Costs and Market Structure

What Do Firms Do? Firms carry out 2 functions. One, they organize resources (or inputs, factors of
production) and make goods and services. Two, they assume risk, which means that they undertake
or bear the problem that the business will fold or lose value; owners can, of course, also gain when
there are zero or positive economic profits. The 3 forms of business are single proprietorships,
partnerships and corporations. While single proprietorships are largest in numbers, corporations
account for the vast majority of sales.
A production function is a relationship between numbers and kinds of inputs (resources) and goods
and services produced (output). The relation depends upon the state of technology used as well as the
quality of resources. For instance, it might take 4 workers, 3,000 gallons of water and 10 packs of
seeds to produce 20 bushels of tomatoes. Introduction of higher technology might allow the business
to produce 20 bushels of tomatoes using 3 workers, 10 packets of seeds and 2,500 gallons of water.
Total product simply means output level; e.g., a business might produce 10 lawn mowers per day
which means that its total product is 10 lawn mowers per day as well. Inputs, or resources, are either
fixed or variable in nature. A fixed input is one whose quantity does not vary over the period of
analysis. For instance, the one factory building used by Acme Corp. is fixed in the sense that within
the next week or year it is unable to purchase or build another building to use to produce more
output. Acme Corp., however, is able to hire more workers, purchase more electricity, light bulbs,
chairs and other inputs or resources that are variable in nature. These inputs are therefore called
variable inputs.

Costs and Market Structure

The short run is defined as the production period whereby at least one input is fixed.
The long run is defined as the production period whereby all inputs are variable.
Marginal product is the change in total product associated with a change in the use of a variable
input. For instance, suppose that it takes 5 workers to produce 30 lawnmowers, but the owner may
produce 35 lawnmowers by hiring 6 workers. The marginal product of the 6th worker then is 5
lawnmowers since this equals the difference in total product (35-30) divided by the change in use of
the variable input (6-5); i.e., 5/1 = 5.

Variable
Input

Total
Product
TP

Marginal
Product
MP

40

40

70

30

90

20

100

10

The nearby chart shows that knowledge of columns 1 and 2 yields

the associated values of marginal product. Notice that the MP=40
for the first worker because it assumes that there is no output
without workers and so adding the 1st worker achieves an increase
in TP from 0 to 40 units, and hence the MP =40 for the first worker.
You should be able to calculate column 3 on the basis of columns 1
and 2.

MP = TP
variable input

Costs and Market Structure

Using the TP data, you should be able to determine MP.

Workers
1
2
3
4
5
6
7
8
9
10
11

TP
100
150
200
250
275
300
320
330
335
335
325

MP
100
50
50
50
25
25
20
10
5
0
-10

Using the MP data, you should be able to determine TP.

Workers
1
2
3
4
5
6
7
8
9
10
11

MP
100
100
50
50
25
25
25
10
0
-25
-75

TP
100
200
250
300
325
350
375
385
385
360
285

Costs and Market Structure

What is Meant by the Law of Diminishing Returns? How Would You Know When it Arises in a Table
Showing Total Product & Marginal Product?
The Law of Diminishing Returns states that, after some point, continued use of a variable input must
result in falling marginal product for that input.
For example, if a farmer continued to add fertilizer to his tomato plants on his one acre of land he
would eventually discover that further doses of fertilizer yield falling marginal product (falling
marginal product means diminishing returns.) Falling marginal product, or diminishing returns,
comes about because continued application of a variable input takes place in the short run whereby at
least one input is fixed. Therefore, the fact that at least one input is fixed is the reason why the law of
diminishing returns holds. In other words, diminishing returns takes place only in the short run.
Students often misinterpret the law of diminishing returns to mean
that total product falls after some point. This is not necessarily true,
however, because falling marginal product does not necessarily mean
that total product is falling at the same time. Consider the nearby
chart which shows labor (variable input) as subject to the law of
diminishing returns. Notice that, while MP falls here, notice that TP
keeps rising.
The moral of this story is that we should not confuse total product
with marginal product. The fact that marginal product is falling only
means that further use of the variable input results in a falling
marginal product, not total product. (The only way for falling
marginal product to coincide with falling total product is when
marginal product is negative.)
Costs and Market Structure

Labor

TP

MP

10

10

18

23

24

1
4

The nearby chart on the right shows that the 3rd and 4th workers
have negative marginal product which simply means that their
work results in less total output.
So, here total product falls, but only because marginal product
becomes negative.

Labor

TP

MP

10

10

18

17

-1

14

-3

In sum, total product rises when marginal product is positive

and total product falls when marginal product is negative. The
nearby chart on the right shows both cases.
The law of diminishing returns only states that marginal
product falls after some point, and therefore without further
information on whether marginal product is positive or
negative, it is unclear what is happening to total product.

Costs and Market Structure

TP & MP, Graphically (This nicely summarizes previous discussion).

max TP

TP

TP

TP starts at 0 units, rises, then reaches

maximum, and then falls. When variable inputs
are first employed MP>0 and thus MP rises.
Eventually, MP reaches 0, before turning
negative. TP is maximized when MP =0. TP
falls when MP turns negative.

Units of
Variable Input

MP

MP

MP (eventually) falls at first law of

diminishing marginal returns-- , then
reaches 0 units (max TP), and then
becomes negative. So, TP begins falling
once MP becomes negative.
Units of
Variable Input
Costs and Market Structure

How is the Law of Increasing Cost Connected to the Law of Diminishing Returns?
Remember that the law of diminishing returns states that, after some point, marginal products
of variables inputs decline. Falling marginal product means that each additional application
of a variable input results in a smaller change in total product.
Therefore, to produce additional output it takes more and more variable input, and because
inputs must be paid for by owners, costs of production rise. This rising cost of production
stems from the fact that marginal products decline and is therefore intimately linked to the law
of diminishing marginal product.

The nearby table demonstrates that the law of

diminishing returns results in the law of increasing
costs. Suppose that each worker receives $100 per
production period. To produce the 1st 10 units of output
it then costs $100 (hiring 1 worker who produces 10
units), to product the 2nd 10 units it costs $200 (hiring 2
workers who produce 5 units each), etc.

We have just demonstrated how the law of increasing

cost follows from the law of diminishing returns because
its the falling marginal product that causes costs to
increase.
Costs and Market Structure

Labor

MP

10

2
7

Suppose firms must pay $100 in

wages to each worker each day.
Using the associated chart, what are
the variable costs of production per
day, associated with producing
additional batches of 100 units?

Workers
1
2
3
4
5
6
7
8
9
10
11

TP
100
150
200
250
275
300
320
330
335
335
325

MP
100
50
50
50
25
25
20
10
5
0
-10

Variable costs are $100 for the 1st 100 units because one worker is needed; variable costs are $20
for the 2nd 100 units because two workers are needed; variable costs are $300 for the 3rd 100 units
because three workers are needed; variable costs approach infinity thereafter because the firm
could keep hiring and never produce the 4th 100 units.
This discussion provides the intuition behind the law of increasing cost that to produce more, it
costs more. Notice that the law of diminishing returns forces the marginal products of workers
to fall, after some point, and thus to produce more output begins requiring additional workers
and thus growing costs. The graph below describes the positive relationship between variable
input costs and total product (output).
Variable
Costs

Q
Costs and Market Structure

Contrast Accounting Profit with Economic Profit. Contrast Explicit from Implicit Costs
Economic profit equals total revenues less explicit plus implicit costs. Accounting profit is simply
total revenues less explicit costs.
A normal profit is defined as a zero economic profit and therefore total expenditures must equal
implicit plus explicit costs. A zero economic profit, or normal profit, therefore means that revenues
exactly cover explicit plus implicit costs. Normal profit represents minimum profit necessary to
keep businesses open in the long run.
Consider a business that sells yoyos and suppose that it receives $250M in revenues and incurs
explicit (i.e., checkbook type) costs of $225M. While accounting profit equals $25M ($250M $225M), we need to know implicit costs to determine economic profit. The implicit cost is the loss of
the next best alternative for the owner of the business. Suppose the firm gives up $15M from its
best alternative, say producing skateboards. Economic profit is $10M ($250M - $225M - $15M),
and is less than accounting profit of $25M.
So, when his total revenues cover this implicit cost, as well as all explicit costs, the owner is happy
to stay in the business of yoyos. In effect, the owner cannot make a higher profit by going
elsewhere whenever economic profit is at least $0M. Yes, $0M in economic profit means that all
costs are met, including implicit costs and explicit costs, there is no greater profit for the firm. Of
course, the firm would love to earn above $0M in economic profit, but as long as economic profit is
at least $0M, there are no better alternatives for the firm.

Costs and Market Structure

Remember, economic profit and accounting profit are not identical, although the latter term is
the one that non-economists emphasize.) Economists focus on economic profit since this is
what we believe motivates the behavior of the owners of firms.

Consider an owner facing an economic profit of -$50M. For example, the owner may earn
$100M in revenues from producing apple pies, but has explicit costs of $75M and implicit costs
(associated with producing meat pies) of $75M. This condition means that the owner can do
better by exiting out of the apple pie industry and entering the next best alternative of producing
meat pies.
We will later show that entry into an industry occurs when businesses in that industry are
earning above-normal profits such as $150M. This means that owners are receiving revenues
that not only fully cover all explicit and implicit costs, but also receive $150M over and above
those costs. Word gets around that industry if very profitable thus sparking entry into the
industry by firms seeking to capture their own above-normal profits. Of course, this will also
mean greater supply and thus lower prices thus causing profits in that industry to decline over
time.
The opposite happens when businesses in an industry are earning below-normal profits such as
-$150M. This means that owners are receiving revenues that dont fully cover all explicit and
implicit costs. Owners are unhappy understanding that they should seek out their next best
alternatives thus sparking exiting from the industry by firms seeking to capture higher profits
elsewhere. Of course, this will also mean falling supply (in the industry with below-normal
profits) and thus higher prices thus causing profits in that industry to rise over time.
Costs and Market Structure

10

1. In the
, a firm can not vary its plant size.
a. short run b. long run
c. intermediate run

d. market period

Consider the following production function for a firm producing staplers, where labor
refers to its variable input, and TP refers to the total product (i.e., staplers). Use this
information to answer the next two questions.
Workers
1
2
3
4
5

TP
40 units
70 units
90 units
100 units
105 units

2. What is the marginal product of the 4th worker?

a. 40 units b. 30 units c. 100 units d. 10 units e. 5 units
3. Suppose a 6th worker has a marginal product of 5 units. What is the total product of 6 workers?
a. 100 units
b.105 units c. 110 units d. 21 units e. insufficient information to know
4. Marginal cost is defined as
a. total cost divided by the level of output
b. the addition to total fixed cost of an additional unit of output
c. the addition to total cost of an additional unit of output
d. explicit plus implicit cost
e. none of these

5. Suppose that Acme Pizza sells 100 pizzas at $10 per pizza and that explicit costs equal $800 and implicit costs,
as measured by what the owner would receive in the next best opportunity, equal $200. What is the owners
economic profit?
a. $0
b. $1,000
c. $200 d. $600 e. $1,200
Costs and Market Structure
11

Use the following total cost (TC) and output (Q) relationship for an owner of business
producing bells to answer the next two questions.
Q
1
2
3
4
5

TC
$100
$250
$500
$800
$1,200

6. What is the marginal cost of producing the 4th unit of output?

a. $100 b. $250 c. $500 d. $800 e. $300
7. Which unit of output is characterized by the highest marginal cost?
a. 1st b. 2nd c. 3rd d. 4th e. 5th
8. The law of diminishing marginal returns
A) is relevant in the short run and the long run..
B) assumes all inputs are fixed.
C) relates to changes in the marginal product.
D) relates to changes in the average product.
9. A farmer is growing corn on an acre of land. Output will be 200 bushels if one
worker is hired, 500 if two, 700 if three, 850 if four, and 900 if five. The marginal
product of the fourth worker is
A) 850 bushels.
B) 150 bushels.
C) 212.5 bushels. D) 50 bushels.

12
Costs and Market Structure

What Are the 5 Assumptions of Perfect Competition?

(1) Many buyers and sellers: so many that no one buyer or seller exerts any significant effect on
price or quantity when they enter or leave market.
(2) Homogeneous product: buyers believe all sellers offer the same product and so buyers shop
only on basis of price.
(3) No entry barriers: any firm that wants to enter market may; no barriers preventing firms from
entering and competing with existing firms. Firms may locate, at no extra cost, anywhere they
choose and buyers may locate, at no extra cost, anywhere as well.
(4) Perfect information: buyers and sellers have complete information on every issue that affects
them; e.g., prices, locations of buyers/sellers, quality, profits.
(5) Profit maximization: sole goal of sellers.

P
$5

3
Market
Demand
1000

2000

The market demand is demand that faces

marketplace and therefore is the aggregate of
all individual demands facing all sellers. Market
demand must obey law of demand that states
there is an inverse relation between P & Qd,
ceteris paribus. The market demand shows how
prices must fall in order to raise quantity of
demand, ceteris paribus. This demand therefore
shows which price is associated with total quantity
sold in market. For instance, in order to raise
sales from 1000 to 2000 units, price must fall from
$5 to $3 per unit.

Costs and Market Structure

13

The intersection of market demand and market supply generates the market price that prevails in a
perfectly competitive market. In the chart on the left we see market price will be $5 and means that
all of the many suppliers must sell their product at $5 per unit.
The demand facing the representative firm is shown below right. It is generated in the market,
where demand and supply intersect. Demand facing the representative firm is perfectly elastic
(horizontal), because the firm must accept market price of $5 per unit.

Market
Supply

$5

$5

D facing representative firm

Market
Demand

1000
The firm is a price-taker because it has no control over price. If the firm raised price above $5, it
would lose all customers because consumers only care about price when they perceive all suppliers as
offering homogeneous products. There is no incentive to drop price below $5 because they can sell all
they want at $5 per unit.
Demand facing representative firm does not obey law of demand because it can sell all it wants at
market price ($5 here). While each firm is a price-taker, they do determine which quantity to sell.
Notice market demand does obey law of demand in order to sell more in the market, price must fall.
14
Costs and Market Structure

How are Total Revenue (TR) and Marginal Revenue (MR) Calculated? Show using information from
a Demand Schedule.

The first 2 columns reveal the demand facing an individual firm in

perfect competition. As mentioned above, individual firms do not
obey the law of demand because they can sell all they want at the
market price.

Qd

TR

MR

$10

$10

$10

10

20

$10

10

30

$10

10

40

$10

Total revenue is price multiplied by quantity sold.

Marginal revenue is the change in total revenue divided by a
change in quantity sold. MR is always the same value, and equal to
price, in a perfectly competitive market ($10 in this example).
You should be able to determine TR and MR from information
given in the first 2 columns.
Demand facing individual firms are perfectly elastic, or horizontal,
and identical to MR and market price; see graph below.
P
$10

D=MR=$10

representative firm

Q
Costs and Market Structure

15

Remember where demand and marginal revenue curves for individual firms come from.
They emanate from the market demand and supply intersection as shown.

Market Supply

representative firm
D = MR = $10

$10

Market
Demand
representative firm

Q
market
Costs and Market Structure

16

Marginal cost MC is the change in total cost divided by a change in

quantity produced. The nearby chart shows how it is calculated.

Marginal cost states how much it costs to produce an additional

unit of output. For instance, to produce the 2nd unit, after the 1st
has been produced, costs $15 at the margin. That is, the marginal
cost of the 2nd unit is $15.
Total cost is $25.

TC

MC

$10

$10

25

15

50

25

120

70

MC

$70

25

15
10

x
x
1

4 Q

The marginal cost MC curve from the chart is drawn above (not to scale).
Notice the MC curve is upward sloping which means that to produce more, it costs more at the
margin.
Costs and Market Structure

17

Why is MR = MC the condition for maximizing profit? MR and MC concepts apply at the
margin, which means they apply when considering adding to (or subtracting from) current
production levels.
The additional cost of producing one more unit of output is measured by marginal cost.

The additional revenue that follows from selling one more unit of output is measured by
marginal revenue. (We can also measure these in terms of one less unit of output.)
The important point is that decisions are made at the margin (i.e., should we sell one more unit
or one less?) rather than at the total (i.e., whether or not to produce anything).
Suppose that Acme Corp. is producing 1,000 bottles of soap and experiences MR of $10 and
MC of $8. This means that if they sell the 1,001st bottle they will gain $10 in added revenue,
but that 1,001st bottle will only cost them $8. This is profitable because $10 in additional
dollars costs them only $8. Profit rises by $2 when they undertake the 1,0001st bottle. So they
should continue producing as long as MR > MC.
Suppose Acme Corp. is producing 1,000 bottles of soap and experiences MR of $10 and MC of
$18. This means if they sell the 1,001st bottle they will gain $10 in added revenue at an
additional cost of $18. This is unprofitable and profit falls by $8 if they undertake the 1,001st
bottle. So they should never produce when MR < MC.

Costs and Market Structure

18

Previous discussion demonstrates that whenever MR > MC firms should produce more and
whenever MR < MC they have over-produced. Profit-maximization arises when MR =MC, which
means that, at the margin, the gain in revenue must equal the gain in cost.
Notice that: when MR>MC for Q<Q* ; when MR<MC for Q>Q* ; when MR=MC for Q=Q*.
$

MC

What Should a Firm Do if MR > MC?

Produce more as this raises profit.

MR=D=P

What Should a Firm Do if MR < MC?

Produce less as this raises profit.

Q*

Costs and Market Structure

19

Entry arises in a competitive market characterized by above-normal profit. Above-normal profit

means economic profit exceeds zero, or total revenues exceed total costs (which include explicit &
implicit costs). So economic profit above zero means revenues not only cover all explicit or
checkbook type costs, but also more-than-cover owners opportunity cost. This is an enviable profit
picture and, because perfect competition model assumes perfect information and no entry barriers,
new competitors flock to this market characterized by above-normal profits. New firms will attempt to
earn above-normal profits as well.

Exit arises in a competitive market characterized by below-normal profit. Below-normal profit means
economic profit is less than zero, or total revenues are less than total costs (which include explicit
plus implicit costs). So economic profits below zero means that revenues do not cover all explicit or
checkbook type costs plus owners opportunity cost. This is an unenviable profit picture and, because
perfect competition model assumes perfect information and no entry or exit barriers, existing
suppliers flee markets characterized by below-normal profits.

Costs and Market Structure

20

What Happens to Market Price When Entry Occurs? What Happens to P and MR Facing the
Representative Firm? How Will Output Change for Each Firm? Entry by firms into a competitive
market means that market supply curve shifts to the right. The graph below on the left shows entry
lowers market prices as the new intersection of market supply and demand occurs at a lower price.
Price and MR facing each individual firm will fall with the drop in market price. See graphs below
right.

$
S after entry

MR=P=D

MR=P=D after entry

D
market

representative firm

Costs and Market Structure

21

Output for firms (in market prior to entry) changes with the new MR=MC intersection associated
with profit-maximization. Output falls as each firm faces a lower market price (and therefore lower
MR as well); see graphs below.

MR=MC before entry

MC

S after entry

MR=P=D
MR=P=D after entry

D
market

MR=MC after
entry

representative firm

Notice that, while output for each firm drops in response to entry, output for entire market rises
(defined by intersection of new supply and demand in market).
Costs and Market Structure

22

What Happens to Market Price When Exit Occurs? What Happens to P and MR Facing the
Representative Firm? How Will Output Change for Each Firm? Exit by firms from a competitive
market means the market supply curve shifts to the left.
The graph shows exit raises market prices as new intersection of market supply and demand occurs at
a higher price.
The price and MR facing each individual firm rise with increase in market price.

S after exit
S

MR=P=D after exit

MR=P=D

D
market

Q
representative firm

Costs and Market Structure

23

Output for firms will change because there will be a new MR=MC intersection associated with profitmaximization. Output will rise as each firm faces a higher market price (and therefore higher MR as
well).
Notice that, while output for each firm rises in response to exiting, output for entire market falls
(defined by intersection of new supply and demand in market).

S after exit

MR=MC
after exit

MC

S
MR=P=D after exit

MR=P=D

D
Q

Market output falls.

MR=MC
before exit

Output of representative firm rises.

Costs and Market Structure

24

Model the Effect of a Higher Resource Price on Behavior of Representative Firm. That is, what
happens to price charged and output produced?
A higher resource price raises marginal costs of firms. Examples include higher oil prices and
higher wage rates for workers. The graphs below demonstrate firms produce less due to rising
MCs because this coincides with new MR=MC intersection. The price charged will change only
when higher resource prices cause market supply curve to shift to the left (not pictured here).

MC reflecting higher resource prices

MC
initial MR=MC

P=MR=D

D
Q
market
MR=MC following higher
resource prices

Q
representative firm
Costs and Market Structure

25

What Ensures the Result that Perfectly Competitive Firms Eventually Enjoy Normal Profits in the
Long Run?
The entry and exit processes result in normal profits for all firms in perfectly competitive markets
over time.
Anytime profits are above-normal, entry causes market prices to fall and firms will experience falling
profits.
Anytime profits are below-normal, exit causes market prices to rise and firms will experience rising
profits.
Over time normal profits will be earned by all firms since otherwise entry or exit will come about.

Costs and Market Structure

26

True-False
1. Freedom of entry and exit is important in maintaining a competitive market over time.

2. The competitive firm is a "price taker" and therefore a quality adjuster.

3. If economic profits exist in a competitive market new firms will enter to drive down
price.
4. Total revenue equals total cost (TR=TC) and marginal revenue equals marginal cost
(MR=MC) are two ways to examine profit maximization.
5. In a price-takers market (perfect competitive), the demand curve for the product of any
single firm is perfectly elastic.

6. A perfect competitive firm maximizes profits by producing that output where P = MC.
7. Product homogeneity is a standard assumption in the traditional theory of pure
competition.
8. A firm should increase production if its current level of production is characterized by
MR >MC.

Costs and Market Structure

27

10. Which one of the following is not an assumption of the competitive model?
A) homogeneous product
B) unrestricted mobility of resources
C) economies of scale
D) possession of all relevant information

11. The demand curve of a perfectly competitive firm is determined by

A) the level of the quality of the good the firm produces.
B) the intersection of the market demand and supply curves.
C) the reputation of the firm. D) the price the firm chooses to charge.
12. For a perfectly competitive firm, the demand curve
A) coincides with the marginal revenue curve.
B) coincides with the market price.
C) A and B are true. D) Neither A nor B are true.
13. The perfectly competitive firm's demand curve is horizontal because,
A) it is part of the industry's demand curve which is horizontal in competitive industries.
B) its demand is so elastic that the firm behaves as a price-taker.
C) all the firms in the industry have agreed upon the price to charge customers.
D) none of the above.
14. A perfectly competitive firm faces a horizontal demand curve, which implies that
A) price never changes, even though market demand and supply might change over time
B) the firm cannot affect price by any action it takes.
C) the output rate of the firm is indeterminate.
D) the firm makes zero profits.
Costs and Market Structure

28

15. A competitive firm maximizes profit at the output level where

A) price minus average total cost is the largest.
B) marginal revenue is equal to marginal cost.
C) average total cost equals marginal cost.
D) marginal revenue exceeds marginal cost by the greatest amount.
16. After a significant decrease in the price of a variable input,
A) demand curves shift downward.
B) marginal cost shifts downward and output falls.
C) marginal cost shifts downward but output remains the same.
D) marginal cost shifts downward and output rises.
17. Suppose a perfectly competitive firm is currently selling 200 units at $5 per unit and has a
marginal cost of $6. The firm can maximize profit by
a. increasing price
b. decreasing price
c. increasing output
d. decreasing output
18. Suppose a perfectly competitive firm is currently selling 200 units at $5 per unit and has a
marginal cost of $2. The firm can maximize profit by
a. increasing price
b. decreasing price
c. increasing output
d. decreasing output
19. Consider a perfectly competitive market. What happens to output of the representative firm when
entry occurs?
a. output will rise
b. output will fall
c. output will not change
Costs and Market Structure

29

Which Assumptions Underlie the Monopoly Model?

1.The firm is a sole seller of the product.
2. There are no ready substitutes for the product.
3. Significant entry barriers prevent competitors from competing with the monopolist.
4. Perfect information is available to the monopolist and consumers.
5. The sole goal of the monopolist is to profit-maximize.

What Does the Demand Facing A Monopolist Look Like?

Does it Differ from the Market Demand? Demand facing
the monopolist is identical to market demand because the
monopolist is the market.
Demand facing the monopolist is therefore negativelysloped as it must obey the law of demand.
Demand

Q
Costs and Market Structure

30

Calculate Total Revenue and Marginal Revenue for a Monopolist. How Do They Differ From
Competitive Firms? The nearby table exhibits a downward sloping demand for a monopolist. The
first 2 columns represent the demand schedule and allows calculation of TR and MR.
You should be able to calculate TR and MR on the basis of columns 1 and 2 alone.
The chart below describes the demand and marginal revenue curves for a monopolist.
$

Monopolist
P

Qd

TR

MR

$10

$10

$10

18

24

28

30

30

20

-10

MR

Costs and Market Structure

31

Notice that, for all Qs except the 1st, P is greater than MR.

Monopolist
P

Qd

TR

MR

$10

$10

$10

18

24

28

30

30

20

-10

8
6

D
3

MR

At Q=3, for instance, P of $8 exceeds MR of $6. (not

drawn to scale).

Costs and Market Structure

32

Fill in the following table.(Answer at Chapter End)

$10
9
8
7
6
5
4
3

1
2
3
4
5
6
7
8

TR

MR

33

Costs and Market Structure

How Can MR < 0?

MR < 0 means that selling one more lowers TR. Given that TR = P * Q, and that price and
quantity demanded are inversely related, this means that as quantity sold rises, price falls and
thus the P effect dominates the quantity effect in this case. Otherwise, TR would rise. You
should remember from earlier discussion of demand elasticity this would mean that demand is
price inelastic in this case.

D (inelastic)

D (elastic)
Q

MR > 0 means that selling one more raises TR. Given that TR = P * Q, and that price and
quantity demanded are inversely related, this means that as quantity sold rises, price falls and
thus the Q effect dominates the price effect in this case. Otherwise, TR would fall. This means
that demand is price elastic in this case.

Costs and Market Structure

34

Most downward sloping demand curves have both inelastic and inelastic segments. We can easily
see now that demand is elastic as long as MR>0 and inelastic when MR<0. Also, demand is price
elastic near the top and inelastic near the bottom.
Intuitively, demand is price elastic near the
top because consumers are purchasing
relatively little and are elated and very
price-sensitive at high prices. At lower
prices, they are purchasing relatively much
and thus yawn when given even lower
prices. Thus, along most demand curves,
price elasticity falls as price falls.

TR

MR

$10
9
8
7
6
5
4
3

1
2
3
4
5
6
7
8

$10
$18
$24
$28
$30
$30
$28
$24

$8
6
4
2
0
-2
-4

elastic
MR> 0
(TR rises as price falls)

inelastic
MR < 0
(TR falls as price falls)
Costs and Market Structure

35

The graph below plots the Demand and Marginal Revenue curves for a monopolist. The elastic
segment of the demand is shown in black, and the inelastic is shown in red.

D is elastic here because

associated MR>0
inelastic here because
associated MR<0

MR>0

D
Q
MR<0
MR

Costs and Market Structure

36

Draw the Marginal Cost Curve for a Monopolist. How Does it Differ from that Facing a
Competitive Firm? The marginal cost curve for a monopolist obeys same law of increasing cost
that perfectly competitive firms face. They are both upward sloping.

Is a Monopolist a Price-Setter or a Price-Taker? Why?

A monopolist is a price-setter, aka price-searcher, and perfectly competitive firms are price-takers.
Monopolists set both price and output, while perfectly competitive firms set only output because they
must accept the price given to them by market supply and demand (and hence the term price-taker
to describe a perfectly competitive firm).

Perfectly Competitive Firm

Monopolist
MC

MC
$

6
Costs and Market Structure

Q
37

Why is MR = MC Key to Profit-Maximization for Monopolist?

MR=MC is where profits are maximized same rule for perfectly competitive firms.
uppose MR > MC, as the case where $10 > $6.
Here, monopolist may sell one more unit of output and receive $10 additional revenue at an added cost
of only $6. Profit would rise by $4 and therefore profits are never maximized when MR > MC.
Suppose MR < MC, as the case where $10 > $16.
Here, the monopolist may sell one more unit of output and receive $10 additional dollars at an added
cost of $16. Profit would fall by $6 and therefore profits are never maximized when MR < MC.
We have just shown that firms should produce more when MR > MC and firms should produce less
when MR < MC.
Profit-maximization therefore must arise when MR = MC since otherwise profits may be increased by
tinkering with output.

Costs and Market Structure

38

Show Graphically How a Monopolist Profit-Maximizes. The first step is to determine output and price
that coincide with intersection of MR and MC.
(P*,Q*) is profit-maximizing price and quantity combination.

MC

Notice that for Q<Q*, MR > MC; and for Q > Q*,
MR < MC.
Any Q other than Q* is thus not profit-maximizing.

P*

Suppose a Monopolist Produces Where MR = MC.

What Happens if It Sells One More Unit of Output.
Why? MR=MC is a unique position in that it is the
only position where profits are maximized.

MR=MC

Q*

MR

Costs and Market Structure

39

To maximize profits, monopolist charges price that is:

a. less than MC
b. equal to MC
c. greater than MC
d. there is not enough information to answer this question

Max profit: MR=MC

MC

charge P*, sell Q*

P*>MC at Q*

P*

Q*

MR
Costs and Market Structure

40

Suppose a Monopolist Produces Where MR > MC. What Happens if it Sells One More Unit of
Output. Why?

The nearby chart shows MR of $10 and MC of $6 at

Q = 3.
MC
$
10

This means adding one more unit of output yields a

higher profit because, at this margin, revenues rise by
$10 at a cost of $6.
Profits rise by $4 if monopolist raised output one unit.

6
D
3

MR
Which Conditions are Necessary if a Monopolist is to Maintain Above-Normal Profits? Why?
Above-normal profits can only be maintained through the help of entry barriers that keep
competitors out of monopolists market. Otherwise, competitors flock into markets with abovenormal profits thus lowering price and erasing above-normal profits until profits are driven to
normal as the case of perfectly competitive markets.
Costs and Market Structure

41

Model How a Monopolist Responds to an Energy Shock that Raises Resource Prices. What
Happens to Price Charged and Output? Show Graphically.

An energy shock raises resource prices thus raising marginal costs. (Remember 2 events may raise MC
curves: higher resource prices and/or lower technology.)

MC (w/ energy shock)

MC (initial)

Price rises and output falls following energy

shock.
These changes can be traced by locating MR =
MC intersections before and after energy
shock.

D
Q
MR

Costs and Market Structure

42

Compare and Contrast How a Monopolist vs. Competitive Firms Price and Set Output. Which
charges a higher price and which sells a larger output, given same market demand & cost
conditions?
The MC curve is the supply curve in a
perfectly competitive market.
MC = S

Ppc and Qpc would then result from the

intersection of supply and demand in the
perfectly competitive market.

Pm
Ppc

D
MR
Qm

Qpc

Therefore, the monopolist sets a higher price (Pm) and sells a smaller quantity (Qm).
Costs and Market Structure

43

Suppose a Market Experienced New Entry. What Would You Predict Would Happen to Price
Charged, Output Sold and Profit for Firms in this Market? Entry into a monopolistic market would
cause price to fall and output to rise as the marketplace evolved into the direction of perfect
competition. These directions for price and output follow those indicated in the previous page.
Profits would also fall and eventually be driven to normal if the market fully evolved into perfect
competition.
Suppose a Monopolist Experiences a Tax Hike on its Output. What Would Predict Would Happen
to Price Charged, Output Sold and Profit for the Monopolist? A per unit tax hike on would cause
its MC curve to shift upward as it now costs more per unit to produce than before.
$

The nearby graph shows that price will rise and output will fall
following a tax hike.

MC w/ tax

These changes follow directly from how MR = MC

intersections change. Profit would fall because, while costs
have risen there has been no change in revenue conditions
(i.e., demand).

MC

Profits must then fall.

D

MR

Costs and Market Structure

44

Suppose Consumers of a Monopolist Experience a Tax Hike on their purchases. Predict Changes
to Price Charged, Output Sold and Profit for the Monopolist.

A tax hike on consumers income will lead to a reduction in demand if the good in question is a
normal good.

$
MC

Price falls and output falls, as traced out by change in MR =

MC intersection.
Price change is opposite that of previous page where tax hike
was placed on firms output.

MR

MR

D
Q

(Price & output should rise if good in question is an inferior good.)

Costs and Market Structure

45

20. The marginal revenue curve of a monopolist lies below the demand curve because
A) the demand curve is unit-elastic.
B) the monopolist must lower price on all units sold in order to sell additional units.
C) the monopolist is a price taker.
D) the marginal revenue curve coincides with the average revenue curve.
21. A monopolist
A) takes the price of its product as given and produces as much output as possible.
B) can choose any price it wants, regardless of demand.
C) can choose any price along the market demand curve.
D) chooses the price of its product so as to maximize the number of sales.
22. The market demand curve and the demand curve faced by a monopoly are
A) different in that the market demand curve is less elastic.
B) different in that the market demand curve is more elastic.
C) different, but we can't tell which is more elastic without more information.
D) identical.
23. If the monopolist is operating in the elastic portion of its demand curve, then
A) an increase in price will increase total revenues.
B) an increase in price will decrease total revenues.
C) marginal revenue is negative.
D) an increase in price will leave total revenue unchanged.

46
Costs and Market Structure

24. Assume that Bost, Incorporated sells game cartridges that can be used in a popular home
video system. Bost currently sells 300 cartridges per week and earns $500 in profit. Bost's
production manager calculates that the marginal cost of the next unit is $5, while marginal
revenue for one additional unit is $10. Based upon this information we would conclude that:
A) Bost should reduce their output.
B) Bost's profit would rise to $510 by increasing output 1 unit.
C) Bost's profit would rise to $505 by increasing output 1 unit.
D) Insufficient information.
25. Generally, we expect monopolies to
output when demand for their product rises.
A) Increase
B) decrease
C) not change
D) double
26. Compared to a competitive industry, ceteris paribus, a monopoly
A) sells more units and charges a higher price.
B) sells the same amount of units but at a higher price.
C) does not try to maximize profits as do firms in competitive industries.
D) restricts output and charges a higher price.

Costs and Market Structure

47

27. Suppose that a monopolist experiences an increase in the tax on its income. Which
of the following will tend to happen, assuming that no other changes arise?
a. it will increase price
b. it will decrease price
c. it will not change price because it is a price-taker
d. it may or may not change price, but will certainly change its output.
28. Consider a monopolist that is currently maximizing profit by producing 10 units.
Which of the following statements is not true?
a. price is less than marginal cost
b. price is greater than marginal cost
c. price is greater than marginal revenue
d. profit will fall if it increases its production
e. profit will fall if it decreases its production
29. To maximize profits, a monopolist will charge a price that is:
a. greater than MC
b. equal to MC
c. less than MC
d. there is not enough information to answer this question

Costs and Market Structure

48

Key Concepts
2 Functions of Firms
3 Forms of Businesses
Production Function, Total Product (TP)
Fixed Inputs vs. Variable Inputs
Short Run vs. Long Run
Marginal Product (MP)
Deriving MP from TP; Deriving TP from MP
Law of Diminishing Returns
Graphing TP and MP Together
Law of Increasing Cost
Accounting Profit vs. Economic Profit
Explicit vs. Implicit Costs
5 Assumptions of Perfect Competition
Market Demand vs. Demand of Representative Firm
Perfectly Competitive Firm is a Price-Taker
Total Revenue (TR) and Marginal Revenue (MR)
Relationship Between Demand, Price and Marginal Revenue for Representative Firm
Total Cost (TC), Marginal Cost (MC)
Why is MC Upward-Sloping?
Condition for Profit-Maximization
What Should a Firm Do When MR<MC?; What Should a Firm Do When MR>MC?
Graphing MR, MC and Profit Curves on 2 Associated Graphs (Perfectly Competitive Firm)
Entry vs. Exit
Normal Profit, Above-Normal Profit, Below-Normal Profit
49
Costs and Market Structure

Effect of an Energy Shock on MC

Effect of an Energy Shock on Output of Perfectly Competitive Firm
5 Assumptions of Monopoly Model
Demand Facing a Monopolist
TR and MR for Monopolist
Demand and MR for a Monopolist
Demand, MR and Elasticity for a Monopolist
MC for a Monopolist
Monopolist as a Price-Setter
Profit-Maximization Condition for a Monopolist
Graphing MR, MC and Profit Curves on 2 Associated Graphs (Monopoly Case)
Compare/Contrast Perfect Competition and Monopoly

Costs and Market Structure

50

TR

MR

$10
9
8
7
6
5
4
3

1
2
3
4
5
6
7
8

$10
$18
$24
$28
$30
$30
$28
$24

$8
6
4
2
0
-2
-4

=(24-18) / (3-2)

=(24-28) / (8-7)

Costs and Market Structure

51

1A
2D
3C
4C
5A
6E
7E
8C
9B
10 C
11 B
12C
13 B
14 B
15 B
16 D
17 D
18 C
19 B
20 B
21 C
22 D
23 B
24 C
25 A
26 D
27 A
28 A
29 A

1T
2F
3T
4F
5T
6T
7T
8T

Costs and Market Structure

52