© 2009 South-Western, a part of Cengage Learning, all rights r.docx

© 2009 South-Western, a part of Cengage Learning, all rights
reserved
C H A P T E R
Oligopoly
Microeconomics
P R I N C I P L E S O F
N. Gregory Mankiw
Premium PowerPoint Slides
by Ron Cronovich
17
In this chapter,
look for the answers to these questions:
competition?

1
OLIGOPOLY 2
Measuring Market Concentration
the percentage of the
market’s total output supplied by its four largest
firms.
the less competition.
a market structure with high concentration ratios.
../../../../../Program Files/TurningPoint/2003/Questions.html
Concentration Ratios in Selected U.S. Industries
Industry Concentration ratio
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%

Soft drinks 93%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
OLIGOPOLY 4
Oligopoly
few sellers offer similar or identical products.
A firm’s decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making decisions.

ve
in strategic situations.
OLIGOPOLY 5
P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
EXAMPLE: Cell Phone Duopoly in Smalltown

cell phone service with unlimited
anytime minutes and free phone
-Mobile, Verizon
(duopoly: an oligopoly with two firms)
OLIGOPOLY 6
5045
6040
7035
8030
9025
10020
11015
12010
1305
140$0

QP
1,750
1,800
1,750
1,600
1,350
1,000
550
0
–650
–1,400
Profit
500
600
700
800
900
1,000

1,100
1,200
1,300
$1,400
Cost
2,250
2,400
2,450
2,400
2,250
2,000
1,650
1,200
650
$0
Revenue
Competitive

outcome:
P = MC = $10
Q = 120
Profit = $0
Monopoly
outcome:
P = $40
Q = 60
Profit = $1,800
OLIGOPOLY 7
market about quantities to produce or prices to
charge
-Mobile and Verizon could agree to each produce

half of the monopoly output:
e.g., T-Mobile and Verizon in the outcome with
collusion
A C T I V E L E A R N I N G 1
Collusion vs. self-interest
8
Duopoly outcome with collusion:
Each firm agrees to produce Q = 30,
earns profit = $900.
If T-Mobile reneges on the agreement and
produces Q = 40, what happens to the
market price? T-Mobile’s profits?
Is it in T-Mobile’s interest to renege on the
agreement?
If both firms renege and produce Q = 40,

determine each firm’s profits.
P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60
45 50
../../../Program Files/TurningPoint/2003/Questions.html
If both firms stick to agreement,
each firm’s profit = $900
If T-Mobile reneges on agreement and
produces Q = 40:

Market quantity = 70, P = $35
T-Mobile’s profit = 40 x ($35 – 10) = $1000
T-Mobile’s profits are higher if it reneges.
Verizon will conclude the same, so
both firms renege, each produces Q = 40:
Each firm’s profit = 40 x ($30 – 10) = $800
Answers
9
P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80

35 70
40 60
45 50
OLIGOPOLY 10
Collusion vs. Self-Interest
cartel agreement.
agreement.
It is difficult for oligopoly firms to form cartels and
honor their agreements.
If each firm produces Q = 40,
market quantity = 80
P = $30

each firm’s profit = $800
Is it in T-Mobile’s interest to increase its
output further, to Q = 50?
Is it in Verizon’s interest to increase its
output to Q = 50?
The oligopoly equilibrium
11
P Q
$0 140
5 130
10 120
15 110
20 100
25 90
30 80
35 70
40 60

45 50
If each firm produces Q = 40,
then each firm’s profit = $800.
If T-Mobile increases output to Q = 50:
T-Mobile’s profit = 50 x ($25 – 10) = $750
T-Mobile’s profits are higher at Q = 40
than at Q = 50.
The same is true for Verizon.
Answers
12
P Q
$0 140
5 130
10 120
15 110

20 100
25 90
30 80
35 70
40 60
45 50
OLIGOPOLY 13
The Equilibrium for an Oligopoly
economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
in which each firm produces Q = 40.
T-Mobile’s best move is to produce Q = 40.

-Mobile produces Q = 40,
Verizon’s best move is to produce Q = 40.
OLIGOPOLY 14
A Comparison of Market Outcomes
When firms in an oligopoly individually choose
production to maximize profit,
but smaller than competitive Q.
but less than monopoly P.
OLIGOPOLY 15
The Output & Price Effects
m’s profits:
If P > MC, selling more output raises profits.

Raising production increases market quantity,
which reduces market price and reduces profit
on all units sold.
the firm increases production.
the firm reduces production.
OLIGOPOLY 16
The Size of the Oligopoly
the price effect becomes smaller
competitive market
efficient quantity

Another benefit of international trade:
Trade increases the number of firms competing,
increases Q, brings P closer to marginal cost
OLIGOPOLY 17
Game Theory
other situations where “players” interact and
behave strategically.
for a player in a game regardless of the
strategies chosen by the other players
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial

OLIGOPOLY 18
Prisoners’ Dilemma Example
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
offer each the following deal:
you go free.
you, you get 20 years in prison.
OLIGOPOLY 19
Confess Remain silent
Confess

Remain
silent
Bonnie’s decision
Clyde’s
decision
Bonnie gets
8 years
Clyde
gets 8 years
Bonnie gets
20 years
Bonnie gets
1 year
Bonnie goes
free
Clyde
goes free
Clyde

gets 1 year
Clyde
gets 20 years
Confessing is the dominant strategy for both players.
Nash equilibrium:
both confess
OLIGOPOLY 20
each gets 8 years in prison.
silent.
being caught to remain silent, the logic of self-
interest takes over and leads them to confess.
OLIGOPOLY 21

Oligopolies as a Prisoners’ Dilemma
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
-Mobile and Verizon are duopolists in
Smalltown.
Each firm agrees to serve Q = 30 customers.
OLIGOPOLY 22
T-Mobile & Verizon in the Prisoners’ Dilemma
Q = 30 Q = 40
Q = 30
Q = 40
T-Mobile

Verizon
T-Mobile’s
profit = $900
Verizon’s
profit = $900
T-Mobile’s
profit = $1000
T-Mobile’s
profit = $800
T-Mobile’s
profit = $750
Verizon’s
profit = $750
Verizon’s
profit = $800
Verizon’s profit
= $1000
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.

The players: American Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone
each airline’s profit = $400 million
each airline’s profit = $600 million
its profit = $800 million
the other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium.
The “fare wars” game
23
Answers

24
Nash equilibrium:
both firms cut fares
Cut fares Don’t cut fares
Cut fares
Don’t cut
fares
American Airlines
United
Airlines
$600 million
$600 million
$200 million
$800 million
$800 million
$200 million
$400 million
$400 million

OLIGOPOLY 25
Other Examples of the Prisoners’ Dilemma
Ad Wars
Two firms spend millions on TV ads to steal
business from each other. Each firm’s ad
cancels out the effects of the other,
and both firms’ profits fall by the cost of the ads.
Organization of Petroleum Exporting Countries
Member countries try to act like a cartel, agree to
limit oil production to boost prices & profits.
But agreements sometimes break down
when individual countries renege.
OLIGOPOLY 26
Other Examples of the Prisoners’ Dilemma
Arms race between military superpowers
Each country would be better off if both disarm,

but each has a dominant strategy of arming.
Common resources
All would be better off if everyone conserved
common resources, but each person’s dominant
strategy is overusing the resources.
OLIGOPOLY 27
Prisoners’ Dilemma and Society’s Welfare
prevents them from achieving monopoly profits
Q is closer to the socially efficient output
P is closer to MC
cooperate may reduce social welfare.

OLIGOPOLY 28
Another Example: Negative Campaign Ads
3000 fewer people will vote for D:
1000 of these people vote for R, the rest abstain.
R loses 3000 votes, D gains 1000, 2000 abstain.
Will each one stick to the agreement?
OLIGOPOLY 29
Do not run attack
ads (cooperate)
R’s decision
D’s decision

no votes lost
or gained
no votes
lost or gained
R gains 1000
votes
R loses
2000 votes
R loses 3000
votes
D loses
3000 votes
D loses
2000 votes
D gains
1000 votes
Each candidate’s
dominant strategy:

run attack ads.
Run attack ads
(defect)
Do not run
attack ads
(cooperate)
Run
attack ads
(defect)
OLIGOPOLY 30
Each side’s ads cancel out the effects of the
other side’s ads.
Lower voter turnout, higher apathy about politics,

less voter scrutiny of elected officials’ actions.
OLIGOPOLY 31
Why People Sometimes Cooperate
cooperation may be possible.
neges in one round,
you renege in all subsequent rounds.
-for-tat”
Whatever your rival does in one round
(whether renege or cooperate),
you do in the following round.
OLIGOPOLY 32
Public Policy Toward Oligopolies
Governments can sometimes

improve market outcomes.
are too high, relative to the social optimum.
olicymakers:
Promote competition, prevent cooperation
to move the oligopoly outcome closer to
the efficient outcome.
OLIGOPOLY 33
Restraint of Trade and Antitrust Laws
titrust Act (1890):
Forbids collusion between competitors
Strengthened rights of individuals damaged by
anticompetitive arrangements between firms
OLIGOPOLY 34

Controversies Over Antitrust Policy
-fixing agreements
among competitors should be illegal.
policymakers go too far when using antitrust laws
to stifle business practices that are not
necessarily harmful, and may have legitimate
objectives.
OLIGOPOLY 35
1. Resale Price Maintenance (“Fair Trade”)
acturer imposes lower limits
on the prices retailers can charge.
competition at the retail level.

is at the wholesale level; manufacturers do not
gain from restricting competition at the retail level.
preventing discount retailers from free-riding
on the services provided by full-service retailers.
OLIGOPOLY 36
2. Predatory Pricing
or drive a competitor out of the market,
so that it can charge monopoly prices later.
to determine when a price cut is predatory and
when it is competitive & beneficial to consumers.
rational strategy:
costly for the firm.

OLIGOPOLY 37
3. Tying
together and sells them for one price (e.g., Microsoft
including a browser with its operating system)
argue that tying gives firms more market
power by connecting weak products to strong ones.
power: Buyers are not willing to pay more for two
goods together than for the goods separately.
may use tying for price discrimination,
which is not illegal, and which sometimes
increases economic efficiency.
OLIGOPOLY 38

CONCLUSION
s
or like competitive markets, depending on the
number of firms and how cooperative they are.
for firms to maintain cooperation, even when
doing so is in their best interest.
the antitrust laws to regulate
oligopolists’ behavior. The proper scope of these
laws is the subject of ongoing controversy.
CHAPTER SUMMARY
y form a
cartel and act like a monopolist.
-interest leads each oligopolist to a higher
quantity and lower price than under the monopoly
outcome.

the quantity and price to the levels that would
prevail under competition.
39
CHAPTER SUMMARY
-interest
can prevent people from cooperating, even when
cooperation is in their mutual interest. The logic of
the prisoners’ dilemma applies in many situations.
oligopolies from engaging in anticompetitive
behavior such as price-fixing. But the application
of these laws is sometimes controversial.
40
reserved
C H A P T E R

Monopolistic Competition
Microeconomics
N. Gregory Mankiw
by Ron Cronovich
16
In this chapter,
competition and monopoly, and what are their
characteristics?
price and quantity? Do they earn economic profit?
tition affect
society’s welfare?

advertising?
1
MONOPOLISTIC COMPETITION 2
Introduction:
Between Monopoly and Competition
Two extremes
products
opoly: one firm
In between these extremes: imperfect competition
identical products.
similar but not identical products.
Characteristics & Examples
of Monopolistic Competition

Characteristics:
Examples:
Comparing Perfect & Monop. Competition
yesnone, price-takerfirm has market power?
downward-
sloping
horizontalD curve facing firm

differentiatedidenticalthe products firms sell
zerozerolong-run econ. profits
yesyesfree entry/exit
manymanynumber of sellers
Monopolistic
competition
Perfect
competition
Comparing Monopoly & Monop. Competition
yesyesfirm has market power?
downward-
sloping
downward-
sloping
(market demand)
D curve facing firm

manynoneclose substitutes
zeropositivelong-run econ. profits
yesnofree entry/exit
manyonenumber of sellers
Monopolistic
competition
Monopoly
profit
ATC
P
A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve.
At each Q, MR < P.

To maximize profit,
firm produces Q
where MR = MC.
The firm uses the
D curve to set P.
Quantity
Price
ATC
D
MR
MC
Q
losses
A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC

at the output where
MR = MC.
The best this firm
can do is to
minimize its losses.
Quantity
Price
ATC
Q
P
ATC
MC
D
MR
Monopolistic Competition and Monopoly

firm behavior is very similar to monopoly.
monopolistic competition,
entry and exit drive economic profit to zero.
New firms enter market,
taking some demand away from existing firms,
prices and profits fall.
Some firms exit the market,
remaining firms enjoy higher demand and prices.
A Monopolistic Competitor in the Long Run
Entry and exit
occurs until
P = ATC and
profit = zero.

Notice that the
firm charges a
markup of price
over marginal cost
and does not
produce at
minimum ATC. Quantity
Price
ATC
D
MR
Q
MC
MC
P = ATC
markup

Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1. Excess capacity
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
perfect competition, firms produce the
quantity that minimizes ATC.
2. Markup over marginal cost
Monopolistic Competition and Welfare
have all the desirable welfare properties of
perfectly competitive markets.

the socially efficient quantity.
Firms earn zero profits, so cannot require them
to reduce prices.
Monopolistic Competition and Welfare
due to external effects from the entry of new firms:
-variety externality:
surplus consumers get from the introduction
of new products
-stealing externality:
losses incurred by existing firms
when new firms enter market
subtle and hard to measure. No easy way for

policymakers to improve the market outcome.
1. So far, we have studied three market
structures: perfect competition, monopoly, and
monopolistic competition. In each of these,
would you expect to see firms spending money
to advertise their products? Why or why not?
2. Is advertising good or bad from society’s
viewpoint? Try to think of at least one “pro”
and “con.”
Advertising
13
Advertising
dustries,

product differentiation and markup pricing
lead naturally to the use of advertising.
the more advertising firms buy.
advertising.
The Critique of Advertising
advertising.
eople’s tastes.
–
it creates the perception that products are
more differentiated than they really are,
allowing higher markups.

The Defense of Advertising
exploit price differences.
reduces market power.
Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
than in states that did not restrict such advertising.
Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts
on advertising may signal the quality of its product

to consumers, regardless of the content of ads.
once,
but the product must be of high quality for people
to become repeat buyers.
unless they lead to repeat buyers.
they think the product must be good if the company
is willing to spend so much on advertising.
Brand Names
with generic ones.
sually spend more on
advertising, charge higher prices for the products.

the economics of brand names…
The Critique of Brand Names
differences that do not really exist.
names is irrational, fostered by advertising.
govt protection of trademarks
would reduce influence of brand names,
result in lower prices.
The Defense of Brand Names

to consumers.
to maintain quality, to protect the reputation of
their brand names.
CONCLUSION
examples of monopolistic competition abound.
many markets in the economy,
yet offers little guidance to policymakers looking
to improve the market’s allocation of resources.
CHAPTER SUMMARY
many firms, differentiated products, and free entry.

monopolistically competitive market
has excess capacity – produces less than the
quantity that minimizes ATC. Each firm charges a
price above marginal cost.
22
CHAPTER SUMMARY
desirable welfare properties of perfect competition.
There is a deadweight loss caused by the markup
of price over marginal cost. Also, the number of
firms (and thus varieties) can be too large or too
small. There is no clear way for policymakers to
improve the market outcome.
23
CHAPTER SUMMARY

the use of advertising and brand names. Critics of
advertising and brand names argue that firms use
them to reduce competition and take advantage of
consumer irrationality. Defenders argue that firms
use them to inform consumers and to compete
more vigorously on price and product quality.
24
reserved
C H A P T E R
Monopoly
Microeconomics
N. Gregory Mankiw
by Ron Cronovich
15

In this chapter,
e their P and Q?
-being?
1
MONOPOLY 2
Introduction
product without close substitutes.
it with perfect competition.
A monopoly firm has market power, the ability to

influence the market price of the product it sells.
A competitive firm has no market power.
MONOPOLY 3
Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws
MONOPOLY 4
Why Monopolies Arise
3. Natural monopoly: a single firm can produce

the entire market Q at lower cost than could
several firms.
Q
Cost
ATC
1000
$50
Example: 1000 homes
need electricity Electricity
ATC slopes
downward due
to huge FC and
small MC
ATC is lower if
one firm services
all 1000 homes
than if two firms
each service

500 homes. 500
$80
MONOPOLY 5
Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
But the demand curve
for any individual firm’s
product is horizontal
at the market price.
The firm can increase Q
without lowering P,
so MR = P for the
competitive firm.
D
P

Q
A competitive firm’s
demand curve
MONOPOLY 6
Monopoly vs. Competition: Demand Curves
A monopolist is the only
seller, so it faces the
market demand curve.
To sell a larger Q,
the firm must reduce P.
Thus, MR ≠ P.
D
P
Q
A monopolist’s
demand curve

A monopoly’s revenue
7
Q P TR AR MR
0 $4.50
1 4.00
2 3.50
3 3.00
4 2.50
5 2.00
6 1.50
n.a.
Common Grounds
is the only seller of
cappuccinos in town.
The table shows the
market demand for
cappuccinos.

Fill in the missing
spaces of the table.
What is the relation
between P and AR?
Between P and MR?
Answers
8
Here, P = AR,
same as for a
competitive firm.
Here, MR < P,
whereas MR = P
for a competitive
firm.
1.506
2.005

2.504
3.003
3.502
1.50
2.00
2.50
3.00
3.50
$4.004.001
n.a.
9
10
10
9
7
4
$ 0$4.500
MRARTRPQ

–1
0
1
2
3
$4
MONOPOLY 9
Common Grounds’ D and MR Curves
-3
-2
-1
0
1
2
3
4
5

0 1 2 3 4 5 6 7 Q
P, MR
MR
$
Demand curve (P)
1.506
2.005
2.504
3.003
3.502
4.001
$4.500
MRPQ
–1
0
1
2
3

$4
MONOPOLY 10
Understanding the Monopolist’s MR
creasing Q has two effects on revenue:
the price on all the units it sells.
n be negative if the price effect
exceeds the output effect (e.g., when Common
Grounds increases Q from 5 to 6).
MONOPOLY 11
Profit-Maximization
profit by producing the quantity where MR = MC.

it sets the highest price consumers are willing to
pay for that quantity.
MONOPOLY 12
Profit-Maximization
1. The profit-
maximizing Q
is where
MR = MC.
2. Find P from
the demand
curve at this Q.
Quantity
Costs and
Revenue
MR

D
MC
Profit-maximizing output
P
Q
MONOPOLY 13
The Monopolist’s Profit
As with a
competitive firm,
the monopolist’s
profit equals
(P – ATC) x Q
Quantity
Costs and
Revenue
ATC
D

MR
MC
Q
P
ATC
MONOPOLY 14
A Monopoly Does Not Have an S Curve
A competitive firm
on P.
A monopoly firm
-maker,” not a “price-taker”
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no supply curve for monopoly.

MONOPOLY 15
CASE STUDY: Monopoly vs. Generic Drugs
Patents on new drugs
give a temporary
monopoly to the seller.
When the
patent expires,
the market
becomes competitive,
generics appear.
MC
Quantity
Price
D
MR
PM
QM

PC =
QC
The market for
a typical drug
MONOPOLY 16
The Welfare Cost of Monopoly
ve market equilibrium,
P = MC and total surplus is maximized.
exceeds the cost of the resources needed to
produce that unit (MC).
–
could increase total surplus with a larger Q.
MONOPOLY 17

P = MC
Deadweight
loss
P
MC
The Welfare Cost of Monopoly
Competitive eq’m:
quantity = QC
P = MC
total surplus is
maximized
Monopoly eq’m:
quantity = QM
P > MC
deadweight loss
Quantity
Price
D
MR

MC
QM QC
MONOPOLY 18
Price Discrimination
on some characteristic, e.g. race or gender.
the same good
at different prices to different buyers.
is willingness to pay (WTP):
price to buyers with higher WTP.
MONOPOLY 19
Consumer
surplus
Deadweight

loss
Monopoly
profit
Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
charges the same
price (PM) to all
buyers.
A deadweight loss
results. MC
Quantity
Price
D
MR
PM
QM

MONOPOLY 20
Monopoly
profit
Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the
competitive quantity,
but charges each
buyer his or her WTP.
This is called perfect
price discrimination.
The monopolist
captures all CS
as profit.
But there’s no DWL.
MC
Quantity
Price

D
MR
Q
MONOPOLY 21
Price Discrimination in the Real World
not possible:
unce it to sellers
based on some observable trait
that is likely related to WTP, such as age.
MONOPOLY 22
Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people

who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have
higher WTP, from more price-sensitive leisure
travelers.
MONOPOLY 23
Discount coupons
People who have time to clip and organize
coupons are more likely to have lower income
and lower WTP than others.
Need-based financial aid
Low income families have lower WTP for
their children’s college education.

Schools price-discriminate by offering
need-based aid to low income families.
MONOPOLY 24
Quantity discounts
A buyer’s WTP often declines with additional
units, so firms charge less per unit for large
quantities than small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s
twice as big.
MONOPOLY 25
Public Policy Toward Monopolies
allow govt to break up monopolies.

Clayton Act (1914)
r natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
or set P = ATC for zero economic profit.
MONOPOLY 26
Public Policy Toward Monopolies
efficient since no profit motive to minimize costs
so the best policy may be no policy.

MONOPOLY 27
CONCLUSION: The Prevalence of Monopoly
competitors
s, most of the results from this
chapter apply, including:
CHAPTER SUMMARY
Monopolies arise due to barriers to entry, including:
government-granted monopolies, the control of a
key resource, or economies of scale over the entire

range of output.
-sloping
demand curve for its product. As a result, it must
reduce price to sell a larger quantity, which causes
marginal revenue to fall below price.
28
CHAPTER SUMMARY
quantity where marginal revenue equals marginal
cost. But since marginal revenue is less than
price, the monopoly price will be greater than
marginal cost, leading to a deadweight loss.
try to raise their profits by charging higher prices
to consumers with higher willingness to pay.
This practice is called price discrimination.
29

CHAPTER SUMMARY
monopolies, using antitrust laws to promote
competition, or by taking over the monopoly and
running it. Due to problems with each of these
options, the best option may be to take no action.
30
reserved
C H A P T E R
Firms in Competitive Markets
Microeconomics
N. Gregory Mankiw
by Ron Cronovich

14
In this chapter,
and average revenue?
that maximizes profits?
short run? Exit the market in the long run?
short run? In the long run?
1
FIRMS IN COMPETITIVE MARKETS 2
Introduction: A Scenario
business.

to charge, how many workers to hire, etc.
perfectly competitive markets.
../../../../../../Program Files/TurningPoint/2003/Questions.html
Characteristics of Perfect Competition
1. Many buyers and many sellers.
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
“price taker” – takes the price as given.
The Revenue of a Competitive Firm

The change in TR from
selling one more unit.
∆TR
∆Q
MR =
TR = P x Q
TR
Q
AR = = P
Calculating TR, AR, MR
5
Fill in the empty spaces of the table.
$50$105
$40$104

$103
$102
$10$101
n/a$100
TRPQ MRAR
$10
Answers
6
Fill in the empty spaces of the table.
$50$105
$40$104
$103
$10
$10
$10

$10$102
$10$101
n/a
$30
$20
$10
$0$100
TR = P x QPQ
∆TR
∆Q
MR =
TR
Q
AR =
$10
$10
$10
$10
$10
Notice that

MR = P
MR = P for a Competitive Firm
without affecting the market price.
-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
MR = P is only true for
firms in competitive markets.
Profit Maximization
If increase Q by one unit,
revenue rises by MR,

cost rises by MC.
rofit.
Profit Maximization
505
404
303
202
101
45
33
23
15
9
$5$00

MR – MC
MCMRProfitTCTRQAt any Q with
MR > MC,
increasing Q
raises profit.
5
7
7
5
1
–$5
10
10
10
10
–2
0
2

4
$6
12
10
8
6
$4$10
(continued from earlier exercise)
At any Q with
MR < MC,
reducing Q
raises profit.
P1 MR
MC and the Firm’s Supply Decision
At Qa, MC < MR.

So, increase Q
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit.
At Q1, MC = MR.
Changing Q
would lower profit. Q
Costs
MC
Q1Qa Qb
Rule: MR = MC at the profit-maximizing Q.
P1 MR
P2 MR2
MC and the Firm’s Supply Decision
If price rises to P2,

then the profit-
maximizing quantity
rises to Q2.
The MC curve
determines the
firm’s Q at any price.
Hence,
Q
Costs
MC
Q1 Q2
the MC curve is the
firm’s supply curve.
Shutdown vs. Exit
utdown:

A short-run decision not to produce anything
because of market conditions.
A long-run decision to leave the market.
A Firm’s Short-run Decision to Shut Down
(firm must still pay FC)
down if TR < VC
Shut down if P < AVC

The firm’s SR
supply curve is
the portion of
its MC curve
above AVC.
Q
Costs
A Competitive Firm’s SR Supply Curve
MC
ATC
AVC
If P > AVC, then
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down

(produces Q = 0).
The Irrelevance of Sunk Costs
committed and cannot be recovered
you must pay them regardless of your choice.
costs whether it produces or shuts down.
down.
A Firm’s Long-Run Decision to Exit

(zero FC in the long run)
decision rule as:
Exit if P < ATC
A New Firm’s Decision to Enter Market
it is profitable to do so: if TR > TC.
entry decision as:
Enter if P > ATC
The firm’s
LR supply curve

is the portion of
its MC curve
above LRATC.
Q
Costs
The Competitive Firm’s Supply Curve
MC
LRATC
Identifying a firm’s profit
19
Determine
this firm’s
total profit.
Identify the
area on the
graph that

represents
the firm’s
profit.
Q
Costs, P
MC
ATC
P = $10 MR
50
$6
A competitive firm
Answers
20
profit
Q

Costs, P
MC
ATC
P = $10 MR
50
$6
A competitive firm
Profit per unit
= P – ATC
= $10 – 6
= $4
Total profit
= (P – ATC) x Q
= $4 x 50
= $200
Identifying a firm’s loss

21
Determine
this firm’s
total loss,
assuming
AVC < $3.
Identify the
area on the
graph that
represents
the firm’s
loss.
Q
Costs, P
MC
ATC
A competitive firm
$5

P = $3 MR
30
Answers
22
loss
MRP = $3
Q
Costs, P
MC
ATC
A competitive firm
loss per unit = $2
Total loss
= (ATC – P) x Q
= $2 x 30
= $60

$5
30
Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other firms
enter or exit the market.
3) The number of firms in the market is
(due to fixed costs)
(due to free entry and exit)
The SR Market Supply Curve

, each firm will produce its
profit-maximizing quantity, where MR = MC.
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.
The SR Market Supply Curve
MC
P2
Market
Q
P
(market)
One firm
Q
P
(firm)

S
P3
Example: 1000 identical firms
At each P, market Qs = 1000 x (one firm’s Qs)
AVC
P2
P3
30
P1
2010
P1
30,00010,000 20,000
Entry & Exit in the Long Run
entry & exit.
rofit,

The Zero-Profit Condition
-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
occurs when P = ATC.
the zero-profit condition is P = MC = ATC.

Why Do Firms Stay in Business if Profit = 0?
– including implicit costs, like the opportunity cost
of the owner’s time and money.
-profit equilibrium,
The LR Market Supply Curve
MC
Market
Q
P
(market)
One firm

Q
P
(firm)
In the long run,
the typical firm
earns zero profit.
LRATC
long-run
supply
P =
min.
ATC
The LR market supply
curve is horizontal at
P = minimum ATC.
S1

Profit
D1
P1
long-run
supply
D2
SR & LR Effects of an Increase in Demand
MC
ATC
P1
Market
Q
P
(market)
One firm
Q
P
(firm)
P2P2

Q1 Q2
S2
Q3
A firm begins in
long-run eq’m…
…but then an increase
in demand raises P,……leading to SR
profits for the firm.
Over time, profits induce entry,
shifting S to the right, reducing P…
…driving profits to zero
and restoring long-run eq’m.
A
B
C
Why the LR Supply Curve Might Slope Upward

1) all firms have identical costs, and
2) costs do not change as other firms enter or
exit the market.
er of these assumptions is not true,
then LR supply curve slopes upward.
1) Firms Have Different Costs
market
before those with higher costs.
for higher-cost firms to enter the market,
which increases market quantity supplied.
ginal firm,

P = minimum ATC and profit = 0.
-cost firms, profit > 0.
2) Costs Rise as Firms Enter the Market
pply of a key input is
limited (e.g., amount of land suitable for farming
is fixed).
input, causing its price to rise.
to increase
the market quantity supplied, so the supply curve
is upward-sloping.
CONCLUSION: The Efficiency of a
Competitive Market

-maximization: MC = MR
P is value to buyers of the marginal unit.
total surplus.
production decisions, deadweight loss, regulation.
CHAPTER SUMMARY
price = marginal revenue = average revenue.
the quantity where MR = MC. If P < AVC, a firm
will shut down in the short run.

d an
increase in demand increases firms’ profits.
and P = minimum ATC.
35

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