STUDY GUIDE AND REVIEW FOR TEST III
Econ 2302 Microeconomics
Test covers Chapters 12 – 17
12.
13.
14.
15.
16.
17.
Perfect Competition
Monopoly
Oligopoly
Monopolistic Competition
Externalities and Public Goods
Asymmetric Information (Adverse Selection and Moral Hazard)
I. Understand these four Market structures:
perfect competitor
monopoly
monopolistic competitor
oligopoly
Know examples and characteristics of each market structure: number of
firms, nature of demand, and nature of product—differentiated or not (i.e.
fungible) , ease of a firm to enter or exit the industry
Understand these key decision points: maximum profit position;
breakeven point; shutdown and exit industry points.
The short term economic environment is in some ways the same for
the Monopoly, Oligopoly, and Monopolistic Competitor. The
Monopoly is content to stay in the short-term position forever, but
needs barriers of entry in order to preserve its monopoly position.
So its short term is the same as its long term as long as it is
successful in remaining a monopoly. The others are pushed into a
different long term equilibrium position, because other firms enter
the industry as long as there is a profit. When all profit is squeezed
out, i.e. when P = ATC, other firms are no longer are attracted to
enter the industry. Neither do they need to exit since recall that
the ATC includes both explicit and implicit costs, and one of the
implicit costs is the opportunity cost of the inputs of the firm’s
owner. Thus, his/her normal profit is included. This is the minimum
that keeps him or her in the business. Thus, at the breakeven point
there is no economic profit, but there is the included normal profit.
This is equal to the imputed value of the owner’s opportunity cost.
So, at the long term breakeven position there is no attraction for
firms to enter or exit.
II. Understand the characteristics of each of the market structures.
Consider these salient characteristics:
Number of firms; nature of the product the firm produces; ease or difficulty of
entry and exit -- barriers to entry; ability to influence price; the nature of its
demand curve, etc. To these also consider how firms in each market structure
might advertise or conduct research and development. Know examples of
firms in each of these four market structures.
III, Consider these basics that apply to all firms in any of these market structures.
A. To maximize the firm’s profit each seeks to produce at an output
level at which MC = MR.
B. They all have fixed costs and variable costs
C. Eventually marginal costs rise. In the early levels of
production, MC may fall. But eventually they rise because
eventually diminishing returns set in.
D. Marginal costs may fall (pulling down average costs) as firms
benefit from division of labor and specialization. However,
when diminishing returns set in, marginal coast rise and pull up
average total cost.
E. With the cost of each extra unit of output (MC), the Average
Total cost is being redefined. If lower than ATC, MC pulls the
average down. If higher than ATC, then MC pulls the average
up…..So, MC always crosses the ATC at the minimum ATC.
(Think about my example of your Grade Point Average and each
marginal course you take.)
F. The decision to close down or not depends on whether price
covers variable costs or not. If Price is greater than average
variable costs, then the excess pays part of fixed cost, rendering
it advantageous to continue in business even at a loss. That loss
is less than closing the business completely, since if the business
is closed, it would still have to pay the fixed cost. The firm does
not need to lose more than the Fixed Cost.
IV. Consider these basics that are different among the market structures
A.. The Nature of the demand and Marginal Revenue.
1. The Perfect Competitor is a market taker since the Perfect
Competitor faces a perfectly elastic demand curve. Depicted by a
horizontal demand curve. The Perfect Competitor can sell any
quantity at the industry price.
2. Since the Perfect Competitor’s demand curve does not decline,
the marginal revenue curve does not decline either.
3. Thus, Marginal revenue is equal to Price for the Perfect
Competitor
4. Marginal Revenue is less than Price for the Monopoly, the
Monopolistic Competitor, and the Oligopoly. They may sell
more output, but they do so at a lower price. And as Price
declines Marginal Revenue also falls. If they choose a higher
price, they give up some quantity demanded. These firms face
a Price – Quantity Demanded decision.
B. For the Perfect Competitor in the long run P=MR=MC= ATC at its minimum
Thus, in the long term breakeven point, (when all firms entering and exiting
the industry is completed), society is getting the maximum output, at the
minimum average cost, and at a Price that equals marginal cost.
Price represents the benefit derived for the buyer. Thus, marginal benefit =
marginal cost. This maximizes society’s position and is the maximum
efficiency of resource allocation.
C. For the other market structures, P > MR =MC and the firm’s maximum profit
output quantity is not at the minimum ATC. Society would be willing to pay
a Price higher than Marginal Cost, but this position is not in the maximum
profit making interest of the firm, who stops at MC =MR, which is < P.
Understand that this concept is at the heart of antitrust legislation that seeks to
prevent or at least regulate chartered monopolies and oligopolies. This position is
a hotly debated position among economists, business persons, lawyers, and the
issues associated with these concepts fill law libraries. Understand these concepts
so you can enter this discussion. (Good Luck.)
D. With an understanding of firms in the four market structures, how would you
assess their behavior with advertising decisions, with research and
development decisions? Pricing and output decisions?
V. Understand these points for each of the markets structures:
G. Profit maximization point: MC = MR
H. The Breakeven point: Zero Economic Profit P = ATC
I. The shut down -- go out of business point. P can’t cover AVC
VI. Understand these concepts and points:

Monopolies can be resource monopolies; sanctioned
monopolies sustained by copyrights, patents, or charters;
or natural monopolies that exist because a market can
sustain only one firm – a forced division would cause each
to “ride up its cost curve” and be unable to survive or it
might survive at the added expense to consumers. Society
often extends a franchise that allows a monopoly but
Society regulates rates. This is a compromise to obtain the
advantage of size but avoid the abuse of power.







Oligopolies have few participants (2 – 12) and are best
understood through game theory: the few firms
strategically engage in price and business actions but avoid
the illegal practice of explicit collusion. They sometimes
undertake implicit price leadership behavior, and actions
that can be depicted by kinked or cornered demand curves.
These arise if other firms match one firm’s reduction in
price, but do not match an increase in price.
Oligopolies would like to be monopolies. There are a few
firms and they know each other and they can see benefits if
they collude. (However, they can go to jail for colluding.
Don’t even think about it!)
Oligopolies are sometimes defined by Market share
concentration, for example, the “four firm ratio.” (The top 4
firms in an industry comprise about 45% market share)
Oligopolies that form cartels are in essence trying to
behave as a monopoly. OPEC is an example. (Cartels to
fix price and interfere with commerce are not legal in the
U.S.)
Barriers to entry clearly may arise from controlling a basic
resource, by copyright or patent, or by large financial
requirements.
What is meant by “a normal profit”?
What are “accounting profits” and “economic profits”?
VII. Other Concepts:
What is meant by Resource Monopoly? (A firm controls all the basic
resource supply – e.g. for a time, DeBeers controlled diamonds; Alcoa
controlled aluminum.)
What is a Natural Monopoly? (the capital requirements and the size of the
market allow only one successful firm in a particular market – often: a
utility company such as a power plant.)
VIII. Be comfortable with the following dynamics underlying the cost and
revenue curves:
Profit Maximization point/loss minimization point is : MC = MR
This is fundamental to all market structures.
Total revenue (Price x Quantity)
Marginal Revenue
Why does Marginal Revenue = Price for the Perfect
Competitor?
Why is MR < P for all the other market structures?
Review all costs:
Total cost = fixed cost + variable cost
Understand average Variable cost AVC
average fixed cost AFC
Marginal costs MC
Average total costs ATC
Law of Diminishing Marginal Returns (for example: using a plant more
intensely; adding more of some factors of production while holding others
constant—the output of the factor held constant will at some point
diminish – this is where “diminishing returns set in”..)
When does the firm exit the business? The Shut down point for a firm
(price is less than AVC. A firm’s Maximum loss is its fixed cost, so if all
variable costs are being covered, the firm is able to pay part of the fixed
cost. Thus, it is better to continue in business even it is operating at a
loss. The loss would be even greater if it shut down, since it would still
be responsible for the full fixed cost. In the long run, it of course would
have to shut down if TR < TC which is to say if ATC < AR (P).
Importance of MC = MR (Profit maximization or loss
minimization rule). This is a fundamental for all firms in
all market structures. For the Perfect Competitor MR = P; for the
others MR < P
Review: What are Explicit and Implicit costs ?
Total Revenue – Total Cost = Profit
Accounting Profits (Total Revenue less explicit cost)
Economic Profit (Total Revenue less both explicit and implicit cost). This
is the same as saying Total Revenue less Total Costs (Total cost to an
economist includes both explicit and implicit costs)
What is meant by Normal profit? (the opportunity cost of the firm owner’s
own time or use of the owner’s own capital or land)-- i.e. what he/she
could make working for someone else.)
Price taker – such as the perfect competitor who has no control over
price.
Cartels and cartel pricing (Oligopolies behaving as monopoly as OPEC
tries to do)
What is Collusion? (We saw in game theory that unregulated oligopolies
tend toward collusion.)
What is meant by the kinked demand curve (or cornered demand curve)?
elastic
above a price point and inelastic below it: this renders it
kinked. (Airline fare matching on downside and not matching on upside .
is good example of cornered demand curve.)
Balanced and unbalanced Oligopoly
What is the Herfindahl-Hirschman Index? How is it used by Federal
Trade
Commission or Justice Department?
< 1000 generally no concern with concentration in an
industry
1000—1800 mergers and acquisitions may be questioned, especially
if
result increases H-H Index by 100 or more
> 1800 almost certain concern and perhaps merger or acquisition
disallowed if H-H Index increases by 50 or more
IX. EXTERNALITIES
A. A pure Free market (ala Adam Smith and the “invisible hand”) results in an
equilibrium price based on supply and demand, and this price influences
how we as a society allocate our scarce resources. However, this
process may not include “spillover” costs or benefits that affect third
parties. When these external costs or benefits are not considered, society’s
resources are not allocated in an optimum manner. Since economics
wrestles with the allocation of society’s scarce resources, we must
consider EXTERNALITIES.
B. Negative externalities exist when external COSTS exist; Positive externalities
Exist when external benefits exist.
Negative externalities. Cigarette smoking and medical costs
associated with lung cancer or environmental pollution were
examples of negative externalities discussed in class. Unless we
internalize these externalities we would overproduce cigarettes as
well as the goods that are associated with the environmental
pollution.
Positive externalities. The “spillover” benefit from education is an
example we discussed in class. Unless we “internalize these benefits from
education, we would under produce education.
Depending on circumstances, we can use fines, taxes, subsidies, legal
proceedings, etc. to solve problems arising for externalities. In some
cases the private sector can sort out and correct externalities – Ronald
Coarse who advocates what we know as the Coarse Theorem argues that
The state is not always the only solution to solving externality issues.
X. PUBLIC GOODS
A. Public goods have two defining characteristics: they are non-rival and nonexcludeable .
Understand the distinction between rival and non-rival
Understand the difference between excludeable and non-excludeable
B. The private sector eagerly produces goods that are rival and excludeable, but
there is little or no incentive for the private sector to produce goods that
are non-rival and non-excludeable. Hence we may have a “market failure”
to produce goods and services such as: national defense, street lights,
judicial systems, etc. If produced at all, these goods and services are
Produced by the state.
C. Be clear that the state often produces “private goods”: such as a cabin at a
Texas state park. Such a good or service is excludeable and rival. We do
this because we consider these goods “Merit Goods” -- good for society.
We consider art galleries, libraries, parks, etc. to be merit goods.
(“Demerit goods” are goods that we as a society consider “bad” for us—
e.g. cigarettes or alcohol. These often attract taxes and regulation.)
D. Other concepts to review:
Freerider; “tragedy of the commons”
XI. ASYMETRIC INFORMATION
A. Adverse selection. A situation in which an informed party benefits in an
exchange because he or she knows more than the other party. A health
insurance company wants to sell insurance to a whole group. If it is NOT
a group policy, and each person is allowed individually to buy or not buy
the insurance. Those that know they are healthy and know they rarely
Get sick or call a doctor, may opt out of buying the insurance policy.
They basically “self-insure themselves”. The statistical base now changes
for the insurance company. The selection process may ultimately lead to
the insurance company only insuring hypochondriacs. This is why
insurance companies want group policies – they can calculate the
probabilities statistically and charge rates accordingly. They do not want
to be caught with adverse selection working against them.
B. Moral Hazard refers to changing your behavior and taking more risk after you
are insured. Consider our recent banking crisis: Banks normally
scrutinize applicants very thoroughly before making loans. After the
banks were guaranteed protection by government agencies, the banks
made NINJA loans (“No Income; No Job, Allright”) or “Liars’s Loans:
The Bank: “What’s your income?”
Applicant: “A million a year.”
The Bank” “Fine, here’s your loan.”
After being insured, the bank changed its “moral obligation to
perform as it was expected to.”