Chapter 11 PRICE AND OUTPUT IN MONOPOLY, MONOPOLISTIC COMPETITION, AND PERFECT COMPETITION Gottheil — Principles of Economics, 7e © 2013 Cengage Learning 1

Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Price, output and economic profit under conditions of monopoly Price, output and economic profit for the firm in monopolistic competition Normal profit 2

Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Price, output and economic profit for the firm in perfect competition The perfectly competitive firm’s supply curve Market supply in perfect competition 3

Economic Principles © 2013 Cengage Learning Gottheil — Principles of Economics, 7e The Schumpeterian illustration of low price and high efficiency under conditions of monopoly 4

Monopoly Price and Output © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Monopolists are distinguished from other types of entrepreneurs by their market position— not by their motivation, morality, strategy or objective. 5

Monopoly Price and Output © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Price-maker A firm conscious of the fact that its own activity in the market affects price. The firm has the ability to choose among combinations of price and output. 6

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 1MARKET DEMAND FOR ICE 7

Exhibit 1: Market Demand for Ice © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Which price and quantity choices does the ice company have available in Exhibit 1? The ice company has unlimited choices. It is a price maker and can choose any combination of price and output it wants. 8

Exhibit 1: Market Demand for Ice © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Which price and quantity choices does the ice company have in Exhibit 1? Although the ice company can charge higher prices, the company must recognize that at higher prices, fewer tons of ice will be demanded. 9

Exhibit 1: Market Demand for Ice © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Which price and quantity choices does the ice company have in Exhibit 1? The company uses the MR = MC rule to determine what combination of price and output will maximize profit. 10

Price and Output Under Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Recall the MR = MC Rule: Expand production if MR > MC. Profit is maximized when MR = MC. 11

Price and Output Under Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e M arginal cost ( MC ) is the increase in total cost when an additional unit of output is added to production. Marginal revenue (MR) is the change in total revenue generated by the sale of one additional unit of goods and services. 12

Price and Output Under Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Economic profit A firm’s total revenue minus its total explicit and implicit costs. 13

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 2COST AND REVENUE SCHEDULES FOR THE NICK RUDD ICE COMPANY Note: Figures are rounded to the nearest dollar. 14

Exhibit 2: Cost and Revenue Schedule for the Nick Rudd Ice Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1.What is the company’s economic profit when 50 tons of ice are produced? Economic profit = total revenue - total cost = $(13,750 – 8,500) = $5,250 15

Exhibit 2: Cost and Revenue Schedule for the Nick Rudd Ice Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2. Since the company is a price- maker, should it charge the highest price possible? No. The highest price possible does not necessarily generate the most profit. 16

Exhibit 2: Cost and Revenue Schedule for the Nick Rudd Ice Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3.At what output should the company be producing in order to maximize profit? The company should be producing 300 tons of ice in order to maximize profit. 17

Exhibit 2: Cost and Revenue Schedule for the Nick Rudd Ice Company © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3.At what output should the company be producing in order to maximize profit? This is the output level where MR = MC. 18

Maximum Profit, but Less than Maximum Efficiency © 2013 Cengage Learning Gottheil — Principles of Economics, 7e The profit-maximizing output is not necessarily the most efficient output. There may be output levels that have a lower average total cost ( ATC ). The firm is interested in maximum profit, however, not maximum efficiency. 19

EXHIBIT 3PRICE AND OUTPUT DETERMINATION IN MONOPOLY © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 20

Exhibit 3: Price and Output Determination in Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e What is the total profit for the profit- maximizing firm in Exhibit 4? The profit-maximizing firm produces where MR = MC. This point is at a quantity of 300 in Exhibit 4. 21

Exhibit 3: Price and Output Determination in Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e At quantity 300, the price (read off the demand curve) is $150. The average total cost (read off the ATC curve) is $52. What is the total profit for the profit maximizing firm in Exhibit 4? 22

Exhibit 3: Price and Output Determination in Monopoly © 2013 Cengage Learning Gottheil — Principles of Economics, 7e What is the total profit for the profit maximizing firm in Exhibit 4? Total profit = $(150 – 52) × 300 = $29,400 23

Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e One way that a new firm can break into a market is through product differentiation. The trick is to differentiate the product enough to claim uniqueness, yet keep it close enough to existing competition. 24

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 4RUDD’S DEMAND CURVE AS NEW FIRMS ENTER THE MARKET 25

Exhibit 4: Rudd’s Demand Curve as New Firms Enter the Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e As new firms enter a market, the demand curve for the existing firms becomes: i.More elastic ii.Less elastic 26

Exhibit 4: Rudd’s Demand Curve as New Firms Enter the Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e As new firms enter a market, the demand curve for the existing firms becomes: i.More elastic ii.Less elastic 27

Exhibit 4: Rudd’s Demand Curve as New Firms Enter the Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e As new firms enter a market, the demand curve for the existing firms becomes: i.More elastic—More substitutes become available, which increases the price elasticity of demand. ii.Less elastic 28

EXHIBIT 5RUDD’S PRICE AND OUTPUT IN A MONOPO- LISTICALLY COMPETITIVE MARKET © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 29

Exhibit 5: Rudd’s Price and Output in a Monopolistically Competitive Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1.How does the ice company determine the best output level to produce after new firms have entered the market? The ice company determines its production level the same way it did before—it uses the MR = MC rule. 30

Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e As long as there is economic profit to be made, firms will continue to enter a market. The limit to further entry is the point where the demand curve is tangent to the ATC curve. 31

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 6RUDD’S LONG-RUN EQUILIBRIUM PRICE AND OUTPUT IN MONOPOLISTIC COMPETITION 32

Exhibit 6: Rudd’s Long-Run Equilibrium Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1.At what output level is profit maximized in Exhibit 6? Profit is maximized at an output level of

Exhibit 6: Rudd’s Long-Run Equilibrium Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2.What are price and average total cost at this output level? Both price and average total cost are $82. The demand curve is tangent to the ATC curve. 34

Exhibit 6: Rudd’s Long-Run Equilibrium Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3.What is Rudd’s economic profit at this output level? Economic profit = $(82 – 82) × 150 = 0 35

Exhibit 6: Rudd’s Long-Run Equilibrium Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 4.If economic profit is zero, should Rudd’s produce at some other output? No. The MR = MC rule always signals the firm’s most profitable output level, even if the profit is zero. Every other output level in this case would yield a loss. 36

Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Normal profit The entrepreneur’s opportunity cost. It is equal to or greater than the income an entrepreneur could receive employing his or her resources elsewhere. Normal profit is included in the firm’s costs. 37

Price and Output in Monopolistic Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Even though the economic profit of a firm may be zero, the firm still generates a normal profit —a wage— for the entrepreneur. The normal profit is at least as much as the entrepreneur can earn elsewhere. 38

Price and Output in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e There is no product differentiation in a perfectly competitive market. Firms in perfect competition are typically modest in size. 39

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 7ATHE COMPETITIVE FIRM’S COST STRUCTURE 40

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 7BTHE COMPETITIVE FIRM’S COST STRUCTURE 41

Exhibit 7: The Competitive Firm’s Cost Structure © 2013 Cengage Learning Gottheil — Principles of Economics, 7e How does ATC change as the firm changes output from 4.5 to 6.0 in Exhibit 7? At an output of 4.5, the firm achieves its minimum ATC of $47. ATC increases to $55 when the firm increases output to

Price and Output in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Price-taker A firm that views market price as a given and considers any activity on its own part as having no influence on that price. 43

Price and Output in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e For firms in perfect competition, price always equals marginal revenue ( P = MR ). 44

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 8ADEMAND AND SUPPLY FOR ICE IN A PERFECTLY COMPETITIVE MARKET 45

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 8BDEMAND AND SUPPLY FOR ICE IN A PERFECTLY COMPETITIVE MARKET 46

Exhibit 8: Demand and Supply for Ice in a Perfectly Competitive Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1. What is the equilibrium price and quantity demanded in panel a of Exhibit 8? The equilibrium price is $78 and the quantity demanded is

Exhibit 8: Demand and Supply for Ice in a Perfectly Competitive Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2.Why is the firm’s demand curve horizontal? The firm is a price-taker. The firm must charge the equilibrium price regardless of the quantity it produces. 48

Exhibit 8: Demand and Supply for Ice in a Perfectly Competitive Market © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 3.Should a firm in perfect competition increase its price in order to generate more profit? No. If the firm increases its price by even a penny, then the firm will not be able to sell any product. 49

Short-Run Equilibrium Price and Output for the Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Economic profit will attract new producers to a market. As new producers enter the market, the supply curve shifts to the right, forcing the equilibrium price to fall. 50

Short-Run Equilibrium Price and Output for the Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Each producer must adjust its output to maximize profit at the new equilibrium price. 51

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 9ATHE PERFECTLY COMPETITIVE FIRM IN THE SHORT RUN 52

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 9BTHE PERFECTLY COMPETITIVE FIRM IN THE SHORT RUN 53

Exhibit 9: The Perfectly Competitive Firm in the Short-Run © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1.How does a price-taker know what output maximizes profit? The price-taker uses the MR = MC rule. Since MR is always equal to price, the firm must determine the output where MC is equal to price. 54

Exhibit 9: The Perfectly Competitive Firm in the Short-Run © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2.What is the economic profit received by the firm in Exhibit 9? Economic profit = $(78 – 51) × 5.5 = $

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 10EFFECTS OF A SHIFT IN MARKET SUPPLY 56

Exhibit 10: Effects of a Shift in Market Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1.How does the equilibrium price change as the supply curve shifts from S 1 to S 2 to S 3 in Exhibit 10? The short-run equilibrium price changes from $78 at S 1 to $60 at S 2 and to $47 at S 3. 57

Exhibit 10: Effects of a Shift in Market Supply © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2.How does the change in price affect the economic profit of firms? With each decrease in price, economic profit decreases. At an output of 4.5 tons, price equals ATC. Economic profit is zero. 58

Long-Run Equilibrium Price and Output for the Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e The long-run equilibrium position of firms in perfect competition is identified by P = MR = MC = ATC. 59

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 11THE MARKET AND FIRM IN LONG-RUN EQUILIBRIUM 60

Exhibit 11: The Market and Firm in Long-Run Equilibrium © 2013 Cengage Learning Gottheil — Principles of Economics, 7e At what point along the ATC curve does the firm in perfect competition end up producing in the long run? The firm produces at the lowest point on its ATC curve. 61

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 12ANATOMY OF THE FIRM’S LONG-RUN SUPPLY CURVE 62

Exhibit 12: Anatomy of the Firm’s Long-Run Supply Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Where does the supply curve begin for the firm in Exhibit 12? The supply curve begins at the point where MC = ATC on its marginal cost curve. Any point on the supply curve below that point will result in loss to the firm. 63

Long-Run Equilibrium Price and Output for the Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e The market supply curve is the aggregation of the long-run MC curves of the firms in the market. 64

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 13ANATOMY OF THE MARKET SUPPLY CURVE 65

Exhibit 13: Anatomy of the Market Supply Curve © 2013 Cengage Learning Gottheil — Principles of Economics, 7e When P = $100, what is the total market supply? At P = $100, 150 firms are willing to supply 6 tons each. Market supply = 150 firms × 6 tons = 900 tons 66

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 14THE INNOVATOR FIRM IN PERFECT COMPETITION 67

Exhibit 14: The Innovator Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Complete this sentence: Innovation results in _____ economic profit in the long-run. i.Higher ii.The same iii.Lower 68

Exhibit 14: The Innovator Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Complete this sentence: Innovation results in _____ economic profit in the long-run. i.Higher ii.The same iii.Lower 69

Exhibit 14: The Innovator Firm in Perfect Competition © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Complete this sentence: Innovation results in _____ economic profit in the long-run. i.Higher ii.The same —Economic profit may initially rise, but it will return to zero in the long-run. iii.Lower 70

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e EXHIBIT 15CONSTANT AND INCREASING RETURNS TO SCALE 71

Exhibit 15: Constant and Increasing Returns to Scale © 2013 Cengage Learning Gottheil — Principles of Economics, 7e How does ATC change between panel a and panel b in Exhibit 15? In panel a, constant returns to scale, the minimum ATC is the same for small and large firms. In panel b, increasing returns to scale, ATC falls as firm size and output increase. 72

The Schumpeter Hypothesis © 2013 Cengage Learning Gottheil — Principles of Economics, 7e According to economist Joseph Schumpeter, bigness can be an advantage for an innovating firm. The economies of scale and low average costs of production available to big firms may allow them to charge prices that are actually lower than those charged by small, competitive firms. 73

The Schumpeter Hypothesis © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Monopoly profits permit these firms to experiment with new technologies that ultimately lead to more efficient production. 74

The Schumpeter Hypothesis © 2013 Cengage Learning Gottheil — Principles of Economics, 7e Other economists, such as Alfred Marshall, disagree. They contend that the large number of small firms that undertake innovation will lead to the greatest efficiency in production over time. 75

EXHIBIT 16MONOPOLY AND PERFECT COMPETITION: SCHUMPETER’S VIEW © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 76

Exhibit 16: Monopoly and Perfect Competition: Schumpeter’s View © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 1.What is price and quantity for the competitive firm in panel a ? Price is $25. With 200 firms in the market, quantity supplied to the market is 4,

Exhibit 16: Monopoly and Perfect Competition: Schumpeter’s View © 2013 Cengage Learning Gottheil — Principles of Economics, 7e 2.How does the competitive firm’s price and quantity compare to the monopoly in panel b ? The monopoly’s price is $20–$5 less than the competitive firm’s price. The monopoly’s output quantity is 10,000–6,000 greater than the competitive firm’s output. 78