DEFINITION OF 'PERFECT COMPETITION'
A market structure in which the following five criteria are met:
1) All firms sell an identical product
2) All firms are price takers - they cannot control the market price of their product
3) All firms have a relatively small market share
4) Buyers have complete information about the product being sold and the prices charged by each firm
5) The industry is characterized by freedom of entry and exit.
Perfect competition is sometimes referred to as "pure competition".
Price Elasticity of Demand

Individual firm VS
Demand curve is Horizontal
Demand curve is perfectly elastic
Firm cannot increase or decrease price
Market demand (industry)
Downward
 Total Revenue
TR = Price*unit sold
 Average Revenue = Total revenue/unit sold
 Marginal Revenue = change in total revenue/ change in unit sold
Profit Maximizing in Short Run
Total Revenue and Total Cost
Profit is equal to total revenue minus total cost, so the profit maximizing output level is where there is the greatest vertical distance between total revenue and total cost. At that point, the slope of the total revenue line is the same as the slope of the total cost curve. Note that since the price remains constant at each quantity, the total revenue line is a straight line with a slope that is equal to the price of the good. The slope of the total revenue is the marginal revenue and the slope of

the total cost curve is the marginal cost. Since at the profit maximizing quantity the slopes of both curves will be the same, profits are maximized where marginal revenue equals marginal cost.
Marginal revenue is the additional revenue generated from selling one more unit of output. The formula is the change in total revenue divided by the change in quantity or output. Total revenue is the price times quantity and since the price is constant for each good sold, the marginal revenue in a purely competitive market is simply the price of the good. Thus in pure competition, the demand is equal to the marginal revenue which is also equal to the average revenue.

A firm will always maximize profits or minimize losses, if it produces where the marginal revenue equals the marginal cost. A firm evaluates if incurring the additional cost is offset by the additional revenue generated. For example, at 30 units of output is it worth 20 cents more to get
65 cents? Certainly. The firm will continue to increase output up to the point where the marginal cost is equal to the marginal revenue, which in our example occurs at 70 units of output. If we produced 80 units, the marginal cost of 70 cents would be greater than the marginal revenue of 65 cents and profits would decline.

If we go to the exact quantity where marginal revenue equals marginal cost, then for the last unit produced there was no increase in the profits. For example, at 70 units the marginal revenue and marginal cost are 60 cents and the profits of 5 dollars is the same as the profits at 60 units.
However, by following the rule of going to the point where marginal revenue equals marginal cost, there will not be another quantity that will yield greater profits.

For pure competition, to solve graphically, we combine our costs curves with the demand curve, which is also our marginal revenue curve and find the quantity where marginal revenue equals the marginal cost. The area representing total revenue, which is price times quantity, is shown in the shaded box.

The total cost can be computed by taking the average total cost at the profit maximizing quantity times the quantity. Profit is total revenue minus total cost and is represented by the upper shaded box.

Why do some businesses open at 9 am and close at 5 pm while others stay open till 11 pm, or are open all night? Would it ever be a wise decision for a business to continue to stay open, in the short run, if it is losing money? The answer depends on the firm’s fixed costs, the additional revenue it generates by being another hour, and the additional costs (variable costs) it incurs by being open another hour.
Producing at a Loss
Recall that in the short run, firms have fixed costs that must be paid regardless. Thus if a firm can cover its variable costs and still have revenue to contribute to its fixed costs, it loses less money by producing than by shutting down. Our rule of producing where marginal revenue equals marginal cost still applies, but since price is below ATC the firm’s loss is represented by the area below ATC and above the demand curve. Even though the firm continues to produce, the amount of production is less than when the price was higher.

The average fixed cost is the vertical distance between average total cost and average variable cost, thus if the firm decided to shut down the firm would still have to pay the total fixed costs, which is represented by the shaded area in the graph on the right.
As demonstrated in the table, if the price is below average total cost but above average variable cost, losses are minimized by producing 50 units and incurring a loss of $3.50. If the firm shut down, it would still have to pay fixed cost of five. Since average variable costs at 50 units is 42 cents and the price is 45 cents, it covers the variable costs and contributes three cents on each unit toward the paying the fixed costs. Three cents times 50 units is $1.50 which is the amount the firm has reduced their loss by producing instead of shutting down.

Shut Down Below AVC
If the price drops below the average variable cost, the firm is unable to cover even the variable cost and can reduce the loss by shutting down and paying only the fixed costs.

The firm losses less money by shutting down and only incurring the fixed costs of five dollars than by producing and losing even more.

With low barriers to entry, if the industry is making an economic profit there is an incentive for other firms to enter the business. As more firms enter, the supply of the product increases, driving down the price and reducing the profits. This will continue until the firm’s economic profit is reduced to zero. At an economic profit of zero, firms are still earning a normal profit, which is a return sufficient to maintain the resources in their current use. Recall that in the long run, all inputs are variable. It is for this reason that we don’t have fixed costs and that we make no distinction between variable costs and total costs

If firms are sustaining economic losses, they will eventually exit the industry due to the high opportunity costs. As firms leave, the market supply shifts to the left and the price rises reducing the losses.
In the short run firms may earn economic profits or losses, but in the long run economic profits can be expected to be zero and firms will earn only normal profits. In the long run, firms are both productively and allocatively efficient. Since the marginal cost curve intersects the average cost curve at the minimum, and firms produce where marginal revenue is equal to marginal costs, firms will be productively efficient (recall productive efficiency means “least cost” since we are at the minimum ATC, we must be at least cost). Moreover, in this market there is a strong incentive to adopt new technologies which reduce costs. Since there is easy entry into the market, if a firm fails to adopt the new technologies that reduce costs, it will eventually be forced out of the market since it is not producing at the lowest average cost.
Firms are also allocatively efficient and produce where the price is equal to the marginal cost. In the market graph on the right, demand reflects the willingness to pay by consumers and the

supply curve reflects the marginal cost. At the quantity produced, economic surplus which is the area of consumer and producer surplus is maximized. The purely competitive market is a useful benchmark when examining other market structures, because it is both productively and allocatively efficient.
Practice
The state of Illinois is known for having some of most fertile soils in the nation, while parts of
Missouri have marginal (low productivity) soils. If the yield per acre is greater in Illinois and the price of the output (corn, wheat, soybeans) is the same for both states, will Illinois farmers make greater profits than Missouri farmers in the long run? Explain why or why not?

Although Illinois farms would be expected to have higher yields, we would expect the economic profits in both states to be zero in the long run. The price will be the same for all farms, but we would anticipate that land in Missouri would sell or rent for less than land in Illinois since it is more productive.
Long Run Supply
If the prices of the resources do not change as their demand changes, then the long run average cost curve for individual firms remains the same as market production increases and decreases.
This would likely be the case, if an industry makes up a relatively small portion of the overall demand for the inputs. If this were the case, the long run supply curve would be horizontal and the price of the good would remain constant as output expands or contracts.

Most industries have increasing costs such that as the quantity of the output increases, production costs also increase. Likewise if output falls, the price of the inputs will also decrease due to the decreased demand. In our wheat example as output increases, production costs such as the price of farmland increases shifting the average cost curve upwards. This would result in an upwardsloping long-run supply curve.

In a decreasing cost industry, the long run supply curve is downward sloping since as output increases and new firms enter, production costs decline. The computer industry is an example of a downward sloping supply curve, since as the number of computers produced increased, the price of inputs, such as chips, decline.

Key Points for Pure Competition in the Long Run
1. Short run economic profits (losses) leads to firms entering (exit) the industry.
2. Ease of entry will cause long run economic profits to be zero.
3. In the long run, purely competitive firms will be both productive and allocatively efficient.
4. Economic surplus is maximized in pure competition.

Pure competition and efficiency

Productive Efficiency (P= minimum ATC)
Requires that goods be produced in the least costly way.

Firms are forced to produce at the minimum average total cost in the long run. o highly favorable situation from the consumer's POV because it means that minimum amount of resources will be used to produce any particular output

Consumers benefit from productive efficiency by pay the lowest product price possible under the
 prevailing technology and cost conditions
Firm receives only a normal profit, which is part of its economic costs and thus incorporated in its
ATC curve

Therefore Purely Competitive firms are the most productively efficient.
Allocative Efficiency (P= MC)


Requires that resources be apportioned among firms and industries to yield the mix of products
 and services that is most wanted by society.
Realized when achieving a net gain for society by altering the combination of goods produced is impossible

Least-cost production must be used to provide society with the "right goods"--the goods that consumers want most

Two elements that are critical: o
1. The money price of any product is society's measure of the relative worth of an

 o additional unit of that product.
2. The idea of opportunity cost, we could see that the marginal cost of an additional unit of a product measures the value, or relative worth, of the other goods sacrificed to obtain it.
In a pure competition economy, when profit-motivated firms produce each good or service to the point where price and marginal cost are equal, society's resources are being allocated efficiently.
Purely competitive markets restore efficiency when disrupted by changes in the economy, e.g.
 consumer tastes, resource supplies, or technology. highly efficient allocation of resources that a competitive economy promotes is because businesses and resource suppliers seek to further self interest
 relates to the concept of Adam Smith's "invisible hand" in which the private interests of producers are fully in sync with society's interest in using scarce resources efficiently.

Purely Competitive firms at the proper MR.Darp value must in turn have an unlimited supply, meaning they have an ample amount of goods to be allocatively efficient to the consumer.
Maximum Consumer and Producer Surplus

A level of output at which P = MC = lowest ATC, marginal revenue = marginal cost, maximum willingness to pay = minimum acceptable price, and combined consumer and producer surplus are maximized.

o o
Consumer surplus is the difference between the max prices that consumers are willing to pay for a product and the market price of that product.
Producer surplus is the difference between the minimum prices that producers are willing to accept for a product and the market price of the product.
Creative Destruction
 Creation of new products and new products methods
 Destroys the old products and methods
 Threat
-> Competitors may soon come out with new technology
-> Replace our products
Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes. Examples are public utilities and professional sports leagues,
Characteristics
1. A single seller: the firm and industry are synonymous.
2. Unique product: no close substitutes for the firm’s product.

3. The firm is the price maker: the firm has considerable control over the price because it can control the quantity supplied.
4. Entry or exit is blocked.
Barriers to Entry
Economies of scale is the major barrier. This occurs where the lowest unit cost and, therefore, low unit prices for consumers depend on the existence of a small number of large firms, or in the case of monopoly, only one firm. Because a very large firm with a large market share is most efficient, new firms cannot afford to start up in industries with economies of scale. Public utilities are known as natural monopolies because they have economies of scale in the extreme case. More than one firm would be inefficient because the maze of pipes or wires that would result if there were competition among water companies or cable companies. Legal barriers also exist in the form of patents and licenses, such as radio and TV stations. Ownership or control of essential resources is another barrier to entry, such as the professional sports leagues that control player contracts and leases on major city stadiums. It has to be noted that barrier is rarely complete. Think about the telephone companies a couple decades ago; there was no substitute for the telephone. Nowadays, cellular phones are very popular. It creates a substitute for your house phone, causing the traditional telephone companies to lose their monopoly position.

Demand Curve
Monopoly demand is the industry or market demand and is therefore downward sloping. Price will exceed marginal revenue because the monopolist must lower price to boost sales and cannot price discriminate in most cases. The added revenue will be the price of the last unit less the sum of the price cuts which must be taken on all prior units of output. The marginal revenue curve is below the demand curve.
Profit –Maximizing Output
The MR = MC rule will still tell the monopolist the profit ‟ maximizing output. The monopolist cannot charge the highest price possible, it will maximize profit where TR minus TC is the greatest. This depends on quantity sold as well as on price. The monopolist can charge the price that consumers will pay for that output level. Therefore, the price is on the demand curve. Losses can occur in monopoly, although the monopolist will not persistently operate at loss in the long run.
Monopolies will sell at a smaller output and charge a higher price than would pure competitive producers selling in the same market. Income distribution is more unequal than it would be under a more competitive situation, unless the government regulates the monopoly and prevents monopoly profits. If a monopoly creates substantial economic inefficiency and appears to be long-lasting, antitrust laws could be used to break up the monopoly.
Efficiency:
1.
Productive efficiency: occurs where P= min ATC. Monopoly firms will not achieve productive efficiency as firms will produce at an output which is less than the output of min ATC. X-inefficiency may occur since there is no competitive pressure to produce at the minimum possible costs.
2 . Allocative efficiency: occurs where P = MC. This efficiency is not achieved because price( what product is worth to consumers) is above MC (opportunity cost of product).
It is possible that monopoly is more efficient than many small firms. Economies of scale (natural monopoly) may make monopoly the most efficient market model in some industries. However, X-

inefficiency and rent-seeking cost (lobbying, legal fees, etc.) can entail substantial costs, causing inefficiency.
Producer surplus is significant due to lack of competition, consumer surplus may be minimized. This market structure will not contribute to a fair income distribution of our society. rice and output under a pure monopoly
THE MONOPOLISTS DEMAND CURVE - CONSTRAINTS ON MONOPOLY
Be careful of saying that "monopolies can charge any price they like" - this is wrong. It is true that a firm with monopoly has price-setting power and will look to earn high levels of profit. However the firm is constrained by the position of its demand curve. Ultimately a monopoly cannot charge a price that the consumers in the market will not bear.
A pure monopolist is the sole supplier in an industry and, as a result, the monopolist can take the market demand curve as its own demand curve. A monopolist therefore faces a downward sloping AR curve with a MR curve with twice the gradient of AR. The firm is a price maker and has some power over the setting of price or output. It cannot, however, charge a price that the consumers in the market will not bear. In this sense, the position and the elasticity of the demand curve acts as a constraint on the pricing behaviour of the monopolist. Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.
Assuming that the firm aims to maximise profits (where MR=MC) we establish a short run equilibrium as shown in the diagram below.

The profit-maximising output can be sold at price P1 above the average cost AC at output Q1. The firm is making abnormal "monopoly" profits (or economic profits) shown by the yellow shaded area. The area beneath ATC1 shows the total cost of producing output Qm. Total costs equals average total cost multiplied by the output.
A CHANGE IN DEMAND
A change in demand will cause a change in price, output and profits.
In the example below, there is an increase in the market demand for the monopoly supplier. The demand curve shifts out from AR1 to AR2 causing a parallel outward shift in the monopolist's marginal revenue curve (MR1 shifts to MR2). We assume that the firm continues to operate with the same cost curves. At the new profit maximising equilibrium the firm increases production and raises price.
Total monopoly profits have increased. The gain in profits compared to the original price and output is shown by the light blue shaded area.

Not all monopolies are guaranteed profits - there can be occasions when the costs of production are greater than the average revenue a monopolist can charge for their products. This might occur for example when there is a sharp fall in market demand (leading to an inward shift in the average revenue curve). In the diagram below notice that ATC lies AR across the entire range of output. The monopolist will still choose an output where MR=MC for this reduces their losses to the minimum amount.
Economic effects of monopoly
Price = Marginal Cost = Minimum Average Total Cost (ATC)

Because product is produced for the minimum ATC possible, a competitive market achieves productive efficiency . Additionally, because the product is sold at the lowest possible price, competition also achieves allocative efficiency , since the lower price not only allows the greatest number of consumers to enjoy the product, but it also maximizes consumer surplus.
However, as demonstrated in the previous article , a monopolist does not set the price equal to the minimum average total cost, but rather when marginal revenue equals marginal cost.
Marginal Revenue (MR) = Marginal Cost (MC)
Therefore, a monopoly does not achieve productive efficiency. Moreover, the monopolist chooses a price on the demand curve that corresponds to the point where marginal revenue equals marginal cost, which is a considerably higher price than when the price is equal to the minimum average total cost. Therefore, the monopoly does not achieve allocative efficiency either, which means that many people will not enjoy the product because of its higher price and those who do buy it will enjoy less consumer surplus . A monopoly's higher price is like a private tax that exhibits the same deadweight loss that most taxes exhibit.

In monopoly :

P exceeds MC

P exceeds lowest ATC
 an effeciency loss (dead weight loss) occurs (sum of consumer surplus + producer surplus is less than maximum)
Income transfer:
 transfers income from consumers to stockholders who own monopoly

 monopoly charges a higher price than a PC firm with the same costs o
Can be seen as a "private tax" on consumers since the higher price generates higher economic profit that is distributed amongst shareholders of the company, who are mostly from high-income groups o owners benefit at the expense of the consumers

Since owners have more income than the consumers, monopoly increases gap between rich and poor o exception: when buyers are richer than owners of the monopoly, then income transfer from consumers to owners may decrease income inequality (usually not the case)
Cost Complications:
- A purely monopolistic industry will charge a higher price, produce a smaller output and allocate economic resoures less efficiently than a purely competitive industry assuming they have equal costs. This is because of the entry barriers that characterize monopoly.
- However, costs may not be the same for purely competitive producers and monopolistic producers: the unit cost that a monopolist has is either larger or smaller than a purely competitive firm's.

4 Reasons Why Costs May Differ:

Economics of scale: o
Simultaneous consumption: a product's ability to satisfy a large number of consumers at the same time o
Network effects are increases in the value of a product to each user



A factor called "X-inefficiency":X-efficiency occurs when a firm produces output, whatever its level, at higher than the lowest possible cost of producing it.

The need for monopoly-preserving expenditures o
Rent-seeking behavior: firms acquire monopoly granted by government through legislation

The "very long run" perspective, which allows for technological advance
If the monopoly is achieved and sustained through anticompetitive actions, creates substantial economic inefficiency, and appears to be long-lasting, the government can file charges against the monopoly under the anti-trust laws. If found guilty of monopoly abuse, the firm can either be prohibited from engaging in certain business or be broken into two or more competing firms.
Assessment and policy options:
How should the government act towards monopolies in the real world?

If the monopoly is achieved and sustained through anticompetitive actions, creates substantial economic inefficiency, and appears to be long-lasting, govt can file charges against the monopoly under anti-trust laws. Thus, government breaks up monopolies that are seen to be abusive


If it is a natural monopoly, government will allow it to profit since it is better for society. Yet govt will also regulate the prices and operations of the monopoly to protect consumers

If the monopoly is earning and lost and seems to be unsustainable, govt can ignore it since it has no potential threat to consumers.
CONDITIONS REQUIRED FOR PRICE DISCRIMINATION TO WORK
There are basically three main conditions required for price discrimination to take place.
1.
Monopoly power
Firms must have some price setting power - so we don't see price discrimination in perfectly competitive markets.
2.
Market Segregation
3.
No resale

 Profit maximization MR=MC
Price Regulation
There are some products that can be provided at a lower cost by what is called a natural monopoly than what could be provided by competing firms. The primary characteristic of a natural monopoly is that its average total cost declines continually over any quantity demanded by the market. If the industry has a large fixed cost, then a single firm can provide the product at a much lower cost than several or many firms, because the average total cost of each firm will be much higher than it will be for the natural monopoly. Hence, a natural monopoly can provide a product for a lower price if there is no competition.

Some examples of a natural monopoly include the distribution of natural gas, electricity, and landline phone service.
What price should be set for the natural monopoly? For a competitive firm , profit is maximized when marginal cost ( MC ) equals market price. However, since the average total cost of a natural monopoly continually declines, the marginal cost will always be less than the average total cost ( ATC ), since the average total cost is the average of all costs including the large fixed costs while the marginal cost is only the extra cost of producing an additional unit. Therefore, a natural monopoly will continually lose money if the price that they can charge is limited to its marginal cost.
A better regulated price would be one that allowed the monopoly to charge a price † sometimes referred to as the fair-return price † that is equal to its average total cost, which in economics, also includes a normal profit . This would allow the natural monopoly to survive as a going concern, but it would not incentivize the owners to reduce costs. So this type the regulation can be enhanced by allowing the monopolist to keep some of the profits earned by reducing costs. Note not this price is less than the price charged by a profit-maximizing monopoly, which selects the price corresponding to the point where marginal cost equals marginal revenue ( MR ).

Four Market Models
Characteristics of the Four Basic Market Models
Characteristic Pure Competition
Number of firms A very large number
Type of product Standardized
Monopolistic Competition
Many
Differentiated
Oligopoly
Few
Standardized or differentiated
Control over price
Conditions of entry
Nonprice competition
Examples
None
Very easy, no obstacles
None
Agriculture
Some, but within rather narrow limits
Relatively easy
Limited by mutual inter-dependence; considerable with collusion
Significant obstacles
Unique; no close subs.
Considerable
Blocked
Considerable emphasis on advertising, brand names, trademarks
Retail trade, dresses, shoes
Typically a great deal, particularly with product differentiation
Mostly public relation advertising
Steel, auto, farm implements
Monopoly
One
Local utilities
Monopolistic Competition
„ Relatively large number of sellers
„ Differentiated products
„ Easy entry and exit
„ Advertising
„ Industry concentration
„ Measured by:
Four-firm concentration ratios o Percentage of 4 largest firms

Price and
„ Herfindahl index
Sum of squared market shares
HI = (%S1)2 +
(%S2)2 + (%S3)2 +
…. +
(%Sn)2
Output in
Monopolistic Comp
„ Demand is highly elastic
„ Short run profit or loss
Produce where MR=MC
„ Long run normal profit
Entry and exit
„ Inefficient
„ Product variety
The Short Run: Profit or Loss

The Long Run: Only a Normal Profit
P
3
= A
3
MR = MC
0
Q
3
Monopolistic Competition: Efficiency
„ Inefficient
Productive inefficiency (P > ATC)
Allocative inefficiency (P > MC)
P=MC=Min ATC for pure competition (recall)
MC
ATC
D
3
MR

P
4
P
3
= A
3
Price is Lower
Excess Capacity at
Minimum ATC
MR = MC
0
Q
3
Q
4
Monopolistic competition is not efficient
Product Variety
„ The firm constantly manages price, product, and advertising
Better product differentiation
Better advertising
„ The consumer benefits by greater array of choices and better products
Types and styles
Brands and quality
Oligopoly
„ A few large producers
„ Homogeneous or differentiated products
„ Limited control over price
Mutual interdependence
Strategic behavior
„ Entry barriers
MC
MR
ATC
D

„ Mergers
Oligopolistic Industries
„ Four-firm concentration ratio
40% or more to be oligopoly
„ Shortcomings
Localized markets
Inter-industry competition
World price
Dominant firms
Game Theory Overview
Oligopolies display strategic pricing behavior
Mutual interdependence
Collusion
Incentive to cheat
Prisoner’s dilemma

• 2 competitors
• 2 price strategies
• Each strategy has a payoff matrix
• Greatest combined profit
• Independent actions stimulate a response
Hi
Lo
A
$1
C
$1
Hi Lo
$1
B
$
$
D
$
$1
$
High
A
High
$12
C
Low
$15
$12
$6
Low
B
$6
$15
D
$8
$8

Three Oligopoly Models
„ Kinked-demand curve
„ Collusive pricing
„ Price leadership
„ Reasons for 3 models
„ Diversity of oligopolies
„ Complications of interdependence
Kinked-Demand Curve
P f
Rivals
Ignore
Price e
Rivals Match
Price
Decrease g
0
Q
M
R
Quantity
„ Criticisms
Explains inflexibility, not price
Prices are not that rigid
Price wars
Cartels and Other Collusion
M
R
D
D
P
D
M
R f e g
0
Q
Quantity
M
R
M
C
M
C
D

M
P
0
A
0
MR=MC
Economic
Profit
MR
Q
0
Overt Collusion
„ Cartels - a group of firms or nations that collude
Formally agreeing to the price
Sets output levels for members
„ Collusion is illegal in the United States
„ OPEC
Obstacles to Collusion
„ Demand and cost differences
„ Number of firms
„ Cheating
„ Recession
„ New entrants
„ Legal obstacles
Price Leadership Model
„ Price Leadership
Dominant firm initiates price changes
Other firms follow the leader
ATC
D

„ Use limit pricing to block entry of new firms
„ Possible price war
Oligopoly and Advertising
„ Prevalent to compete with product development and advertising
„ Less easily duplicated than a price change
„ Financially able to advertise
Positive Effects
Low-cost way of providing information to consumers
Enhances competition
Speeds up technological progress
Negative Effects
Can be manipulative
Contains misleading claims that confuse consumers
Consumers pay high prices for a good while forgoing a better, lower priced, unadvertised version of the product
Can help firms obtain economies of scale
Oligopoly and Efficiency
„ Oligopolies are inefficient
Productively inefficient P > minATC
Allocatively inefficient P > MC
„ Qualifications
Increased foreign competition
Limit pricing
Technological advance

Firms demand resources
„ Focus on labor
Resource prices are important
„ Money-income determination
„ Cost minimization
„ Resource allocation
„ Policy issues
All markets are competitive (good and resource)
Derived demand depends on:
„ Productivity of resource (MP)
„ Price of the good it helps produce (P)

Marginal revenue product (MRP)
„ Change in TR resulting from unit change in resource (labor)
Rule for employing resources:
„ MRP = MRC
„ Marginal Revenue Product (MRP)
Marginal
Revenue
Product
=
„ Marginal Resource Cost (MRC)
Marginal
Resource
Cost
=

Changes in product demand
Changes in productivity
„ Quantities of other resources
„ Technological advance
„ Quality of the variable resource
Changes in the price of substitute resources
„ Substitution effect
„ Output effect
„ Net effect
Changes in the price of complementary resources
Rising employment
„ Services
„ Health care
„ Computers
Declining employment
„ Labor saving technological change

„ Textiles
E rd
=
„ Ease of resource substitutability
„ Elasticity of product demand
„ Ratio of resource cost to total cost
.
„ All resource inputs are variable
„ Choose the optimal combination
„ Minimize cost of producing a given output
„ Maximize profit
„ Minimize cost of producing a given output
„ Last dollar spent on each resource yields the same marginal product

L
L
„ MRP of each resource equals its price
P
L
= MRP
L and
=
P
C
C
C
= MRP
C
MRP
L
P
L
=
MRP
C
P
C
= 1
Paid according to value of service
„ Workers
„ Resource owners
Inequality
„ Productive resources unequally distributed
Market imperfections
Numerical Illustration
„ Data for finding the least-cost and profit-maximizing combination of labor and capital

Labor, Wages, and Earnings
Chapter 16 Wage Determination
Wages
Price paid for labor
Direct pay plus fringe benefits
Wage rate, Nominal wage, Real wage, General level of wages
Role of Productivity
„ Labor demand depends on productivity
„ U.S. labor is highly productive
Plentiful capital
Access to abundant natural resources
Advanced technology
Labor quality
Other factors
Real Wages and Productivity
Long-run trend of average real wages in the U.S.
S
1900
S
1950
S
2000
D
1900
D
1950
D
2000
Quantity of Labor
S
2020
D
2020

Competitive Labor Market
„ Market demand for labor
Sum of firm demand
Example: carpenters
„ Market supply for labor
Upward sloping
Competition among industries
„ Labor market equilibrium
MRP = MRC rule
S
($1
0)
0 Q
(100
Quantity of
Monopsony Model
D=MR
P a
($1
0) e
0
b q
( c d=m
Quantity of s= MR

„ E p m e y r o l h
W c
W m s a u b y ing power
0
„ Characteristics
Single buyer
Labor immobile
Firm “wage maker”
„ Firm labor supply is upward sloping
„ MRC higher than wage rate
„ Equilibrium
„ Examples of monopsony power b
Q m
Q c
Monopsony Power
„ Maximize profit by hiring smaller number of workers
„ Examples of monopsony power
Nurses
Professional Athletes
Teachers
„ Three union models
MRC c a
S
MRP

Demand Enhancement Model
„ Union model
Increase product demand
Alter price of other inputs
W u
W c
S
Increase
In Demand
D
1
Q c
Q u
D
2

Craft Union Model
W u
W c
Industrial Union Model
„ Inclusive unionism
Auto and steel workers
Q u
Q c
S
2
S
1
Decrease
In Supply
D

S
W
W a b e
D
Q Q Q
Bilateral Monopoly Model
„ Monopsony and inclusive unionism
„ Single buyer and seller
„ Not uncommon
„ Indeterminate outcome
„ Desirability
The Minimum Wage Controversy
„ Case against minimum wage
„ Case for minimum wage
„ State and locally set rates
„ Evidence and conclusions
Wage Differentials
„ Differences across occupations
„ What explains wage differentials?
„ Marginal revenue productivity
„ Noncompeting groups
Ability
Education and training
W
W
W
M a
Q u
= Q
S
D=M

„ Compensating differences
„ Workers prevented from moving to higher paying jobs
„ Market imperfections
Lack of job information
Geographic immobility
Unions and government restraints
Discrimination
Pay for Performance
„ The principal-agent problem
„ Incentive pay plan
Piece rates
Commissions or royalties
Bonuses, stock options, and profit sharing
Efficiency wages
„ Negative side-effects