Chapter 5
COMPETITION AND MONOPOLY: VIRTUES AND VICES
The Chapter in a Nutshell
1. A perfectly competitive market is characterized by many sellers and buyers, firms that
produce a standardized product, perfect information among buyers and sellers, and easy entry
into and exit from a market.
2. Because a perfectly competitive firm supplies a negligible share of the market output, it has
to "take" or accept the price that is determined in the market.
3. Given favorable demand conditions, a firm will maximize total profit by selling that output at
which marginal revenue equals marginal cost.
4. If total revenue exceeds total variable cost, a firm would minimize short-run losses by
producing where MR = MC rather than shutting down. As a result, losses are less than the
fixed-cost losses that would exist if the firm shut down.
5. Because of easy entry into and exit from a market, perfectly competitive firms operate at the
lowest possible cost, charge the lowest price they can without going out of business, and earn
no economic profit. These characteristics are ideal for the consumer.
6. Barriers to entry are impediments, created by government or the firm or firms already in the
market, that protect an established firm from potential competition. Among the major
barriers to entry are legal barriers, control over essential resources, and economies of scale.
7. A monopoly differs from a perfectly competitive firm in that the monopoly's demand curve
and marginal revenue curve are down sloping rather than horizontal. Like a perfectly
competitive firm, a monopolist will maximize total profit by operating where marginal
revenue equals marginal cost.
8. Given identical costs, a monopolist would find it profitable to produce a smaller output and
charge a higher price than a perfectly competitive firm. Moreover, a profit-maximizing
monopoly would not operate at the minimum point on its average total cost curve in the long
run. However, economies of scale may make lower average total cost more attainable for a
monopoly than for a competitive firm. Moreover, a monopolist generally has greater
financial resources for research and development programs than a competitive firm, which
make it possible for the monopolist to achieve lower cost per unit.
Chapter Objectives
After reading this chapter, you should be able to:
1. Describe how a perfectly competitive firm maximizes profits or minimizes losses.
2. Explain how a perfectly competitive firm achieves economic efficiency in the long run.
3. Identify factors that contribute to monopoly.
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Chapter 5: Competition and Monopoly: Virtues and Vices
4. Develop a model that illustrates profit maximization and loss minimization for a monopoly.
5. Assess the advantages and disadvantages of a perfectly competitive firm and a
monopoly
Knowledge Check
Key Concept Quiz
1. standardized product
2. price taker
3. marginal revenue
4. marginal cost
5. profit maximization
6. shut-down rule
7. perfect competition
8. monopoly
9. barriers to entry
10. natural monopoly
11. privatization
12. perfect information
_____ a. a guide for a firm realizing losses in the short run
_____ b. increase in total revenue from the sale of another
unit of output
_____ c. when buyers and sellers are fully aware of market
opportunities
_____ d. when MR = MC
_____ e. implies irrelevance of brand loyalty
_____ f. new firms cannot enter the market
_____ g. increase in total cost that results from the
production of another unit of output
_____ h. a market structure characterized by a single
supplier
_____ i. change in ownership to allow a company to
operate on a for-profit basis
_____ j. characteristic of a perfectly competitive firm
_____ k. when a firm can supply the entire market at a
lower unit cost than would be achieved by two or
more firms
_____ l. the most competitive market structure
Multiple Choice Questions
1. The soft-drink market is NOT a perfectly competitive market because
a.
b.
c.
d.
new firms cannot enter this market
there are very few buyers in this market
there are only two sellers in this market
the product sold is not homogeneous
Chapter 5: Competition and Monopoly: Virtues and Vices
47
2. A competitive firm sells at a price that is decided by
a.
b.
c.
d.
the federal government
the firm
the buyers of the product
interaction of all the suppliers and consumers of the product
3. The demand curve for a competitive firm is
a.
b.
c.
d.
drawn as a horizontal line
price line
determined by the market price
all of the above
4. For a competitive firm the marginal revenue curve is
a.
b.
c.
d.
an upward-sloping curve
a horizontal line
a downward-sloping curve
a vertical line
5. If New England Fishing Co. is a perfectly competitive firm, then its
a.
b.
c.
d.
MR is constant
MR > P
MR < P
MR must increase as output increases
6. If Gap operates as a profit-maximizing firm, it must be operating at an output where,
a.
b.
c.
d.
MR = MC
MR > MC
MR < MC
MR is maximum
7. If all sport-utility vehicles are sold in a perfectly competitive market at the profit-maximizing
output for each firm, price
a.
b.
c.
d.
equals marginal cost
is less than marginal cost
exceeds marginal cost
exceeds all costs
8. Suppose that a preference for synthetic fibers decreases the demand for cotton clothing. This
forces Banana Republic, which mostly sells cotton products, to sell at a price that is lower
than its average total cost and eventually to shut down its production. Banana Republic’s
losses
a.
b.
c.
d.
are equal to zero
are equal to its fixed cost
are equal to its variable costs
cannot be determined
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Chapter 5: Competition and Monopoly: Virtues and Vices
9. If a steel maker facing plunging prices is able to change a price that exceeds its average
variable cost but is less than its average total cost, in the short run the firm should
a.
b.
c.
d.
shut down
keep producing at the output level where MC = MR
reduce the price it charges
lobby Congress for import restrictions on foreign steel
10. The short-run supply curve of a perfectly competitive firm
a. corresponds to the segment of its marginal cost curve that lies above the average
variable cost curve
b. cannot lie below the average total cost curve
c. is downward-sloping
d. is higher than the marginal cost curve
11. If Amazon.com is operating in a competitive market, in the long run it will
a.
b.
c.
d.
earn zero economic profits
earn positive economic profits
earn negative economic profits
it will go out of business
12. If Microsoft continues to earn economic profits in the long run, one should conclude that
a.
b.
c.
d.
it is the best company ever created
it is producing at the minimum point on the long-run average total cost curve
it is not producing at an output where MC = MR
there are significant barriers to entry in the market
13. If AOL.com is able to eliminate all its competition and emerges as a monopoly, then it
a.
b.
c.
d.
is assured that AOL.com will always earn economic profits
will product at an output where MC = MR, if profit maximization is the objective
will always recover all its variable costs
can charge any price it wishes without consideration of its marginal costs
14. All of the following may allow a local cable company to operate as a monopoly, except
a.
b.
c.
d.
control over essential inputs
lack of close substitutes
barriers to entry
price-taking behavior
15. Even in the long run, a monopolist can change a price
a.
b.
c.
d.
that exceeds the minimum average total cost
that is decided by the firm
that exceeds marginal revenue
all of the above
Chapter 5: Competition and Monopoly: Virtues and Vices
49
16. As a monopolist, suppose that DeBeers produces more than the profit-maximizing output. As
a result
a.
b.
c.
d.
average total cost will exceed price
marginal revenue will exceed average total cost
marginal cost will exceed marginal revenue
marginal revenue will exceed average variable cost
17. Comparing a monopolist to a perfectly competitive firm
a.
b.
c.
d.
the monopolist is a price taker and the competitive firm is a price maker
the monopolist is a price maker and the competitive firm is a price taker
both are price takers
both are price makers
18. A monopolist’s demand curve differs from that of a perfectly competitive firm in that the
monopolist’s demand curve is
a.
b.
c.
d.
perfectly elastic and thus horizontal
perfectly inelastic and thus vertical
perfectly elastic at high prices and perfectly inelastic at low prices
identical to the industry demand curve
19. Which aspect of agriculture would best illustrate perfect competition?
a.
b.
c.
d.
Land O’Lakes’ national advertising program for its dairy products
Grapefruit producers organized under the Sunkist cooperative
Wheat farmers forming a cartel to restrict output and drive up price
Corn farming by thousands of farmers throughout the United States
20. A perfectly competitive firm’s short-run supply curve is the segment of the
a.
b.
c.
e.
marginal cost curve that lies above the average total cost curve
marginal cost curve that lies above the average variable cost curve
average total cost curve that lies above the marginal cost curve
average variable cost curve that lies above the marginal cost curve
21. The U.S. Postal Service (UPS) has a monopoly on the delivery of first-class letter mail, which
is the result of
a.
b.
c.
d.
a legal, exclusive franchise to deliver letters
the USPS’s control over the supply of workers that can deliver mail
a natural monopoly caused by diseconomies of scale
relatively low wages paid to postal employees
22. Owners of cable television companies have traditionally justified their monopoly status on
the grounds that cable television is an industry characterized by
a.
b.
c.
d.
a relatively small number of firms
substantial economies of scale
low fixed costs and high variable costs
high employee costs due to strong labor unions
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Chapter 5: Competition and Monopoly: Virtues and Vices
23. Critics of America’s public system have argued that _______ is (are) needed to encourage
public schools to meet the needs of the children and parents it serves
a.
b.
c.
d.
stronger unions for teachers
a voucher system
less competition
a socialistic economy
24. In the short run, a perfectly competitive firm can
a.
b.
c.
d.
realize an economic loss
realize a normal profit
realize an economic profit
any of the above
25. In the long run, a perfectly competitive firm will realize a (an)
a.
b.
c.
d.
normal profit
economic profit
economic loss
any of the above
26. Relative to a monopoly, the price that a perfectly competitive firm would charge, given
identical costs, is
a.
b.
c.
d.
higher than the monopoly
the same as the monopoly
lower than the monopoly
not comparable to the monopoly
True-False Questions
1.
T
F
A perfectly competitive firm is a price maker.
2.
T
F
The demand curve of a competitive firm is always downward-sloping.
3.
T
F
New firms can enter a perfectly competitive market with ease.
4.
T
F
A perfectly competitive firm changes a price that is higher than its
marginal cost.
5.
T
F
A perfectly competitive firm earns marginal revenues that exceed the
price.
6.
T
F
At the level of output where MR = MC, both the perfectly competitive
firm as well as the monopolist maximize profits.
7.
T
F
A perfectly competitive firm will shut down its production when it
cannot recover all of its variable costs.
8.
T
F
The supply curve of a perfectly competitive firm lies above the average
variable cost.
9.
T
F
In the long-run, a perfectly competitive firm cannot earn positive
economic profits.
Chapter 5: Competition and Monopoly: Virtues and Vices
51
10.
T
F
In the long run, a perfectly competitive firm may incur economic losses.
11.
T
F
In the long run, a perfectly competitive firm behaves like a price maker.
12.
T
F
In the long run, a perfectly competitive firm produces at the point where
P = MR = minimum ATC.
13.
T
F
A perfectly competitive market is characterized by homogeneous
products.
14.
T
F
Monopolists maximize profits by changing prices that equal marginal
revenue.
15.
T
F
In maximizing profits monopolists do not follow the MC = MR rule.
16.
T
F
There are significant barriers to entry in monopoly markets.
17.
T
F
In the long run, monopolies earn zero economic profits.
18.
T
F
Monopolists always charge prices that exceed their average total cost.
19.
T
F
Monopolies may result from economies of scale.
20.
T
F
A monopoly typically produces less than a perfectly competitive firm.
21
T
F
If the American school system adopted a system of vouchers, public
schools would face additional competition from private schools.
22.
T
F
Established airlines have benefited from barriers to entry in the form of
restricted access to takeoff and landing slots at many large airports.
23.
T
F
Diseconomies of scale have contributed to the natural monopoly status of
many public utilities.
24.
T
F
25.
T
F
De-Beers is an example of a perfectly competitive firm in the diamond
industry.
The U.S. Postal Service has an exclusive franchise to deliver all package
mail in the United States.
26.
T
F
Concerning the U.S. airline industry, research has shown that when the
market share of the dominant airline falls, fares tend to increase.
27.
T
F
If Northern States Power Co. is a natural monopoly, its long run average
total cost curve is upward sloping.
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Chapter 5: Competition and Monopoly: Virtues and Vices
Application Questions
1. a. The following table shows price and quantity data for Jevis, a jeans manufacturer’s
demand schedule. Complete the columns for total revenue and marginal revenue; then
plot the demand and marginal revenue curves on the graph below that show the average
total cost and marginal cost for the firm.
Price ($/pair)
Total
Revenue
Quantity
30
1,000
25
2,000
20
3,000
15
4,000
10
5,000
5
6,000
Marginal
Revenue
30
ATC
MC
Price
20
10
0
-10
-20
1000
2000
3000
4000
5000
6000
Quantity of Jeans
b. What is the firm’s profit-maximizing level of output? Will this firm make a profit? If so,
shade the area, label it profit, and calculate the size of the profit.
2. The two graphs drawn below show a perfectly competitive firm in a short-run equilibrium
and in long-run equilibrium. Which is which? How do you know? In each graph, label the
profit-maximizing level of output with Q*, the profit maximizing price with P*, and shade
the area of profit or loss. How will this market make the transition from short-run to long-run
equilibrium?
Price
Price
MC
MC
P = MR
Chapter 5: Competition and Monopoly: Virtues and Vices
3. Consider the graph of the perfectly competitive firm shown below. Does this firm make a
profit or a loss? Shade the area of profit or loss. If the firm is incurring a loss, should it
continue to produce in the short run? Explain.
Price
MC
ATC
AVC
P = MR
Quantity
Answers to Knowledge Check Questions
Key Concept Answers
1. e
5. d
9.
f
53
54
2. j
3. b
4. g
Chapter 5: Competition and Monopoly: Virtues and Vices
6. a
7. l
8. h
10.
11.
12.
k
i
c
Multiple Choice Answers
1. d
6. a
2. d
7. a
3. d
8. b
4. b
9. b
5. a
10. a
11.
12.
13.
14.
15.
a
d
b
d
d
16.
17.
18.
19.
20.
c
b
d
d
b
21.
22.
23.
24.
25.
a
b
b
d
a
26. c
True-False Answers
1. F
6. T
2. F
7. F
3. T
8. T
4. F
9. T
5. F
10. F
11.
12.
13.
14.
15.
F
T
T
F
F
16.
17.
18.
19.
20.
T
F
F
T
T
21.
22.
23.
24.
25.
T
T
F
F
F
26. F
27. F
Application Question Answers
1. a.
The completed table is shown below.
Quantity
Total
Revenue
30
1,000
30,000
25
2,000
50,000
20
20
3,000
60,000
10
15
4,000
60,000
0
10
5,000
50,000
-10
5
6,000
30,000
-20
Price ($/pair)
Marginal
Revenue
The graph with the demand and marginal revenue curves plotted is shown below.
Chapter 5: Competition and Monopoly: Virtues and Vices
55
30
ATC
MC
20
Profit
Price
10
D
0
-10
MR
-20
1000
2000
3000
4000
5000
6000
Quantity of Jeans
b.The firm’s profit-maximizing level of output can be read from the graph above as 3,000
pairs of jeans. This is the level of output that corresponds to MR = MC. The price at this
level of output is read from the demand curve—$20 per pair. The firm makes a profit that is
equal to the area of the rectangle labeled profit— ($20 - $15) x 3,000 = $15,000
2. The graph to the left shows the firm in short-run equilibrium earning economic profit. This
has to be a short-run situation because the profit won’t persist in the long run. The profit will
be a signal for new firms to enter the market. As entry occurs, the market supply curve will
shift to the right causing the price to fall. Entry continues and price falls until economic
profit is zero. This occurs when the marginal revenue curve is tangent to the average total
cost curve as its minimum point, shown in the graph to the right.
Price
Price
MC
P*
MC
P = MR
Profit
ATC
ATC
AT
P = MR
P*
Q*
Quantity
Q*
Quantity
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Chapter 5: Competition and Monopoly: Virtues and Vices
3. This firm incurs a loss. The area of the loss is shown in the graph below as the rectangle
labeled “loss” that is bounded on top and to the right by the dashed line. This firm should
continue to produce in the short run because it has enough total revenue to cover its total
variable costs and a portion of its total fixed cost. We know this is the case because the price
(marginal revenue) is greater than minimum average variable cost.
Price
MC
ATC
AVC
P = MR
Quantity