Econ 201 Lecture 17
The Perfectly Competitive Firm Is a Price Taker (Recap)
The perfectly competitive firm has no influence over the market price. It can sell as many units as it wishes at that
price.
Typically, a "perfectly" competitive industry is one that consists of a large number of sellers, each of which makes a
highly standardized product.
An example is corn production.
Profit-maximization for the perfectly competitive firm
Profit = Total revenue - total cost
Q. How much output should a perfectly competitive firm produce if its goal is to earn as much profit as possible?
A. It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost.
The marginal benefit of expanding output by one unit is the market price.
The marginal cost of expanding production by one unit is the firm's marginal cost at its current production level.
Example 17.1. Consider a corn grower whose marginal cost of growing corn is labeled MC in the diagram. If this
grower can sell as many bushels of corn as he chooses to at a price of $5 per bushel, how many bushels should he
sell in order to maximize profit?
$/bushel
Marginal cost
of producing corn
6
5
4
Price
6
9
12
Thousands of
bushels of corn/yr
The profit-maximizing quantity for the perfectly competitive firm is the one for which price = MC.
Imperfect Competition
Monopoly = "single seller"
Example: Time Warner Cable in the Ithaca market for cable TV service
Oligopoly = "few sellers"
Example: AT&T, Sprint, and MCI in the market for long-distance telephone service
Monopolistic competition: Many sellers, each with a differentiated product
Example: Local gasoline retailing
Five Sources of Monopoly
1. Exclusive control over important inputs
Example: Perrier's mineral spring
2. Economies of Scale (Natural monopoly)
Example: Local telephone service
3. Patents
Example: Polaroid cameras & film
4. Government licenses or franchises
Example: Burger King on Mass Pike
5. Network Economies
Example: Microsoft Windows
2
Most enduring source of monopoly is economies of scale.
Scale Advantage in the Old Economy
Two widget producers, Acme and Ajax, each have fixed costs of $200,000, and variable costs of $0.80 per widget.
Acme
annual production:
1,000,000 units
fixed costs:
$200,000
variable costs:
$800,000
total costs:
$1,000,000
cost per widget:
$1.00
Ajax, the high volume producer, has only a small cost advantage.
Ajax
1,200,000 units
$200,000
$960,000
$1,160,000
$0.97
Scale Advantage in the New Economy
In the new economy, fixed costs are $800,000, reflecting the growing importance of the information and ideas in the
product. Variable costs are only $0.20/widget.
Acme
annual production:
1,000,000 units
fixed costs:
$800,000
variable costs:
$200,000
total costs:
$1,000,000
cost per widget:
$1.00
Now Ajax has a much larger cost advantage.
Ajax
1,200,000 units
$800,000
$240,000
$1,040,000
$0.87
This cost advantage becomes self reinforcing, as more and more of the market goes to Ajax:
Acme
annual production:
fixed costs:
variable costs:
total costs:
cost per widget:
500,000 units
$800,000
$100,000
$900,000
$1.80
Ajax
1,700,000 units
$800,000
$340,000
$1,140,000
$0.67
Monopoly, oligopoly, and monopolistically competitive firms have in common the fact that the demand curves for
their goods are downward sloping.
Price
D
Quantity
For convenience, we will refer to any of these three types of imperfectly competitive firms as monopolists.
The demand curve facing a perfectly competitive firm is a straight line at the market price.
$/unit of output
Market
Price
D
Quantity
3
Marginal Revenue
The marginal benefit to a competitive firm of selling an additional unit of output is the market price.
By contrast, the marginal benefit to a monopolist of selling an additional unit of output is less than the market price.
The reason is that it must cut its price in order to sell an extra unit of output, and this means that it will earn less on
the output is was selling thus far.
Example 17.2. A monopolist with the demand curve shown in the diagram is currently selling 3 units of output at a
price of $7 per unit. What is its marginal benefit from selling an additional unit?
Price
10
7
6
D
3 4
10
Total revenue from the sale of 3 units = $7x3 = $21
Quantity
Total revenue from the sale of 4 units = $6x4 = $24
So marginal revenue from the fourth unit is $3, which is less than both the original price and the new price.
Example 17.3. A monopolist with the demand curve shown in the diagram is currently selling 4 units of output at a
price of $6 per unit. What is its marginal benefit from selling an additional unit?
Price
10
6
5
D
4
5
10
Total revenue from the sale of 4 units = $6x4 = $24
So marginal revenue from the fifth unit is $1.
Quantity
Total revenue from the sale of 5 units = $5x5 = $25
Example 17.4. A monopolist with the demand curve shown in the diagram is currently selling 5 units of output at
a price of $5 per unit. What is its marginal benefit from selling an additional unit?
Price
10
5
4
D
5 6
Total revenue from the sale of 5 units = $5x5 = $25
So marginal revenue from the sixth unit is -$1
The Marginal Revenue Curve for a Monopolist
For the monopolist in the preceding examples:
10
Quantity
Total revenue from the sale of 6 units = $6x4 = $24
4
Price
10
5
MR
D
Quantity
5
10
For any monopolist with a straight-line demand curve:
Price
a
a/2
MR
Quantity
Q0
Q0 /2
For a straight-line demand curve:
P = a - bQ
The corresponding MR curve:
MR = a - 2bQ
For calculus-trained students:
MR = dTR/dQ
TR = PQ = aQ-bQ2
MR = a - 2bQ
so
Example 17.5. Find the marginal revenue curve for the monopolist whose demand curve is given by D in the
diagram.
Price
Price
8
8
4
D
D
Quantity
16
Quantity
8
MR
16
Profit-maximization for the monopolist
Profit = total revenue - total cost
Q. How much output should a monopolist produce if its goal is to earn as much profit as possible?
A. It should keep expanding output as long as the marginal benefit of doing so exceeds the marginal cost.
The marginal benefit of expanding output by one unit is marginal revenue at the current output level.
The marginal cost of expanding production by one unit is the firm's marginal cost at the current output level.
Example 17.6. Consider a monopolist with the demand and marginal cost curves shown in the diagram.
5
True or False: The profit-maximizing level of output for this monopolist is 9 units.
$/unit of output
12
$/unit of output
12
Marginal cost
Marginal cost
8
6
4
6
D
D
Quantity
9
Quantity
6
18
9
18
At 9 units of output, marginal cost is 6 and marginal revenue is zero. Therefore the gain from contracting
output ($6/unit) is less than the loss from contracting output ($0/unit). And this means that the monopolist cannot
be maximizing profit at a quantity of 9 units.
The profit-maximizing quantity for the monopolist is the one for which MR = MC, in this case 6 units of
output. At that level of output the monopolist will charge a price of $8/unit.
Example 17.7. Consider the profit-maximizing monopolist in Example 17.6. At the profit-maximizing level of
output, what is the benefit to society of an additional unit of output? What is the cost to society of an additional
unit? Is this situation efficient from society's point of view?
$/unit of output
12
Marginal cost
8
6
4
D
Quantity
6
9
18
The marginal benefit to society of an additional unit of output is $8. The marginal cost of an additional
unit is only $4. This means that society would gain a net benefit of $4 per unit of output if output were expanded
from the profit-maximizing level.
Note that the monopolist would love to expand output if it could do so without having to sell the current
output at a lower price.
Example 17.8. If this monopolist maximizes profit, by how much will total economic surplus be smaller than the
maximum possible economic surplus?
Price
12
MC
6
D
9
18
Quantity
Maximum possible economic surplus = CS + PS
6
Consumer
surplus
P
MC
Producer
surplus
12
6
D
Q
18
9
Loss in economic surplus from monopoly:
P
12
Consumer Producer
surplus
surplus
MC
8
Loss in
surplus
6
4
D
6
9
MR
18
Q