1. Business Economics
Q1: The marginal product of labour in a production process is statistically estimated as
MPL = 10(K/L)0.5
Currently the process is using 100 units of K and 121 units of L. Given the Very specialised
nature of capital equipment K, it takes about a year to increase K; but the rate of labour
input, L, can be varied daily. If the wage rate is $ 10 per unit and the price of output is $2 per
unit, is the firm operating efficiently in the short run? If not, explain why. Also determine the
optimal rate of labour input. On what factors does the labour efficiency depend?
The concept of a production function
The production function is a mathematical expression which relates the quantity of factor
inputs to the quantity of outputs that result. We make use of three measures of production /
productivity.
Total product is simply the total output that is generated from the factors of production
employed by a business. In most manufacturing industries such as motor vehicles,
freezers and DVD players, it is straightforward to measure the volume of production
from labour and capital inputs that are used. But in many service or knowledge-based
industries, where much of the output is “intangible” or perhaps weightless we find it
harder to measure productivity
Average product is the total output divided by the number of units of the variable factor
of production employed (e.g. output per worker employed or output per unit of capital
employed)
Marginal product is the change in total product when an additional unit of the variable
factor of production is employed. For example marginal product would measure the
change in output that comes from increasing the employment of labour by one person,
or by adding one more machine to the production process in the short run.
The Short Run Production Function
The short run is defined in economics as a period of time where at least one factor of
production is assumed to be in fixed supply i.e. it cannot be changed. We normally assume that
the quantity of capital inputs (e.g. plant and machinery) is fixed and that production can be
altered by suppliers through changing the demand for variable inputs such as labour,
components, raw materials and energy inputs. Often the amount of land available for
production is also fixed.
The time periods used in textbook economics are somewhat arbitrary because they differ from
industry to industry. The short run for the electricity generation industry or the
telecommunications sector varies from that appropriate for newspaper and magazine
publishing and small-scale production of foodstuffs and beverages. Much depends on the time
scale that permits a business to alter all of the inputs that it can bring to production.

2. In the short run, the law of diminishing returns states that as we add more units of a variable
input (i.e. labour or raw materials) to fixed amounts of land and capital, the change in total
output will at first rise and then fall. Diminishing returns to labour occurs when marginal
product of labour starts to fall. This means that total output will still be rising – but increasing at
a decreasing rate as more workers are employed. As we shall see in the following numerical
example, eventually a decline in marginal product leads to a fall in average product.
What happens to marginal product is linked directly to the productivity of each extra worker
employed. At low levels of labour input, the fixed factors of production - land and capital, tend
to be under-utilised which means that each additional worker will have plenty of capital to use
and, as a result, marginal product may rise. Beyond a certain point however, the fixed factors of
production become scarcer and new workers will not have as much capital to work with so that
the capital input becomes diluted among a larger workforce. As a result, the marginal
productivity of each worker tends to fall – this is known as the principle of diminishing
returns.
An example of the concept of diminishing returns is shown below. We assume that there is a
fixed supply of capital (e.g. 20 units) available in the production process to which extra units of
labour are added from one person through to eleven.
Initially the marginal product of labour is rising.
It peaks when the sixth worked is employed when the marginal product is 29.
Marginal product then starts to fall. Total output is still increasing as we add more
labour, but at a slower rate. At this point the short run production demonstrates
diminishing returns.
The Law of Diminishing Returns
Capital Input Labour Input Total Output Marginal Product Average Product of Labour
20 1 5 5
20 2 16 11 8
20 3 30 14 10
20 4 56 26 14
20 5 85 28 17
20 6 114 29 19
20 7 140 26 20
20 8 160 20 20
20 9 171 11 19
20 10 180 9 18
20 11 187 7 17
Average product will continue to rise as long as the marginal product is greater than the
average – for example when the seventh worker is added the marginal gain in output is 26 and
this drags the average up from 19 to 20 units. Once marginal product is below the average as it

3. is with the ninth worker employed (where marginal product is only 11) then the average will
decline.
This marginal-average relationship is important to understanding the nature of short run cost
curves. It is worth going through this again to make sure that you understand it.
Criticisms of the Law of Diminishing Returns
How realistic is this notion of diminishing returns? Surely ambitious and successful businesses
do what they can to avoid such a problem emerging.
It is now widely recognised that the effects of globalisation, and in particular the ability
of trans-national corporations to source their factor inputs from more than one country and
engage in rapid transfers of business technology and other information, makes the concept of
diminishing returns less relevant in the real world of business. You may have read about the
expansion of “out-sourcing” as a means for a business to cut their costs and make their
production processes as flexible as possible.
In many industries as a business expands, it is more likely to experience increasing returns.
After all, why should a multinational business spend huge sums on expensive research and
development and investment in capital machinery if a business cannot extract increasing
returns and lower unit costs of production from these extra inputs?
Long run production - returns to scale
In the long run, all factors of production are variable. How the output of a business responds
to a change in factor inputs is called returns to scale.
Increasing returns to scale occur when the % change in output > % change in inputs
Decreasing returns to scale occur when the % change in output < % change in inputs
Constant returns to scale occur when the % change in output = % change in inputs

4. A numerical example of long run returns to scale
Units of Units of Total % Change in % Change in Returns to Scale
Capital Labour Output Inputs Output
20 150 3000
40 300 7500 100 150 Increasing
60 450 12000 50 60 Increasing
80 600 16000 33 33 Constant
100 750 18000 25 13 Decreasing
In the example above, we increase the inputs of capital and labour by the same proportion each
time. We then compare the % change in output that comes from a given % change in inputs.
In our example when we double the factor inputs from (150L + 20K) to (300L + 40K) then
the percentage change in output is 150% - there are increasing returns to scale.
In contrast, when the scale of production is changed from (600L + 80K0 to (750L + 100K)
then the percentage change in output (13%) is less than the change in inputs (25%)
implying a situation of decreasing returns to scale.
As we shall see a later, the nature of the returns to scale affects the shape of a business’s long
run average cost curve.
The effect of an increase in labour productivity at all levels of employment
Productivity may have been increased through the effects of technological change; improved
incentives; better management or the effects of work-related training which boosts the skills of
the employed labour force.

5. The length of time required for the long run varies from sector to sector. In the nuclear power industry
for example, it can take many years to commission new nuclear power plant and capacity.
Normally though efficiency of labour means the ability or4 fitness of a worker to produce goods
and services in proper quantity and of the right quality which is a given period. The ability can
be measured in terms of number of units of a commodity produced by a worker with in a given
period. Thus, one factor worker producing more number of a commodity with in a given time
than the other worker is considered more efficient. Efficiency of labour is thus an important
determinant of the study of labour in a productive sense. It determines the size of real
productive labour force in a country. A country labour supply will be substantially augmented if
it possesses a relatively small labour force possessing a high degree of efficiency.
Factors affecting the efficiency of labour are as follows:-
1.Racial Stock: - Man acquires some physical qualities from the racial stock to which he belongs.
The Sikhs and Jats are very strong and are capable of hard work.
2. Wages: - If a labourer get a low wage, he can’t maintain his efficiency, if wages are low,
labour productivity will also be low.
3.Climate: -In temperate and cold climate, people can work hard. Hot climate is not conductive
to very hard work. In hot climate, labourers cannot work as hand as labourer in cool climate
can.
4.Hours to Work: -The efficiency of labour is affected by the working hours. If a labourer works
for long hours, work becomes monotonous and the labourers worse only half heartily. He
cannot give the best.
5.Working Conditions: - If the factory building is dirty and not well-ventilated workers cannot
hard work. However, if factory building is clean and well ventilated and if the atmosphere is
pleasant, workers like to work hard.
6.Education and Training: - Education and Training impact technical knowledge, sense of
responsibility and improve the efficiency of labour. Trained labourer can use modern machinery
efficiency.
7.Welfare Activities: - Social security measures like medical facilities and maternity benefits
help laborer to maintain their health and efficiency. Measures to improve efficiency of labour:-
Efficiency of labour can be improved by eradicating the cause of low efficiency.
This can be done particularly through proper education, training improvement in machines and
betterment in working living conditions. Thus, labour efficiency can be improved with respect of
following points:-
1. By linking about labour efficiency and by wages and incentive bonus, it is possible to
motivate labour.
2. Labour efficiency can be raised by mutual argument between management and workers
regarding distribution of benefits of raising labour productivity.
3.Improving industrial relations can raise labour efficiency.
4.Comprehensive planning and introducing input is creating quality consciousness in production
and in cost control, that efficiency can be raised.

6. 5.Bringing improvement in plan lay out material handling and better internal management in a
factory has positive effect on labour efficiency.
6.By providing modern training course to those in personnel department who handle worker
such trained personnel will be able to create an atmosphere of better effort by workers.
7. Providing training to workers and taking measures to improve labour welfare.
8.By introducing modern methods of organization, labour efficiency can be raised

7. Q2: Explain how equilibrium of the firm is achieved. Also, explain (along with examples) how
profit maximizing output is determined in short run and long run for:
A:
Perfect Competitive market
Monopoly market
Monopolistic market
Oligopoly market
Market equilibrium in economics refers to level of prices at which the quantity demanded by
the customers is same as the quantity offered for for supply by the suppliers. Thus the market
equilibrium has two dimensions.
(1) price, and (2) quantity sold and purchased. Here we are talking about quantity actual sold
and purchased. Unlike quantities demanded and quantity offered for supply, the actual
quantity sold and purchased is always equal.
In a monopoly market, the entire market supply is accounted by one firm. Therefore,
equilibrium point for the market and for the firm is the same. In a perfectly competitive market,
individual firms have no influence on the market price as the demand curve for the firm is a
horizontal line at the level of the market price. Thus same price is applicable to firm level
equilibrium. However the quantity supplied by each firm at this equilibrium price depends on
the cost structure of the firm. The firm can supply as much as it wishes, therefore it supplies a
quantity that maximizes its profit. This occurs when the marginal cost of the firm just equals the
marginal revenue. In a perfectly competitive market the marginal cost and revenue at this point
are also same as the market price. Since marginal cost for every firm operating in a perfect
competition is same as market price, the combined marginal cost for all the firms in a perfectly
competitive market is also same as market equilibrium price.
In an oligopoly it is not possible to give a fixed formula for the equilibrium point for individual
firms as it is dependent on actions of competitor firms and may change from time to time in
response to changing competitive action and the competitive strategy of the firm itself.
Average Fixed Cost:
Fixed cost refers to the minimum fixed cost that a firm incurs for manufacturing irrespective of
the total quantity produced. Average fixed cost is simply this fixed cost divided by total quantity
produced.
Thus: Average Fixed Cost = AFC = Fixed cost/Total quantity produced.
In the above equation for AFC we see that numerator (fixed cost) is constant, while
denominator (total quantity produced) is variable. Therefore, AFC reduces with increasing

8. production quantity. As a result AFC curve, which is a graph showing AFC on y-axis and
production of x-axis, is a downward sloping curve.
How equilibrium is achieved depends on what is being equalized. Equilibrium means balance or
equality between two opposing forces. When those forces are equal, there is rest.
Equilibrium is achieved when both sides are effectively in balance. In other words, one side
does not contain more than the other side. Any changes made to the sides are done to both
sides
MARKET EQUILIBRIUM:
The state of equilibrium that exists when the opposing market forces of demand and supply
achieve a balance with no inherent tendency for change. Once achieved, a market equilibrium
persists unless or until it is disrupted by an outside force, especially the demand and supply
determinants. A market equilibrium is indicated by equilibrium price and equilibrium quantity.
In general, equilibrium is the balance of opposing forces. For market equilibrium, the opposing
forces are demand and supply. Buyers seeking to buy at a lower price and sellers seeking to sell
at a higher price. The balance of these two forces generates a price and a quantity that are
mutually agreeable to both sides.
The Imperial Forces of Demand and Supply
A market equilibrium is comparable to a robust tug-of-war between two equally matched
teams of burly lumberjacks, such as those employed by the Natural Ned Lumber Company. On
one end of the rope is a group of ten burly lumberjacks in red plaid shirts. On the other end is a
group of ten burly lumberjacks in blue plaid shirts. As the red burly team tugs and pulls they are
matched tug for tug and pull for pull by the blue burly team. The yellow flag marking the center
of the rope budges nary an inch. The two opposing forces of burly red and burly blue balance
out. The result is equilibrium.
Except for the plaid shirts, market equilibrium works in much the same way.
Demand: Wearing red flannel, the demand "force" is buyers seeking to pay the lowest
possible price for a good. In particular, the demand force is the demand curve, which
embodies the law of demand. However, it is not just the demand curve that is this force,
but the whole demand space beneath the demand curve. Buyers are willing to go as
high as the demand curve, but would really, really prefer to go lower.
Supply: In the blue corner, the supply "force" is sellers seeking to receive the highest
possible price. This is best indicated by thesupply curve, which embodies the law of
supply. And like demand, it is not the supply curve itself, but the entire supply space
above the curve. Sellers are willing to go as low as the supply curve, but would really,
really prefer to go higher.

9. Striking A Balance
Market equilibrium is the balance between buyers Market Equilibrium
trying to move the price down and sellers trying to
move the price up. When the two forces are in
balance, the "yellow flag" or price does not budge.
The unmoving price is not actually yellow, but it is the
equilibrium price.
Specifically equilibrium price is the price that
exists when the market is in equilibrium.
Paired with the equilibrium price, is
the equilibrium quantity, which is the quantity
exchanged between buyers and sellers when
the market is in equilibrium.
There is more, however, to equilibrium price and
quantity than yellow flags. The equilibrium price is also equal to BOTH the demand
price andsupply price. Moreover, the equilibrium quantity is equal to BOTH thequantity
demanded and quantity supplied.
As a matter of fact, equilibrium price and equilibrium quantity result when the demand and
supply prices are equal AND the quantities demanded and supplied are equal. And this is ONLY
achieved at the intersection of the demand and supply curves. This market equilibrium is
illustrated in the accompanying market diagram.
Efficiency and the Invisible Hand of Competition
Economists like market equilibrium almost as much as a box of Double-Dot Caramel Nougat
Clusters. The reason is efficiency. The forces of demand and supply, almost as if guided by
an invisible hand, efficiently allocate society's scarce resources when they achieve market
equilibrium. Efficiency, however, requires a competitive market--a market with large numbers
of buyers and sellers such that neither side is able to influence the price or exchange process
and the absence of market failures such as externalities.
A competitive market is comparable to a tug-of-war in which each team consists of a hundred
thousand flannel-shirted lumberjacks. Should any single lumberjack from either side leave their
team to climb a pine tree, fell a redwood, or pursue other lumberjacking activities, then the
tug-of-war is unaffected. One lumberjack, one buyer, one seller, does not affect a competitive
market.
If, however, the tug-of-war teams consist of only three lumberjacks each, then the absence or
presence of a one can make a difference. Likewise the efficiency balance in a market can be
easily comprised if the number of competitors is limited.

10. Those Disrupting Determinants
Market equilibrium perpetually persists unless or until disrupted by an outside force.
The demand determinants and supply determinants are the prime disrupters of market
equilibrium. When they change, the demand and supply curves shift, the original equilibrium
price and quantity are no longer equilibrium, and the market is out of balance with surpluses
and shortages.
Fortunately, a market equilibrium is a stable equilibrium. Any determinant-triggered disruption
that results in a surplus or shortage induces the price to change to restore equilibrium. If the
market wavers from equilibrium, the demand and supply forces bring it back. If the price is too
high or too low, that is, above or below the equilibrium price, then the price automatically
returns it to the equilibrium.
A high price creates a surplus, which means sellers are not able to sell all that they want
at the existing price. To eliminate this surplus, they force the price lower.
A low price creates a shortage, which means buyers are not able to buy all that they
want at the existing price. To eliminate this shortage, they force the price higher.
In either situation, the price returns to the equilibrium.
Perfect Competitive Market
A perfectly competitive firm with rising marginal costs maximizes profit by producing up until
the point at which marginal cost is equal to marginal revenue. The marginal revenue for a
perfectly competitive firm is the market price determined by the intersection of the supply and
demand curves, as shown in the panel on the left. The panel on the right shows the orange
price line intersecting the purple marginal cost curve at the profit maximizing quantity, . The
per unit profit is represented by the distance between the price line and the point on the U-
shaped average total cost curve corresponding to .The total profit is the per unit profit
times and is represented by the shaded rectangle. If the price is below the average total
cost, the profit is negative and can be interpreted as the loss minimizing level of output.
Short-Run Profit Maximization
- Since firms take price as given, the only decision they have to make is how much output to
produce (if any).
- Choose output “Q” to maximize economic profits

11. (Q) TR(Q) TC(Q)
PQ TVC(Q) TFC
Note: TC(Q) already incorporates the firm’s cost-minimizing input choices for each Q.
Note: Economic profits include all relevant opportunity costs (including the opportunity cost of
the owner’s investment), so an economic profit of zero actually corresponds to a “normal” rate
of return on one’s investment.
- Two components to firm’s decision:
(Part 1) Should they produce any output at all?
(Part 2) If so, how much?
(Part 1) Should the firm produce Q > 0 or shut down (produce Q = 0)?
The firm should stay open if there exists a positive output level Q such that
(Q) (Q 0)
TR(Q) TVC(Q) TFC TFC
TR(Q) TVC(Q)
Alternatively, we can rewrite this as:
TR(Q) TVC(Q)
Q Q
PQ TVC(Q)
Q Q
P AVC(Q) for some Q 0
(or)

12. P min AVC(Q)
Intuition:
Fixed costs are irrelevant for the shut down decision since they must be paid whether the firm
remains open or not.
However, as long as TR > TVC for some Q > 0 (alternatively, P > min AVC), the firm can increase
profits by producing Q > 0 (since additional revenue earned on these units exceeds the cost of
producing them).
Conversely, if TR < TVC for all Q > 0 (alternatively, P < min AVC), then the firm loses money on
each unit it produces so it is better off not producing any output.
Observation: In the short run, it may well be in the firm’s interest to remain open even if their
profits are negative.
This is because
(q) TR(Q) TVC(Q) TFC 0
even if
TR(Q) TVC(Q) 0
(Part 2) Given that it is in the firm’s interest to produce Q > 0, how much output should the firm
produce in order to maximize profits?
- Easiest to see graphically…(see diagram)
- Observe that profits are maximized (the difference between TR and TC is the greatest) at
the point where
slope of TR = slope of TC
P = MC
(in region where MC (slope of TC) is increasing!)

13. - Notice that the slope of the TR curve might also equal the slope of the TC curve in the
region where MC (slope of TC) is decreasing.
- This would not be the profit-maximizing level of output (in fact, this is the level of output
where losses are maximized.)
Both components of the firm’s output decision can be summarized in the following graphs:
Case 1) Profit > 0 (see diagram)
- First, notice that there are many levels of Q for which P > AVC produce Q > 0.
- Second, given Q > 0 is optimal, choose output level where P = MC (in region where MC is
increasing).
- Profits at the optimal output level Q* are given by the area of the shaded rectangle
(Q) P ATC(Q* ) Q*
TC (Q* ) *
P Q
Q *
PQ* TC (Q*)
TR(Q*) TC (Q*)
Case 2) Profit < 0; but remain open in short run (see diagram)
- Here, P > AVC for many values of Q, so the firm should produce Q > 0.
- Profit-maximizing Q is where P = MC (in region of increasing MC).
- At Q* , P < ATC
(Q*) P ATC(Q* ) Q* 0

14. Case 3) Profits < 0; firm should shut down (see diagram)
- Here there is no Q for which P > AVC
(i.e., P < min AVC), so firm should shut down.
Numerical Example:
TC 100 Q 2
MC 2Q
P $60
1) Should the firm stay open (produce Q > 0)?
Q2
TVC Q2 AVC Q
Q
Clearly, P > AVC for some Q > 0, so produce Q > 0.
2) What is the profit-maximizing level of Q?
Set P = MC in region where MC is increasing.
MC = 2Q, so MC is always increasing.
P MC 60 2Q Q* 30
3) What are the firm’s economic profits?
(Q*) TR(Q*) TC(Q*)
PQ* TC(Q*)

15. (30) 60(30) 100 (30)2
1800 100 900
$800
Application: Two Misconceptions about Short-Run Profit Maximization
a) Many companies have a culture that encourages managers to maximize profit margins
(see diagram).
b) Accounting departments often advise against projects if they can’t “pay their share,” i.e.
earn enough revenue to cover some portion of existing fixed costs.
Example: Meat packing company my father worked for.
Current Production:
TR = $30,000,000
TVC = $10,000,000
TFC = $15,000,000
Proposed Project (to be housed in unused basement):
TR = $2,000,000
TVC = $1,000,000
Rejected because it was assigned a 10% share of the existing fixed costs ($1,500,000).
The Firm’s Short-Run Supply Curve
The two conditions for profit maximization define the firm’s short-run supply curve (see
diagram)
0 if P min AVC
Q
MC(Q) if P min AVC
where MC denotes the upward-sloping portion of the marginal cost curve.
Thus, the firm’s short-run supply curve is the portion of its MC curve above min AVC.

16. Note: Firm’s short-run supply curve is upward sloping because it is equal to the upward-sloping
portion of the MC curve.
Short-Run Industry Supply
Short-run Industry Supply Curve – The horizontal sum of the short-run supply curves of all firms
in the industry.
Example: Identical firms
Suppose an industry has 200 identical firms, each with the short-run supply curve
P 100 1000Q
i
Question: What is the short-run industry supply curve?
- Must sum firm supply curves horizontally, i.e. must sum quantities at each price.
Rearrange supply curves so Q is on the left-hand side.
P 1
Q
i 1000 10
With 200 firms, summing the above supply curve is equivalent to multiplying it by 200, i.e.
Q 200Q
i
P 1
200
1000 10
P
20
5
Finally, rearrange so P is on the left-hand side

17. P 100 5Q
Long-Run Profit Maximization
In the long run, firms can adjust fixed inputs (capital) to minimize the costs of producing the
desired level of output.
Firms operate on their long-run average and marginal cost curves
In the long run, all costs are variable.
ATC = AVC = LRAC (long-run average cost)
Still two components to choosing the profit-maximizing level of output:
1) Should we produce any output at all (i.e. remain in the industry)?
2) If we remain in the industry, how much output should we produce?
1) Should we remain in the industry?
If there exists some Q > 0 such that economic profits are greater than or equal to zero, i.e. if
(Q) P LRAC (Q) Q 0
then the firm should remain in the industry.
If not (if economic profits are negative), it means that at least one of the inputs is more highly
valued in another industry.
2) If we remain in the industry, how much output should we produce?
The rule is the same as before:
Choose the level of output such that P = LRMC (in the region where LRMC is increasing)
(see diagram)
V) Long-Run Competitive Equilibrium

18. Fact 1: Entry and exit by firms guarantees that in long-run competitive equilibrium economic
profits must be zero.
Fact 2: Firms operate on their long-run cost curves.
Facts 1 and 2 imply that in a long-run competitive equilibrium, firms produce where
P = LRMC = min LRAC
(see diagram)
Reason: (see diagram)
If P > min LRAC, economic profits would be positive and firms would enter, thereby driving
down the price.
If P < min LRAC, economic profits would be negative and firms would exit, thereby driving up
the price.
Application – Reparations for Slavery
Q: Who should pay? (Robert Fogel’s argument).
Example: Calculation of Long-Run Equilibrium
Consider 4 identical firms, each with the cost curves shown below
LRTC 4Q 2 2Q3
LRMC 8Q 6Q 2
LRAC 4Q 2Q 2
min LRAC occurs at Q 1
Note: Observe that we don’t require any information on the demand side of the market!
Question: What is the long-run equilibrium price and quantity in this market?
It helps to draw the picture for a representative firm (see diagram).
Since there are 4 identical firms, each producing 1 unit of output, the equilibrium quantity is 4.

19. To find the equilibrium price, use the fact that, for each firm, P = LRMC = LRAC at the profit-
maximizing output level Q = 1.
Thus, substitute Q = 1 into either LRMC or LRAC to get P * = 2.
Question: What are profits for a representative firm?
(Q) PQ TC(Q)
Profit Maximization
2(1) 4(1)2 2(1)2 Profit Curve
Total Curves
2 4 2 Marginal Curves
0
as must be true in long-run competitive
equilibrium.
Efficiency Properties of Long-Run Competitive
Equilibrium
1) Pareto Efficiency – all gains from trade are
realized (since MB = P = LRMC).
2) Productive Efficiency – output is produced at
the lowest possible unit cost (since each firm
produces at the min of LRAC).

20. MONOPOLY, PROFIT MAXIMIZATION:
A monopoly is presumed to produce the quantity of output that maximizes economic profit--
the difference between total revenue and total cost. This production decision can be analyzed
directly with economic profit, by identifying the greatest difference between total revenue and
total cost, or by the equality between marginal revenue and marginal cost.
The profit-maximizing level of output is a production level that achieves the greatest level
of economic profit given existing market conditions and production cost. For a monopoly, this
entails adjusting the price and corresponding production level to achieved the desired match
between total revenue and total cost.
Three Views
Profit-maximizing output can be identified in one of three ways--directly with economic profit,
with a comparison of total revenue and total cost, and with comparison of marginal revenue
and marginal cost.
This exhibit illustrates how it can be identified for a monopoly, such as that operated by Feet-
First Pharmaceutical, a well-known monopoly supplier of Amblathan-Plus, the only cure for the
deadly (but hypothetical) foot ailment known as amblathanitis. Feet-First Pharmaceutical is the
exclusive producer of Amblathan-Plus, meaning that it is a price maker and the demand curve it
faces is the market demand curve.
The top panel presents the profit curve. The middle panel presents total revenue and total cost
curves. The bottom panel presents average revenueand average total cost curves. In all three
panels, Feet-First Pharmaceutical maximizes when producing 6 ounces of Amblathan-Plus.
Profit: First, profit maximization can be illustrated with a direct evaluation of profit. If the profit
curve is at its peak, then profit is maximized. In the top panel, the profit curve achieves its
highest level at 6 ounces of Amblathan-Plus. At other output levels, profit is less.
Total Revenue and Total Cost: Second, profit maximization can be identified by a comparison of
total revenue and total cost. The quantity of output that achieves the greatest difference of
total revenue over total cost is profit maximization. In the middle panel, the vertical gap
between the total revenue and total cost curves is the greatest at 6 ounces of Amblathan-Plus.
For smaller or larger output levels, the gap is either less or the total cost curve lies above the
total revenue curve.
Marginal Revenue and Marginal Cost: Third, profit maximization can be identified by a
comparison of marginal revenue and marginal cost. If marginal revenue is equal to marginal
cost, then profit cannot be increased by changing the level of production. Increasing production

21. adds more to cost than revenue, meaning profit declines. Decreasing production subtracts
more from revenue than from cost, meaning profit also declines. In the bottom panel, the
marginal revenue and marginal cost curves intersect at 6 ounces of Amblathan-Plus. At larger or
smaller output levels, marginal cost exceeds marginal revenue or marginal revenue exceeds
marginal cost.
More on the Marginal View
Further analysis of the marginal approach to analyzing profit maximization provides
further insight into the short-run production decision of a monopoly.
First, consider the logic behind using marginals to identify profit maximization.
Marginal revenue indicates how much total revenue changes by producing one more or
one less unit of output.
Marginal cost indicates how much total cost changes by producing one more or one less
unit of output.
Profit increases if marginal revenue is greater than marginal cost and profit decreases if
marginal revenue is less than marginal cost.
Profit neither increases nor decreases if marginal revenue is equal to marginal cost.
As such, the production level that equates marginal revenue and marginal cost is profit
maximization.
Profit Maximization,
The Marginal View
With this in mind, now consider this exhibit to the
right, which will eventually contain the marginal
revenue and marginal cost curves for Feet-First
Pharmaceutical's Amblathan-Plus production.
Average Revenue: First up is the average
revenue curve, which can be seen with a click
of the [Average Revenue] button. Because
Feet-First Pharmaceutical is a monopoly, this
average revenue curve is the market demand
curve for Amblathan-Plus, which is negatively-
sloped due to the law of demand.
Marginal Revenue: A click of the [Marginal Revenue] button reveals the greenline
labeled MR that depicts the marginal revenue Feet-First Pharmaceutical receives from
Amblathan-Plus production. Because Feet-First Pharmaceutical is a price maker, this

22. marginal revenue curve is also a negatively-sloped line, and it lies beneath the average
revenue (market demand) curve.
Marginal Cost: The marginal cost curve is U-shaped, reflecting the principles of short-run
production. Click the [Marginal Cost] button to add this curve to the diagram. It has a
negative slope for small amounts of output, then the slope is positive for larger
quantities due to the law of diminishing marginal returns.
Profit Maximization: Profit is maximized at the quantity of output found at the
intersection of the marginal revenue and marginal cost curves, which is 6 ounces of
Amblathan-Plus. Click the [Profit Max] button to highlight this production level. This is
the same profit-maximizing level identified using the total revenue and total cost curves
and the profit curve.
Consider what results if marginal revenue is not equal to marginal cost:
If marginal revenue is greater than marginal cost, as is the case for small quantities of
output, then the firm can increase profit by increasing production. Extra production
adds more to revenue than to cost, so profit increases.
If marginal revenue is less than marginal cost, as is the case for large quantities of
output, then the firm can increase profit by decreasing production. Reducing production
reduces revenue less than it reduces cost, so profit increases.
If marginal revenue is equal to marginal cost, then the firm cannot increase profit by
producing more or less output. Profit is maximized.
Monopolistic Market
In monopolistic competition, there are many firms vying for control of one market. Each firm
offers a different type of product, as opposed to perfect competition in which all offer the same
product. Each firm, then, has a monopoly in the market of their own product. Thus, the firms
try to advertise their products so people buy more of their product. At the same time,
monopolistic competitors do not try to compete so as to undermine other competitors. There
are too many other businesses in a monopolistic competition to worry about them, you simply
try to get people to buy your own product as opposed to respond to others' tactics.
Monopolistic competition, because there are so many relatively weak firms, there are no
barriers to entry. Companies can enter the market relatively easily (although, of course, not as
perfectly easy as in perfect competition). This makes for a long-term equilibrium competition of
no profit. When there is profit to be made, just as in perfect competition, new companies come
in and take that profit away through expanded production and dropping prices. Unlike in
perfect competition, though, monopolistic competition has a normal downward-sloping
demand curve. The competing companies in monopolistic competition are not so much price

23. takers as price setters and thus the demand curve is sloped, not set constant at the market
price.
In monopolistic competition, there are many firms vying for control of one market. Each firm
offers a different type of product, as opposed to perfect competition in which all offer the same
product. Each firm, then, has a monopoly in the market of their own product. Thus, the firms
try to advertise their products so people buy more of their product. At the same time,
monopolistic competitors do not try to compete so as to undermine other competitors. There
are too many other businesses in a monopolistic competition to worry about them, you simply
try to get people to buy your own product as opposed to respond to others' tactics.
Monopolistic competition, because there are so many relatively weak firms, there are no
barriers to entry. Companies can enter the market relatively easily (although, of course, not as
perfectly easy as in perfect competition). This makes for a long-term equilibrium competition of
no profit. When there is profit to be made, just as in perfect competition, new companies come
in and take that profit away through expanded production and dropping prices. Unlike in
perfect competition, though, monopolistic competition has a normal downward-sloping
demand curve. The competing companies in monopolistic competition are not so much price
takers as price setters and thus the demand curve is sloped, not set constant at the market
price.
Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its
profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal
cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The
difference between the firms average revenue and average cost, multiplied by the quantity sold
(Qs), gives the total profit.
The monopolistically competitive firm's long-run equilibrium situation is illustrated in the
Figure below.

24. Long-run profit maximization by a monopolistically competitive firm
The entry of new firms leads to an increase in the supply of differentiated products, which
causes the firm's market demand curve to shift to the left. As entry into the market increases,
the firm's demand curve will continue shifting to the left until it is just tangent to the average
total cost curve at the profit maximizing level of output, as shown in Figure 1 . At this point, the
firm's economic profits are zero, and there is no longer any incentive for new firms to enter the
market. Thus, in the long-run, the competition brought about by the entry of new firms will
cause each firm in a monopolistically competitive market to earn normal profits, just like a
perfectly competitive firm.
Excess capacity. Unlike a perfectly competitive firm, a monopolistically competitive firm ends
up choosing a level of output that is below its minimum efficient scale, labeled as point b in
Figure 1 . When the firm produces below its minimum efficient scale, it is under-utilizing its
available resources. In this situation, the firm is said to have excess capacity because it can
easily accommodate an increase in production. This excess capacity is the major social cost of a
monopolistically competitive market structure.
Oligopoly Market
An oligopoly is a market dominated by a few producers, each of which has control over the
market. It is an industry where there is a high level of market concentration.
However, oligopoly is best defined by the conduct (or behaviour) of firms within a
market rather than its market structure.

25. The concentration ratio measures the extent to which a market or industry is dominated by a
few leading firms. Normally an oligopoly exists when the top five firms in the market account
for more than 60% of total market demand/sales.
Price leadership – tacit collusion
Another type of oligopolistic behaviour is price leadership. This is when one firm has a
clear dominant position in the market and the firms with lower market shares follow the pricing
changes prompted by the dominant firm. We see examples of this with the major mortgage
lenders and petrol retailers where most suppliers follow the pricing strategies of leading firms.
If most of the leading firms in a market are moving prices in the same direction, it can take
some time for relative price differences to emerge which might cause consumers to switch their
demand.
Firms who market to consumers that they are “never knowingly undersold” or who claim to be
monitoring and matching the cheapest price in a given geographical area are essentially
engaged in tacit collusion. Does the consumer really benefit from this?
Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive
response, e.g. avoiding price cutting or not attacking each other’s market
Explicit collusion under oligopoly
It is often observed that when a market is dominated by a few large firms, there is always the
potential for businesses to seek to reduce market uncertainty and engage in some form of
collusive behaviour. When this happens the existing firms decide to engage in price fixing
agreements or cartels. The aim of this is tomaximise joint profits and act as if the market was a
pure monopoly. This behaviour is deemed illegal by the UK and European competition
authorities. But it is hard to prove that a group of firms have deliberately joined together to
raise prices.
Price fixing
Collusion is often explained by a desire to achieve joint-profit maximisation within a market or
prevent price and revenue instability in an industry. Price fixing represents an attempt by
suppliers to control supply and fix price at a level close to the level we would expect from a
monopoly.
To fix prices, the producers in the market must be able to exert control over market supply. In
the diagram below a producer cartel is assumed to fix the cartel price at output Qm and price
Pm. The distribution of the cartel output may be allocated on the basis of an output quota
system or another process of negotiation.

26. Although the cartel as a whole is maximising profits, the individual firm’s output quota is
unlikely to be at their profit maximising point. For any one firm, within the cartel, expanding
output and selling at a price that slightly undercuts the cartel price can achieve extra profits.
Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same. If all
firms break the terms of their cartel agreement, the result will be an excess supply in the
market and a sharp fall in the price. Under these circumstances, a cartel agreement might break
down.
Collusion in a market or industry is easier to achieve when:
There are only a small number of firms in the industry and barriers to entry protect the
monopoly power of existing firms in the long run.
Market demand is not too variable
Demand is fairly inelastic with respect to price so that a higher cartel price increases the
total revenue to suppliers in the market
Each firm’s output can be easily monitored – this enables the cartel more easily to
control total supply and identify firms who are cheating on output quotas.