals total revenue minus total costs as shown below (Mankiw).
Profit = TR – TC
Profit = (TR/Q - TC/Q) ´ Q
Profit = (P - ATC) ´ Q
The monopolist will receive economic profits as long as price is greater than average
total cost (Exhibit 8.9).
Exhibit 8.9. The Economic Profit of a Monopoly
Reference: Mankiw, N. Gregory (2003). Principles of Economics, USA: South-Western College Pub.
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0
DemandMarginalrevenue
Cost and
revenue
Price during
patent effectivity
Price after patent
Marginal cost
Monopoly quantity Competitive quantity
59
Exhibit 8.10. Patents: Duration and Expiration.
PATENTS
A patent or copyright is a means by which the government empowers a patent holder
to exclusively produce a certain product or provide a service to the exclusion of everybody else.
The duration of a patent or copyright is usually 20 years (Sicat).
A patent allows the firm to charge a price far above the marginal cost. At the expiration
of the patent, other firms are allowed entry, making the price competitive (Exhibit 8.10).
THE CASE FOR AND AGAINST MONOPOLY
For monopoly:
Where patents and copyrights are granted, inventors have the incentives to spend large
amounts for the invention and development of new products and services. Writers and film
makers are encouraged to produce outstanding literary works.
Against Monopoly:
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0
D
MC = SUPPLY
MR
A B
DC E
Marginal
cost of monopoly
F
Monopoly’s
deadweight lossG H
I
Price
Monopoly price
Monopoly
quantity
PC/Efficient quantity Quantity
Perfect
Competition price
60
The high price that monopoly charges makes it undesirable to consumers (Mankiw).
DEADWEIGHT LOSS
In evaluating the deadweight loss due to a monopoly, the firm has to be compared with
a firm under perfect competition.
Exhibit 8.11 illustrates the deadweight loss due to a monopoly and perfect competition.
Under perfect competition, consumer surplus is equal to ABCDE while producer surplus is FGHI.
In a monopoly consumer surplus is AB and producer surplus is CDFGI. From this information it is
clear that the consumers are losers. The dead weight loss is EH which, unlike a tax, does not go
to the government but to the firm under monopoly (Sexton).
Exhibit 8.11. Deadweight Loss and Efficient Level of Output Under a Monopoly and Perfect
Competition.
PUBLIC
POLICY
ON MONOPOLIES
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Government attitude towards monopolies range from regulation to just letting them
operate freely (Mankiw). Among the actions the government takes are
1. Imposition of anti-trust laws which result to the following:
Prevention of mergers that tend to make giant companies that lead to
monopolies.
Breaking up of monopolistic firm to break their control of the market.
Prevention of companies from gaining control of the market through the
stifling of competition.
2. Price regulation which prevents the monopoly from charging any price it wants.
3. Conversion of monopolies into public corporations. This is done to protect the public
from the adverse practices of monopolies.
4. Let monopolies operate without doing anything.
When the perceived imperfections of government policies are deemed too
inconsequential or too minimal compared to the advantages of monopolies, the government is
unable to do anything to control or regulate them.
PRICE DISCRIMINATION
When a monopoly sells identical items at different prices to different consumers, it
engages in price discrimination. The firm sells the same goods to different consumers at
different prices although the production cost for all is the same (Landsburg).
Exhibit 8.12 shows the different prices which consumers pay for the commodity
supplied by the monopoly. There is no consumer surplus because each of them is willing to pay
the marginal value that the goods possess.
EFFECTS OF PRICE DISCRIMINATION
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1. Price discrimination results to increase in monopoly profits and
2. Price discrimination reduces deadweight loss but all the profit goes to the
monopolist and there is no consumer surplus. (Exhibit 8.11).
DEGREES OF PRICE DISCRIMINATION
Price discrimination comes in three degrees.
1. First degree is when the monopoly charges “each customer the most he
would be willing to pay for each item that he buys.” This kind of price
discrimination is said to be perfect because the monopolist knows exactly the
price each customer is willing to pay and charge each in accordance with that
knowledge (Exhibit 8.11).
Exhibit 8.12. Price Discrimination
Price
0
5
10
15
20
25
30
35
40
A
D
B
C
Quantity
MR
MC
D
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63
2. Second degree is when the monopoly charges the “same customer different
prices for identical items.”
3. Third degree is charging different prices in different markets” (Lansburg,
2005)
EXAMPLES OF PRICE DISCRIMINATION
Airline tickets
Discount coupons
College and university tuitions
Quantity discounts
Movie tickets
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STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus).
1. Enumerate and explain the characteristics of a monopolistic market.
2. Name some government impositions that serve as barriers to entry into a market and give
rise to monopolies. Explain each.
3. What is a natural monopoly?
4. What makes it difficult for a new entrant in a monopoly market to stay in such market.
5. Compare the characteristics of a monopoly with a firm in a perfectly competitive market.
6. Explain and illustrate the total revenue-total cost method of maximizing profit in a
monopoly.
7. Explain and illustrate the marginal revenue-marginal-cost method of maximizing profit in a
monopoly.
8. Explain and illustrate how a monopoly can minimize its losses.
9. Under what situation relative to price and average total cost can a monopoly earn economic
profits.
10. Explain and illustrate how a market responds to the duration and expiration of a patent.
11. Cite an argument for and against monopoly and briefly explain.
12. Explain how deadweight loss can result from a monopoly.
13. What are some of the actions that government take to control or regulate monopolies.
14. Explain the concept of price discrimination and give examples.
15. Briefly explain the three degrees of price discrimination.
TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the
statement is false. Assume that other things are held constant. If your answer is false, explain
why.
____ 1. Monopolies are price takers because consumers have no choice but buy their
goods or products.
____
2. There are firms who cannot enter a monopolistic market because of barriers to
entry. .
____ 3. A true or pure monopoly refers to a single firm which sells a product that has
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no substitute.
____ 4. Legal barriers are government regulations that prevent firms from price
manipulation in monopolies.
____ 5. Patents are meant to protect the rights of consumers to return defective
products.
____ 6. Monopolies always control or exclusively own input resources because they
such resources cannot be purchased or secured from other sources.
____ 7. Small firms cannot compete with monopolies because of the economies of
scale.
____ 8. When a monopoly increases quantity sold the price increases because of the
price effect .
____ 9. Maximum profit can e attained by a monopoly at the production level where
total revenue is equal to total cost.
____ 10. Another way of maximizing profit for a monopoly is by determining the
quantity where the marginal revenue and marginal cost intersect and project
the intersection upward to the demand curve and then to the vertical axis for
the price.
____ 11. When the price is greater than ATC, a monopoly gains economic profits.
____ 12. After the expiration of a patent the price of the commodity will be higher
because of a shortage in supply.
____ 13. Patents and copyrights discourage inventors from developing new products
because such government impositions are forms of control in the manufacture
or invention of new products.
____ 14. In a monopoly, deadweight loss is not really lost because it accrues to the
monopolist.
____ 15. When firms selling the same product join together to control a market, the
merged firms become a monopoly.
____ 16. A consumer who is charged a price higher than the market price, but
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nevertheless is willing to pay is subjected to price discrimination.
FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that
complete each statement. Assume that all other things are held constant.
_______________ 1. When there are barriers to the entry of other firms in an
industry or market and there is only one seller selling a product
that has no substitute, there is a __________.
_______________ 2. Government impositions that serve as legal barriers to entry are
__________,
_______________ 3. __________,
_______________ 4. __________, and
_______________ 5. __________.
_______________ 6. A monopoly can dictate the price of its product. It is thus a price
__________.
_______________ 7. The effects of a monopoly’s increase in the amount it sells are
__________ and
_______________ 8. __________.
_______________ 9. Producing the quantity where the vertical distance between
total revenue and total cost is widest is the __________ method
of maximizing profit in a monopoly.
_______________ 10. At a price higher than the average total cost a monopoly gains
__________ profits.
_______________ 11. The right to exclusively produce or invent a gadget or a
consumer product or service is protected by a __________.
_______________ 12. Selling identical items to different consumers at different prices
is __________.
_______________ 13. Monopolists who are charging different prices for identical
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products in different markets commit __________.
1. The following is a hypothetical schedule of a monopolist.
Price Quantity Fixed Costs Variable Costs
200 0 120 0
180 1 120 50
160 2 120 80
140 3 120 100
120 4 120 140
100 5 120 200
80 6 120 280
60 7 120 380
40 8 120 500
Using the above data, determine the level of output at which the monopoly can
maximize profits.
2. Profit maximization for a monopoly.
ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris
paribus).
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a. Determine profit maximizing or loss minimizing output for the monopoly in the above graph.
Explain.
b. Is the monopoly earning economic profit or incurring losses? Explain.
c. What price should it charge to maximize profit? Why?
20
80
60
40
0 100 500400300200
MC
ATC
AVC
DMR
Quantity of outputs (units per day)
Pric
e, c
ost,
and
reve
nue
(in p
esos
)
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69
d. If the monopoly operates at the profit maximizing output, is it able to cover all fixed costs?
Explain.
CHAPTER IX. MONOPOLISTIC COMPETITION AND OLIGOPOLY
OBJECTIVES:
The lesson will enable the student to
1. Discuss and the characteristics of a firm under monopolistic competition.
2. Analyze and evaluate the operation of a monopolistically competitive firm in order
to maximize profit and/or minimize losses.
3. Compare a monopolistically competitive firm with one under perfect competition.
4. Analyze, evaluate, and explain the welfare effects of monopolistic competition.
5. Appreciate the merits and demerits of advertising and brand names.
6. Make critical analyze and evaluation of oligopoly market structure.
7. Explain the reasons for the emergence of oligopolies.
8. Discuss and explain the different models of oligopolies and their impact on
consumers, the firms, and the society.
9. Explain the different practices of oligopolies and how the government intervenes to
control and moderate their effects on consumers and the society.
TOPICS FOR DISCUSSION
1. Monopolistic competition
2. Product differentiation
3. Models of Oligopoly
4. Mergers
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Key Words and Terms
Imperfect competition Monopolistic competition Mark up
Oligopoly Pure oligopoly Differentiated oligopolies
Cartel Price leadership Game theory
Cost-plus pricing Cooperative games Non-cooperative games
Maximin/Dominant strategy Nash equilibrium Prisoners’ dilemma
Kinked demand curve Horizontal merger Vertical merger
Conglomerate merger Price discrimination Exclusive dealing
Tying contracts Predatory pricing Interlocking directorates
Resale Price Maintenance
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CHAPTER IX. MONOPOLISTIC COMPETITION
MONOPOLISTIC COMPETITION
Imperfect competition is a market structure or situation where a number of sellers gain
control over the outcome of quantity and equilibrium prices in the market. It exists when sellers
with similar products, each of which have control over price, compete for sales (Hyman, 1994).
Firms under imperfect competition fall between perfect competition and monopoly.
The two types of imperfectly competitive market are monopolistic competition and oligopoly.
Monopolistic competition is a market structure with the following characteristics:
1. Numerous small participants (buyers and sellers): Many sellers compete for
the same group of customers. Some businesses under this structure are
restaurants, professional games, and entertainment.
2. Free entry and exit: There is no restriction to entry or exit. However, the
number of firms adjust to the point where economic profit is zero.
3. Perfect information: There is perfect information due to massive information
campaign in the form of advertising to attract customers.
4. Differentiated products: Each firm produces a product which serves the same
purpose as that of other firms but with some slight difference such as brand
name and packaging.
MONOPOLISTICALLY COMPETITIVE FIRMS AND PROFIT MAXIMIZATION
A firm under monopolistic competition has some similarity with a monopoly where MR
= MC. The free entry and free exit attribute which, however does not prevail in a monopoly,
will, in the long-run push economic profit to zero.
Exhibit 9.1. Profit Maximization in Monopolistic Competition
Page 72
P
C
(Profit maximizing quantity)
0Q Quantity
A
B
D
ATC
MR
MC
72
Exhibit 9.1 illustrates
the short-run profit maximization under monopolistic competition. Note that the MC curve
intersects the MR curve at a point below ATC curve. The price and the demand curve intersect
at a point above the intersection of marginal revenue (MR) and marginal cost (MC) curves and
above average total cost curves (ATC). In this short-run situation the firm is earning economic
profits because total revenue, AP0Q is greater than total cost, CBQ0. A lower price will increase
the quantity demanded while a higher price will reduce it below the profit maximization
quantity (Mankiw).
LOSS MINIMIZATION IN A MONOPOLISTIC COMPETITIVE MARKET
In Exhibit 9.2, the firm’s average total cost curve lies above the demand curve so
that at any level of output the firm could not breakeven. The decision whether to stop
producing or to shut down faces the firm. As in a firm in a competitive market, as long as the
price is above the average variable cost, the firm should continue producing in the short run
and be able to cover a part of the fixed cost. If, however, the firm fails to cover the variable
cost, it has to shut down to avoid further losses (Sexton).
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Exhibit 9.2. Losses in a Monopolistic Competitive Market
COMPETITION WITH DIFFERENTIATED PRODUCTS
Because of the prevailing perfect information, new firms get wind of the economic
profit in the business and are encouraged to enter. This results to
1. An increase in the number of products in the market resulting to
2. A decrease in the demand for firms already in the market, thus shifting the demand
to the left and decline in their profits.
3. The chain reaction to this situation is the exit of firms from the market.
The departure of firms under monopolistic competition will
1. Result to a decrease in the products available in the market,
2. Increasing the demand for the remaining firms’ products, a rightward shift of the
demand , thus
3. Increasing the profit of the firms that stayed in the market.
0
Price
Average
total cost
MCATC
DMR
Loss minimizing quantity QUANTITY
P
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DemandMR
ATC
MC
P = ATC
Profit maximizing quantity 0 Quantity
74
DETERMINING ECONOMIC PROFITS AND LOSSES
The three-step method is applied in determining whether a firm under monopolistic
competition is earning economic profit, zero economic profit, or incurring economic losses.
Step 1. On the graph, find the point where MR = MC and proceed downward to the horizontal
axis to find Q which is the profit-maximizing output level.
Step 2. Move upward to the point on the demand curve and the left to the vertical axis to find
the market price. Finding P x Q enables the firm to determine total revenue because TR = P x Q.
Step 3. To find the total cost, go to Q and proceed straight up to the ATC curve and leftward to
the vertical axis to find the ATC. The TC will be derived by multiplying ATC by Q (TC = ATC x Q).
(Sexton, 2005).
LONG-RUN EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION
Exhibit 9.3. Long-run Equilibrium under Monopolistic competition
Price
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Producing and selling where price exceeds average costs enables a firm to earn profits
which encourages other firms to enter the market which in turn decreases the demand for the
firm’s products. The entry of more firms and the decrease in demand prompts a reduction in
price until it reaches a point where it is equal to the ATC that is now tangent to the demand
curve (Exhibit 9.3). This is the long-run equilibrium point of a firm under monopolistic
competition (Mankiw).
At this equilibrium point where there is no economic profit, there is no tendency for
sellers to enter or leave the market.
MONOPOLISTIC VERSUS PERFECT COMPETITION
There are two noteworthy differences between monopolistic and perfect competition in
the long-run—excess capacity and markup (Mankiw). These are excess capacity and mark-up
over marginal cost (Exhibit 9.4).
Exhibit 9.4. Monopolistic Competition, Perfect Competition in the Long-run
a) Monopolistic Competition
Excess
Capacity
1. In the long-run, there is no excess capacity in perfect competition.
0
P
Price MC ATC
DMR
Quantity
produced
Efficient scale
QUANTITY
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2. Free entry of firms in a competitive market results to firms’ producing at efficient
scale, the point where average total cost is minimized.
3. In a monopolistic competition, there is excess capacity in the long-run.
4. The efficient scale of firms under monopolistic competition is less than that of firms
under perfect competition.
b)Perfect Competition
Markup Above the Marginal Cost
1. For a firm under perfect competition, price is equal to marginal cost.
2. For a firm under monopolistic competition, price is far above marginal cost.
3. With this kind of pricing, an extra unit sold at the posted price means more profit for
the firm under monopolistic competition.
0
PriceMC
ATC
P = MC P = MR
Demand curve
Quantity Produced
Efficient Scale
QUANTITY
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Exhibit 9.5. Monopolistic Competition, Perfect Competition and Pricing
a) Monopolistic Competition
B) Perfect Competition
0
Price
P = MC P = MR
Demand curve
MCATC
Quantity produced
Efficient scale
Quantity
0
Price
Mark up
Marginal cost
P
MR
MCATC
D
Quantity
producedEfficient Scale
Excess capacity
QUANTITY
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WELFARE EFFECTS OF MONOPOLISTIC COMPETITION
Under monopolistic competition, the entry of new firms introducing new products
benefits the consumers. This is a positive welfare effect for society and a negative one for
existing firms (Mankiw).
The deadweight loss that prevails in monopoly pricing exists in monopolistic
competition due to the mark up of price over and above the marginal cost.
Regulation of prices is difficult to enforce.
The number of firms in the industry may be too large or too small
ADVERTISING
Advertising is an important tool for firms under monopolistic competition to attract
more consumers to patronize their product. However, opinions about the merits of advertising
are varied (Sexton; Tucker).
Those arguing for advertising state that
1. Consumers get to know more products and are therefore able to make better
decisions about the choices available to them.
2. Advertising informs the consumers about the quality of the products and are
helped in making their choices.
3. Consumers are better informed of the quality of the products.
Those arguing against advertising state that
1. Advertising manipulates people’s feelings to influence their tastes.
2. The amount spent on advertising contributes to increase in the price of goods.
3. Advertising hinders competition by implying that products are different when in
reality they are not.
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BRAND NAMES
Brand names are means of identifying products which more or less also serve as means
of advertising (Mankiw).
Critics argue that brand names give consumers the perception that products are
different though they are practically the same.
However, economists and firms argue that brand names are useful means for
consumers to be sure about the quality of their products.
OLIGOPOLY
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Oligopoly is a market dominated by few sellers that account for more than half of the
industry’s
Oligopolies exist in some localities where there are few firms supplying the needs of the
community. For instance, a few gasoline stations, groceries, hardware stores (Mankiw).
Characteristics of an Oligopoly Market
1. Few sellers offering similar or identical products
2. Interdependent firms. They are interdependent because they take into consideration
the effect of their decisions and actions on other firms and their consequent reactions.
3. Best off cooperating and acting like a monopolist by producing a small quantity of
output and charging a price above marginal cost
VARIETIES OF OLIGOPOLY
1. Pure Oligopolies produce or sell homogeneous products. There is greater
interdependence among the firms because each firm is sensitive to the pricing policies
of others particularly in pricing. An increase in the price of one firm may drive customers
to other firms (Mankiw).
2. Differentiated Oligopolies are those producing or selling products with differentiated
features. Examples of these are vehicle manufacturers (Sexton).
CAUSES OF THE EMERGENCE OF OLIGOPOLIES (Mankiw)
1. Barriers to entry such as economies of scale(Exhibit 9.6)
2. Legal restrictions
3. Brand names which are developed through years of advertising
4. Control of essential resources
Barriers to Entry
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Exhibit 9.6. Barriers to Entry: Economies of Scale
The above figure shows a comparison of the production of a new entrant and a
firm already established in the industry. The latter has achieved minimum efficient scale
(economies of scale). The new entrant which has a high cost of production has to sell a
lot of his products to compete with the firm producing at Qo at lower cost.
High Cost of Entry
The new entrant is bound to incur enormous setup and promotion cost to be
able to compete. If its competitors have established and strong brand names, it will be
more difficult for the newcomer to enter the industry.
OLIGOPOLY MODELS
Oligopolies’ behavior of interdependence is influenced by the model on which they are
categorized (Sexton; Tucker). These models are
1. Cartel
2. Price Leadership
3. Game Theory
4. Kinked demand curve
5. Cost-plus pricing
CARTELS AND COLLUSION
Cost
per
uni
t
Cn
QoQn
Po
Quantity per year
Long-run average cost
0
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A cartel is a group of oligopolist firms which, acting in unison, behave like a monopoly.
They agree to coordinate their production and pricing decisions.
Benefits Provided by a Cartel to Members
1. Each member is certain about the behavior of the other firms in the cartel.
2. There is an organized effort to block new entrants.
3. They can increase prices by collusive reduction of output.
Profit Maximization of a Cartel
Since a cartel operates like a monopoly, its demand curve is similar to a
monopoly as shown in Exhibit 9.7.
Exhibit 9.7. Demand, Marginal Revenue, and Marginal Cost Curves of a Cartel
The marginal cost curve in Exhibit 9.7 represents the aggregate marginal costs of all the
firms in the cartel. To attain maximum profits price is determined using as base the
intersection of the marginal revenue and marginal cost. The output is then divided by the
members.
PROBLEMS ENCOUNTERED BY CARTEL MEMBERS
1. Differences in Costs
Pric
e pe
r uni
t
per u
nit
P
Q Quantity per
period
0
MC
D
MR
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A firm with high marginal cost has to sell more than firms with lower marginal cost.
This is contrary to the cartel provision that marginal cost be equal for all the firms in the
cartel.
2. Difficulty in arriving at a consensus.
As the number of firms grow, arriving at a consensus becomes difficult because of
the growth in the number of conflicting interests.
3. New Entries That May Push Down The Prices
When news spread that a cartel earning, new entrants may enter the industry. This
increases the supply and push prices down.
4. Cheating among members.
Because oligopolists operate at excess capacity, some find the incentive to raise
their prices slightly. This activity comes in the form of rebates, extra services, and other
concessions.
The incentive to cheat prevails during sales slump.
OBSTACLES AND HINDRANCES TO THE ESTABLISHMENT OF AN EFFECTIVE CARTEL
1. Differentiation of products across firms
2. Differences in costs across firms
3. Low entry barriers
PRICE LEADERSHIP
Price leadership occurs when a few firms set the price for the rest of the firms in the
industry. These few firms are called “price leaders."
Price leadership give rise to an informal or tacit collusion.
OBSTACLES TO PRICE LEADERSHIP
1. It is against anti-trust laws
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2. There is no guarantee that other firms will follow. When this happens, the leader has to
lower its prices or lose sales.
3. Price leadership is less effective as a means of collusion when products are highly
differentiated.
4. Firms cheat by lowering their prices to increase sales and profit.
COST-PLUS PRICING
Cost-plus pricing is a strategy whereby oligopolists calculate average variable costs per
unit and add a certain percentage as a “mark up.”
ATTRACTION OF COST-PLUS PRICING
It is a way of coping with uncertainty about the shapes and elasticity of the demand
curve.
Calculating price based on marginal analysis is complicated and costly. This is especially
true for firms producing different products.
Firms with similar costs can apply the same percentage of markup. This gives rise to an
implied collusion.
MARK-UP POLICY PREVALENT AMONG FIRMS
Uniform mark-up is not resorted to by firms producing differentiated products. Mark-
ups usually vary with the price elasticity of the demand for the product. The more elastic the
demand, the lower will be the mark up.
GAME THEORY
Game theory is an oligopoly model that looks at the behavior of oligopolists as a series
of strategic moves and countermoves among rival firms”(McEachern, 1997).
The theory examines the players’ incentives to compete or cooperate.
Game theory stresses the tendency of firms in oligopoly to act in such a way that the
damage that may be caused by a competitor is minimized.
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1. Cooperative game is one where two firms decide to collude to maximize profits.
In this type of game firms can enter into binding contracts. But such contracts
which may constitute collusion are violations of antitrust law. Thus, the
noncooperative game.
2. Noncooperative games is one where each firm sets its own price without
consulting others.
Exhibit 9.8. Payoff Matrix
The payoff matrix (Exhibit 9.8) portrays the maximin strategy (dominant strategy) by
which the players choose the best payoff for the worst possible outcome.
Maximin or Dominant Strategy is “a strategy that will be optimal regardless of the
opponent’s action (Sexton, 2005).
NASH EQUILIBRIUM
Nash equilibrium, named after the mathematician, John Nash, is an outcome from
which neither player would want to deviate, taking the other player’s behavior as given.
It is a situation in which economic actors interacting with one another each choose their
best strategy given the strategies that all the others have chosen.
Exhibits 9.9. Pig in a Box
B earns P100
A losses P30
A earns P50
B earns P50
High Price
Low Price
High Price Low Price
A’s Strategy
B’s
Stra
tegy
A earns P100
B losses P30
A earns P80
B earns P80
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The above exhibit illustrates the application of Nash equilibrium. Their choices are
summarized below (Lansburg, Price Theory ; 2005, 416).
SITUATION:
Dispenser yields 100 calories.
Pushing the lever burns 10 calories.
CHOICES:
(Upper left-hand box) Both pigs push the lever – they both run to the dispenser, strong
pig pushes the weak pig and eats all the calories. The strong pig gains 90 calories (100 –
10 burned by pushing lever).
(Upper right-hand box) The weak pig loses 10 calories for pushing the lever. The strong
pig waits by the dispenser and the weak pig pushes the lever. The strong pig eats all the
calories and the weak pig loses 10 calories.
Strong pig gets 90
calories
Weak pig gets -10
calories
Strong pig gets
100 calories
Weak pig gets -10
caloriesStrong pig gets 15
calories
Weak pig gets 75
calories
Strong pig gets 0
calories
Weak pig gets 0
calories
Push lever
Wait by
dispenser
Push lever Wait by dispenser
Strong Pig’s
Strategy
Weak Pig’s
Strategy
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(Lower left-hand box) The strong pig pushes the lever as the weak pig waits by the
dispenser. The weak pig consumes 75 calories. The strong pig eats 25 calories but loses
10 calories for pushing the lever. He gains a net of 15 calories.
(Lower right-hand box) Both pigs wait by the dispenser. Both pigs eat nothing.
Note:
The only Nash equilibrium is the lower left-hand box. From any other box, at least one of
the pig will want to make a change.
THE PRISONERS’ DILEMMA
The prisoners’ dilemma (Exhibit 9.10) is a dominant strategy which demonstrates the
fundamental problem of oligopolists that do not collude (Sexton).
It demonstrates why cooperation is difficult to maintain even when it is mutually
beneficial. This is because cooperation is not in the interest of the individual player. This
situation is often true among people who fail to cooperate even when cooperation would be
beneficial to both.
Exhibit 9.10. The Prisoners’ Dilemma
A gets 5 years
B gets 5 years
A gets 10 years
B gets 1 year
A gets 1 year
B gets 10 years
A gets 2 years
B gets 2 years
Confess
Not Confess
Confess Not Confess
Prisoner A’s Strategy
Prisoner B’s Strategy
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Oligopolies as a Prisoners’ Dilemma
Self-interest makes it difficult for the oligopoly to maintain a cooperative outcome with
low production, high prices, and monopoly profits.
Why People Sometimes Cooperate
Firms that care about future profits will cooperate in repeated games rather than
cheating in a single game to achieve a one-time gain. However, cooperation among oligopolists
is undesirable from the standpoint of society as a whole because it leads to very low
production and very high prices as can be seen in Exhibit 9.11 (Mankiw).
Exhibit 9.11. A Cooperative Oligopoly Game
In the above exhibit, if Matt and Jeff agreed to sell 40 units each, they will each earn
P1,700. If Matt decides to cheat and sell 50 units, he will earn P1,900 units and Jeff earns only
P1,400.00. However, Once Jeff gets wind of Matt’s decision, he will also sell 50 units, thus
Matt’s DecisionSells 40 Units
Sells 40 Units
Sells 50 Units
Sells 50 Units
Jeff’s
Decision
Earns P1,500
Earns P1,500
Earns P1,400
Earns P1,400
Earns P1,900
Earns P1,900Earns P1,700
Earns P1,700
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equalizing their profit to P 1,500. Both of them therefore lose P 200.00. It will be to their
mutual interest if they sell only 40 units each.
The decision to sell 40 units each Matt and Jeff’s total earning is P3,400.00 or P42.50 per
unit. When Matt was producing 50 units and Jeff was producing 40 units their total earnings
was P 3,300.00 or P36.66 per unit. Clearly, when they cooperated to produce, they each earn
more than if they compete.
KINKED DEMAND CURVE
In the kinked demand curve (Exhibit 9.12), D1 represents the elastic demand curve of
the firm. Raising the price from 10 to 15 resulted to a reduction in quantity demanded from
1,400 to 900. Competitors did not respond to the price increase. Customers shifted to those
competitors/other suppliers..
Reducing the price to 5 resulted to a slight increase in quantity demanded from 1,400 to
1,600. The competitors followed the price reduction and reduced their own prices. Hence the
small increase in quantity demanded. Since D2 is inelastic price will be rigid under the kinked
demand curve because of the possible and anticipated response of competitors (McEachern).
MARGINAL REVENUE UNDER THE KINKED DEMAND CURVE
The marginal revenue of the monopoly (oligopolists operate as a monopoly) is D1abM2
since D1a is the marginal revenue curve that applies to DE of the demand curve. Line bM2 is the
marginal revenue curve that applies to line ED2 of the kinked demand curve. There is therefore
no single marginal revenue curve because of the gap along the quantity produced at 1,400.
Thus the marginal curve D1abM2.
Exhibit 9.12. Kinked Demand Curve
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PRICE RIGIDITY
As is shown in Exhibit 9.13, a monopoly (an oligopolists operate like a monopoly)
maximizes its profit using the intersection of the marginal cost and marginal revenue. In Exhibit
9.13, which is derived from Exhibit 9.12, the point where MC crosses the gap in the marginal
revenue curve identifies the profit maximizing level of output quantity (Q) and price (P). Even if
the marginal cost falls to MC2 there will be no change in price because the firm has to consider
the response of other firms.
Therefore, unless the MC curve crosses quantity (Q) above point “a” there will be no
change in the equilibrium price and quantity (McEachern).
Exhibit 9.13. Price Rigidity, Marginal Revenue Curves and Demand for the Kinked Demand
Model
MR1
1,400900
D2
MR2
Quantity per period
0
Pric
e pe
r uni
t
D1
15
105
1,600
E
a
b
Pric
e pe
r uni
t
MC1
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HIGHER PRICE UNDER OLIGOPOLY
Under oligopoly, industry output will be lower and the price higher than in a perfect
competition if the oligopolists engage in some sort of explicit or implicit collusion (McEachern).
The average cost of production in an oligopoly will be higher in the long run than with a
perfect competition even if oligopolists do not collude but simply operate at excess capacity.
If a price war breaks out, prices in an oligopoly will be temporarily lower than in a
perfect competition.
HIGHER PROFITS UNDER OLIGOPOLY
In the long-run, firms under perfect competition cannot earn more than normal profit
because of easy entry (McEachern).
Under oligopoly, the obstacles to entry allow firms to earn economic profits in the long-
run.
Some economists view this profit maximizing power of oligopolists as market power.
However, others consider it as a result of efficiency due to economies of scale.
OLIGOPOLY AND MERGERS
1,400
D2
MR2
Quantity per period0
D1
15
E
a
b
MC2
MC3
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Larger firms are more profitable than small ones. Therefore, some firms achieve rapid
growth through mergers – joining other firms. This joining together creates oligopolies
(McEachern).
Horizontal Merger
Horizontal merger is achieved when a firm joins with another producing the
same product.
Vertical Merger
Vertical merger is done when one firm joins another from which it acquires or
purchases production inputs or to which it sells outputs.
Conglomerate Merger
Conglomerate merger is a merger of different firms producing different products or
operating in different industries.
PUBLIC POLICY TOWARD OLIGOPOLIES
Since cooperation among oligopolists leads to low production and very high prices, such
cooperation which practically amounts to collusion is undesirable from the point of view of
society.
ANTITRUSTLAWS AND RESTRAINT OF TRADE
A trust is a combination of firms or cartel that place their assets under the custody of a
board of directors.
Organizers of trusts which “exploited and bullied anyone in their way” were called
“robber barons.” John D. Rockefeller who put up Standard Oil is among the famous “robber
barons” (Tucker, 320-323).
Antitrust laws prohibits the monopolization and conspiracies that restrain trade that
seek to monopolize the market
a. Sherman Antitrust Act of 1890 declares as illegal “every contract, combinations in
the form of trust or otherwise, or conspiracy in restraint of trade or commerce. . . .”
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b. Clayton Act of 1914 is an amendment to the Sherman Act. It makes illegal the
following anticompetitive business practices
1. Price discrimination – charging different customers different prices for the same
products although the price differences are not related to costs.
2. Exclusive dealing – A retailer is required by the manufacturer to sign an agreement
stipulating the condition that the retailer will not carry rival products.
3. Tying contracts - The seller of a product requires the buyer to purchase other products.
A firm offers two (or more) of its products together at a single price, rather than
separately.
4. Predatory pricing – a practice of one or more firm to reduce prices to eliminate
competition and them raise them again when the latter is eliminated.
5. Acquisition of stock of competing firm – a firm buys the stocks of its competitor.
6. Interlocking directorates – exists when the directors of one firm serves as directors of
another firm in the same industry.
7. Resale Price Maintenance - occurs when suppliers (like wholesalers) require retailers to
charge a specific amount.
STUDY GUIDE QUESTIONS. Assume that all other things are held constant (ceteris paribus).
1. Under what circumstances does imperfect competition exist?
2. Explain why imperfect competition falls between perfect competition and monopoly.
3. Enumerate and explain the characteristics of a monopolistic competition.
4. How does perfect information prevail in a monopolistic competition?
5. Explain the concept of differentiated products and cite some examples.
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6. With regards to profit maximization, in what way is monopolistic competition similar to
monopoly?
7. Explain how a firm under monopolistic competition can minimize losses. At what point
should it resort to shut down?
8. Explain the effects of perfect information on a monopolistically competitive market
structure.
9. Explain the way how a firm in monopolistic competition determines the viability of
attaining economic profits, or incurring zero economic profits or economic losses.
10. Explain the differences between firms in perfect competition and monopolistic
competition in terms of pricing and excess capacity in the long-run.
11. Discuss and illustrate the welfare effects of monopolistic competition.
12. What are the advantages and disadvantages of advertising? Give some examples.
13. What are the merits and demerits of using brand names? Give some examples.
14. Explain the concept of oligopoly and what gives rise to its emergence.
15. Enumerate and explain the characteristics of an oligopoly.
16. Differentiate pure oligopoly from differentiated oligopoly.
17. Enumerate the oligopoly models and briefly explain each.
18. What are the benefits that cartel members get from the organization (cartel)?
19. Explain and illustrate how a cartel maximizes profits.
20. Name and explain the problems encountered by cartel members.
21. What are price leaders and how do they give rise to tacit collusion?
22. What are the hindrances to the emergence of price leaders?
23. What is cost-plus pricing and why is it attractive some oligopolists?
24. Why is cost-plus pricing not advisable for firms offering differentiated products?
25. Briefly explain the game-theory model of oligopoly.
25. Differentiate cooperative and non-cooperative games?
26. Explain and illustrate a payoff matrix.
27. What is a dominant strategy?
28. Briefly explain and illustrate the Nash Equilibrium?
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29. Why is cooperation difficult to maintain among oligopolists even when it is apparent
that it is beneficial to both parties?
30. Explain why cooperation among oligopolists is undesirable from the point view of
society?
31. Why is it not advisable for an oligopolist in a kinked-demand-curve model to raise or
lower its prices?
32. Identify and explain the three types of mergers resorted by firms that wish to control
the market or resort to oligopolistic practices.
33. What is a trust and how does it operate?
34. Enumerate the business activities considered illegal by the Clayton Act of 1914.
TRUE OR FALSE. On the blank before each item write T if the statement is true and F if the
statement is false. Assume that other things are held constant. If your answer is false, explain
why.
____ 1. When there are sellers selling similar products and each one has control over the
price notwithstanding the competition the market structure is said to be
perfectly competitive.
____ 2. Perfect information through massive advertising is resorted to by firms under
monopolistic competition because the firms are competing for the same group of
customers.
____ 3. Firms in a monopolistically competitive market have the same products which
serve the same purpose. Therefore, there is not difference between such firms
and those under the perfectly competitive market.
____ 4. The free entry and free exit attribute of a monopolistically competitive market
will in the long-run result to zero economic profit for the firm.
____ 5. Profit maximization can be attained by a monopolistically competitive firm in the
same way as it is done by a monopolistic firm.
____ 6. A monopolistically competitive firm that cannot cover variable cost should
continue to operate in order not to incur losses.
____ 7. In a monopolistic competition excess capacity prevails in the long-run because a
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firm in this market structure limits its production below its efficient scale.
____ 8. Where as price is equal to marginal cost in a perfectly competitive firm, in a
monopolistically competitive firm price is above the marginal cost.
____ 9. In spite of the competition in a monopolistically competitive market, deadweight
loss still prevails because of the practice of mark-up pricing above the marginal
cost.
____ 10. Advertising is not good for consumers because it simply confuses consumers
because of the enormous number of products being advertised.
____ 11. Being informed about products through advertising help consumers make
decisions about choices.
____ 12. Advertising is a manipulative business practice. However, that is a debatable
opinion against advertising.
____ 13. Advertising does not contribute to price increase because the firm can get its
advertising expenses from increase in its sales.
____ 14. Brand names project similar products as different although in reality they are the
same.
____ 15. Oligopoly market structure is one where few firms cannot control the market
because of steep or intense competition among the firms in the market.
____ 16. Oligopoly firms act unilaterally because of their individual control of the market.
____ 17. It would be best for oligopolist to put their acts together or cooperate limiting
their output and charge a price above their marginal cost.
____ 18. Pure oligopolies are not sensitive to the pricing policies of other similar firms
because they have the same or similar products.
____ 19. Car manufacturers are pure oligopolies because they produce and sell the same
products.
____ 20. Some of the causes of the emergence of monopolies are also the causes of the
emergence of oligopolies.
____ 21. It is impossible for cartel member to resort to collusion particularly in pricing.
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____ 22. Cartels are organized by oligopolists to block entry of other firms in the market.
____ 23. A cartel is like a monopoly. It determines a volume of output below the demand
curve and based on the equality or intersection of the marginal cost and marginal
revenue.
____ 24. The emergence of many conflicting interests renders it difficult for a cartel to
arrive at a consensus.
____ 25. It is impossible for cartel members to cheat on other members.
____ 26. Firms who have the power to set the prices for other firms are price leaders.
____ 27. Price leadership cannot never result to collusion because the leader has control
over the prices.
____ 28. Price leadership is very effective particularly when products are highly
differentiated.
____ 29. The position of a price leader is secured because members always follow the
price it dictates.
____ 30. Cost-plus pricing is based on the determination of average cost per unit and then
add a certain amount. The sum then becomes the price.
____ 31. When firms in an oligopoly engage in cost-plus pricing, they cannot engage in
collusion because each firm will want to set its own price.
____ 32. Game theory is an oligopoly model that is more or less like a chess game.
____ 33. One of the underlying factors in game theory is minimizing damage that can be
inflicted by a competitor.
____ 34. In cooperative games firms agree to either lower or increase their production to
maximize their profit.
____ 35. The reason why firms engage in non-cooperative games is the protection of their
self-interest and protection of their profit potential.
____ 36. There are times when no matter what strategy is adopted, others refuse to
cooperate and resort to their own strategy until they are all locked into positions
where they would not wish to make changes. This is maximin or dominant
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strategy.
____ 37. The prisoner’s dilemma shows that people really wish to cooperate when doing
so is beneficial for both players.
____ 38. When oligopolists cooperate, society is benefited because oligopolists will always
promote society’s welfare to stay in business.
____ 39. The kinked demand curve model is similar to price leadership because other
firms always follow another who sets a higher or lower price.
____ 40. When firms join another producing the same product there is vertical merger
because together, they can produce a high volume of goods or services.
____ 41. Horizontal merger is when a firm joins another from which it sells outputs or
purchase inputs. It is like buying the firm on the left side and right side of a
business transaction.
____ 42 A merger of firms selling or producing different products or services is
conglomerate merger.
____ 43. When a board of directors takes over custody of the assets of a cartel, a trust is
established.
____ 44. In a tying contract the retailer is required to agree to the condition that it will not
sell the product of rivals.
____ 45. An oligopolist that sets an extremely low price and raises it after competitors are
eliminated is a predator.
FILLING THE BLANKS. On the blank before each statement write the word, words, or phrase that
complete each statement. Assume that all other things are held constant.
______________ 1. A market structure where a number of sellers gain control over
the outcome of quantity and prices in the market is characterized
by __________.
______________ 2. __________ and
______________ 3. __________ are two types of imperfectly competitive market.
______________ 4. Products of firms under monopolistic competition serve the same
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purpose but are slightly __________ .
______________ 5. A firm that fails to recover variable cost has to __________ to
avoid further losses.
______________ 6. The mark-up pricing policy in monopolistically competitive firm
which is similar to monopolies is socially disadvantageous because
it results to a __________.
______________ 7. __________ is an effective tool in informing consumers about the
quality, pricing, availability, and uses of a product or service. It is,
however, contested because of the cost involved.
______________ 8. Products are identified and differentiated through their
__________ names.
______________ 9. A market dominated by few sellers but control more than half of
it is a/an __________.
______________ 10. Oligopolistic firms that are interdependent and selling or
producing homogeneous products are __________ oligopolies.
______________ 11. Years of advertising a certain product result to the development
of the product’s __________name.
______________ 12. Firms that act together like a monopoly and coordinate their
production and pricing decisions are called __________.
______________ 13. Few firms setting the price for other firms are called __________.
______________ 14. The existence of price leaders give rise to __________ collusion.
______________ 15. Adding a certain percentage to the average variable cost per unit
is called __________ pricing.
______________ 16. The tendency of an oligopolistic firm to examine the behavior of
another with the end in view of minimizing the damage the latter
can inflict is the goal of the __________ model.
______________ 17. Under the game theory model colluding to maximize profit is
called __________ game.
______________ 18. Optimal strategy regardless of the opponent’s action is a
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__________ strategy.
______________ 19. The kind of game theory formulated by John Nash is the
__________.
______________ 20. The fundamental problem of oligopolists who do wish to resort to
collusion is demonstrated in the __________, a kind of dominant
strategy.
______________ 21. In the __________ oligopoly model, it is disadvantageous for a
firm to raise its prices because other firms will not follow. It is also
not advisable to lower its prices because other firms will surely
follow.
______________ 22. When firms producing the same product or service join together,
their merger is a/an ___________ merger.
______________ 23. Joining a firm from which it purchases input resources or to which
it sells its products is a/an __________ merger.
______________ 24 The merger of firms selling different products or services is
a/an__________ merger.
______________ 25. A combination cartel that places its assets under the custody of a
board of directors is a/an__________.
______________ 26. Charging different customers different prices for the same
product is a/an __________.
______________ 27. Making a retailer sign a contract stipulating that he/she will not
carry the products of a competitor is __________.
______________ 28. An agreement whereby a buyer is required to purchase two or
more products at a single price is called a/an __________.
______________ 29. A powerful firm that lowers its price considerable and then raises
it again after competitors are eliminated as a result commits
__________.
______________ 30. __________ is practiced by firms that dictate to retailers the price
that should be charged to consumers.
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______________ 31. When there are two or more firms in an industry and the directors
of one also serve as directors in the other or others, there is a/an
__________.
ANALYSIS AND EVALUATION PROBLEMS. Always consider other things constant (ceteris
paribus).
1. Nestle and Alaska are confronted with the decision of whether or not they should promote
their milk products with small or large advertising budget. The matrix below show their
potential profits in millions of pesos.
Describe and explain the interdependence between the two firms . Determine if there is
Nash Equilibrium in their interdependence.
2. There are only two air conditioned jeepney manufacturers in the Philippines, Sarao and
Pampanga Built. The latter is certain that Sarao will match any price it sets. From the
following information about profit and prices, answers the questions below. All amounts
are denominated in pesos. Profits are in millions of pesos.
Pampanga sells at Sarao sells at Pampanga’s profits Sarao’s profits
140,000 140,000 10 10
Small Advertising
Budget
Large Advertising
Budget
Alaska’s Decision
Nestle’s Decision
Small Advertising
Budget
Large Advertising
Budget
Nestle earns Php160M.
Alaska earns Php40M.
Alaska earnsPhp 120M.
Nestle earnsPhp 50M.
Alaska earns Php60M.
Nestle earns Php60M.
Alaska earns Php170M.
Nestle earns Php170M.
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140,000 280,000 14 70
140,000 420,000 16 4
280,000 140,000 8 14
280,000 280,000 12 12
280,000 420,000 12 8
420,000 140,000 4 16
420,000 280,000 8 14
420,000 420,000 9 9
a. At what price will Pampanga Built sell its jeepneys?
b. At what price will Sarao sell, given the price of Pampanga Built?
c. What will be Pampanga Built’s profit after the response of Sarao?
d. Should they cooperate to maximize joint profits, what price would the two set?
e. Considering your answer in question d, how can cheating on price cause each
manufacturer’s profit to rise?
3. A monopolistically competitive firm has the following demand, cost, and price schedule.
OUTPUT PRICE FC VC TC TR PROFIT/(LOSS)
0 100 100 0
1 90 50
2 80 90
3 70 150
4 60 230
5 50 330
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6 40 450
7 30 590
a. Fill the blank spaces on the table.
b. What is the most favorable profit or loss for the firm?
c. Will it be wise to shut down or continue operation in the short-run? Explain your answer.
d. As the firm increases its output, what are the resulting marginal cost and marginal revenue.