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1 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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Page 1: Cost to Oligopoly

1

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

Page 2: Cost to Oligopoly

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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

Page 19: Cost to Oligopoly

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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

Page 28: Cost to Oligopoly

28

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.

Page 29: Cost to Oligopoly

29

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

Page 30: Cost to Oligopoly

30

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

Page 31: Cost to Oligopoly

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

Page 32: Cost to Oligopoly

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

Page 33: Cost to Oligopoly

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

Page 34: Cost to Oligopoly

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.

Page 35: Cost to Oligopoly

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

Page 36: Cost to Oligopoly

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

Page 37: Cost to Oligopoly

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: Cost to Oligopoly

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

Page 40: Cost to Oligopoly

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.

Page 41: Cost to Oligopoly

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: Cost to Oligopoly

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).

Page 43: Cost to Oligopoly

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.

Page 44: Cost to Oligopoly

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.

Page 45: Cost to Oligopoly

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.

Page 46: Cost to Oligopoly

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

__________.

Page 47: Cost to Oligopoly

47

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: Cost to Oligopoly

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?

Page 49: Cost to Oligopoly

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: Cost to Oligopoly

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

Page 51: Cost to Oligopoly

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: Cost to Oligopoly

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

Page 53: Cost to Oligopoly

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

Page 54: Cost to Oligopoly

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: Cost to Oligopoly

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

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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

Page 58: Cost to Oligopoly

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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62

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

Page 65: Cost to Oligopoly

65

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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66

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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67

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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68

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

)

Page 69: Cost to Oligopoly

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

Page 71: Cost to Oligopoly

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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: Cost to Oligopoly

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

Page 74: Cost to Oligopoly

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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75

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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76

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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77

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

Page 82: Cost to Oligopoly

82

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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83

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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87

(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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89

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.