Unit 3:

Costs of Production and

Perfect Competition

1
Production= Converting
inputs into output

2
Analyzing
Lets look at an example
to show the relationship
Production
between inputs and
outputs

3
Widget
Production Simulation
Overview
Production Simulation
• The class will be divided into two firms.
• There will be several rounds in which each firm will produce
chains out of paper.
• Each round last exactly 2 minutes
• Each firm is going to hire one more worker at the start of
each round.
Resources
• 1 stapler, 1 scissors, 1 table, and plenty of staples and paper
Rules
• Workers cannot stockpile slips of paper. No extras
• Workers cannot cut more than one paper at a time
• Workers can only add links to one side of the chain
• Each link must pass inspection
• If links don’t meet specifications they won’t count
Responsibilities
• The manager will hire the workers.
• The inspector will check to make sure each product is made
to specifications
Production Simulation

Step 1: Cut Step 2: Fold Step 3: Wrap Step 4: Add

paper down the piece down the ends around more links
middle into two middle and staple to one end
piece
Production Simulation
Complete the chart for your firm:
Number of Total Product Marginal
Workers (inputs) (output) Product
0
1
2
3
4
5
6
Inputs and Outputs
• To earn profit, firms must make products (output)
• Inputs are the resources used to make outputs.
• Input resources are also called FACTORS.
•Total Physical Product (TP)- total output or quantity
produced
•Marginal Product (MP)- the additional output
generated by additional inputs (workers).
Change in Total Product
Marginal Product =
Change in Inputs
•Average Product (AP)- the output per unit of input
Total Product
Average Product =
Units of Labor 8
Production Analysis
•What happens to the Total Product as you hire
more workers?
•What happens to marginal product as you hire
more workers?
•Why does this happens?
The Law of Diminishing Marginal Returns
As variable resources (workers) are added to fixed
resources (machinery, tool, etc.), the additional output
produced from each new worker will eventually fall.

Too many cooks in

the kitchen!
9
Graphing Production

10
Three Stages of Returns
Stage I: Increasing Marginal Returns
MP rising. TP increasing at an increasing rate.
Why? Specialization.
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 11
Marginal Product
Three Stages of Returns
Stage II: Decreasing Marginal Returns
MP Falling. TP increasing at a decreasing rate.
Why? Fixed Resources. Each worker adds less and less.
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 12
Marginal Product
Three Stages of Returns
Stage III: Negative Marginal Returns
MP is negative. TP decreasing.
Workers get in each others way
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 13
Marginal Product
The Law of Diminishing Marginal Returns is NOT
the results of laziness, it is the result of limited
fixed resources. 14
With your partner calculate MP and AP then discuss
what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70 15
With your partner calculate MP and AP then discuss
what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10
2 25 15
3 45 20
4 60 15
5 70 10
6 75 5
7 75 0
8 70 -5 16
With your partner calculate MP and AP then discuss
what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75 17
Identify the three stages of returns
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75 18
Identify the three stages of returns
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75 19
More Examples of the Law of Diminishing
Marginal Returns
Example #1: Learning curve when studying for an exam
Fixed Resources-Amount of class time, textbook, etc.
Variable Resources-Study time at home
Marginal return-
▪1st hour-large returns
▪2nd hour-less returns
▪3rd hour-small returns
▪4th hour- negative returns (tired and confused)
Example #2: A Farmer has fixed resource of 8 acres
planted of corn. If he doesn’t clear weeds he will get 30
bushels. If he clears weeds once he will get 50 bushels.
Twice -57, Thrice-60. Additional returns diminishes each
time. 20
Costs of Production

21
Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
•Explicit costs (out of pocket costs) are payments
paid by firms for using the resources of others.
•Example: Rent, Wages, Materials, Electricity Bills
Accounting Total
Profit Accounting Costs
Revenue (Explicit Only)
Economists examine both the EXPLICIT COSTS and
the IMPLICIT COSTS
•Implicit costs are the opportunity costs that firms
“pay” for using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic Total
Economic Costs
Profit Revenue 22
(Explicit + Implicit)
Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
•Explicit costs (out of pocket costs) are payments
paid by firms for using the resources of others.
•Example: Rent, Wages, Materials, Electricity Bills
Accounting Total
From now
Profit on,
Revenue
all costs
Accounting Costs
(Explicit Only)
are automatically
Economists examine both the EXPLICIT COSTS and
ECONOMIC
the IMPLICIT COSTS COSTS
•Implicit costs are the opportunity costs that firms
“pay” for using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic Total
Economic Costs
Profit Revenue 23
(Explicit + Implicit)
Short-Run
Production Costs

24
Definition of the “Short-Run”
• We will look at both short-run and long-run
production costs.
• Short-run is NOT a set specific amount of
time.
• The short-run is a period in which at least one
resource is fixed.
– Plant capacity/size is NOT changeable
• In the long-run ALL resources are variable
– NO fixed resources
– Plant capacity/size is changeable
Today we will examine Short-run costs.
25
Different Economic Costs
Total Costs
FC = Total Fixed Costs
VC = Total Variable Costs
TC = Total Costs
Per Unit Costs
AFC = Average Fixed Costs
AVC = Average Variable Costs
ATC = Average Total Costs
MC = Marginal Cost 26
Definitions
Fixed Costs:
Costs for fixed resources that DON’T change
with the amount produced
Ex: Rent, Insurance, Managers Salaries, etc.
Average Fixed Costs = Fixed Costs
Quantity
Variable Costs:
Costs for variable resources that DO change as
more or less is produced
Ex: Raw Materials, Labor, Electricity, etc.
Variable Costs
Average Variable Costs =
Quantity 27
Definitions
Total Cost:
Sum of Fixed and Variable Costs

Average Total Cost = Total Costs

Quantity
Marginal Cost:
Additional costs of an additional output.
Ex: If the production of two more output
increases total cost from $100 to $120, the MC
$10
is _____.
Change in Total Costs
Marginal Cost =
Change in Quantity 28
Calculating TC, VC, FC, ATC, AFC,
and MC
TP VC FC TC MC AVC AFC ATC
0 0 100
1 10
2 16
3 21
4 26
5 30
6 36
7 46
Draw this in your notes 29
Calculating TC, VC, FC, ATC, AFC,
and MC
TP VC FC TC MC AVC AFC ATC
0 0 100
1 10 100
2 16 100
3 21 100
4 26 100
5 30 100
6 36 100
7 46 100
30
Calculating TC, VC, FC, ATC, AFC,
and MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100
1 10 100 110
2 16 100 116
3 21 100 121
4 26 100 126
5 30 100 130
6 36 100 136
7 46 100 146
31
TOTAL COSTS GRAPHICALLY
Combining VC TC
With FC to get
800 VC
700
Total Cost
Fixed Cost
Costs (dollars)

600
500
400
300
200
100 FC
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
32
TOTAL COSTS GRAPHICALLY
Combining VC TC
With FC to get
800 VC
700
Total Cost
Fixed Cost
Costs (dollars)

600
500 What is the
400 TOTAL COST,
300 FC, and VC for
200 producing 9 units?
100 FC
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
33
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 -
1 10 100 110
2 16 100 116
3 21 100 121
4 26 100 126
5 30 100 130
6 36 100 136
7 46 100 146
34
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 -
1 10 100 110 10
2 16 100 116 6
3 21 100 121 5
4 26 100 126 5
5 30 100 130 4
6 36 100 136 6
7 46 100 146 10
35
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - -
1 10 100 110 10 10
2 16 100 116 6 8
3 21 100 121 5 7
4 26 100 126 5 6.5
5 30 100 130 4 6
6 36 100 136 6 6
7 46 100 146 10 6.6
36
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - -
1 10 100 110 10 10 100
2 16 100 116 6 8 50
3 21 100 121 5 7 33.3
4 26 100 126 5 6.5 25
5 30 100 130 4 6 20
6 36 100 136 6 6 16.67
7 46 100 146 10 6.6 14.3
Asymptote 37
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
38
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
39
Per-Unit Costs (Average and Marginal)
MC
12
11
10 ATC
9
AVC
Costs (dollars)

8
7
6 How much does
5
4
the 11th unit costs?
3
2
1 AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
40
Per-Unit Costs (Average and Marginal)
MC ATC and AVC get
closer and closer but
12 NEVER touch
11
10 ATC
9
AVC
Costs (dollars)

8
7
6
5 Average
4 Fixed Cost
3
2
1 AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
41
Per-Unit Costs (Average and Marginal)

At output Q, what
area represents:
TC 0CDQ
VC 0BEQ
FC 0AFQ or BCDE

42
Why is the MC curve U-shaped?

12
11 MC
10
9
Costs (dollars)

8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
43
Marginal Product Relationship between Production and Cost

Why is the MC curve

U-shaped?
MP •When marginal product is
increasing, marginal cost falls.
Quantity of labor
•When marginal product falls,
MC marginal costs increase.
MP and MC are mirror images
of each other.
Costs

Quantity of output 44
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0
1 5
2 13
3 19
4 23
5 25
6 26 45
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0 -
1 5 5
2 13 8
3 19 6
4 23 4
5 25 2
6 26 1 46
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker (Wage = $10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0 - $20
1 5 5 $30
2 13 8 $40
3 19 6 $50
4 23 4 $60
5 25 2 $70
6 26 1 $80 47
Why is the MC curve U-shaped?
•The MC curve falls and then rises because of diminishing
marginal returns.
•Example:
•Assume the fixed cost is $20 and the ONLY variable cost is the
cost for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0 - $20 -
1 5 5 $30 10/5 = $2
2 13 8 $40 10/8 = $1.25
3 19 6 $50 10/6 = $1.6
4 23 4 $60 10/4 = $2.5
5 25 2 $70 10/2 = $5
6 26 1 $80 10/1 = $10 48
Why is the MC curve U-shaped?
•The additional cost of the first 13 units produced falls
because workers have increasing marginal returns.
•As production continues, each worker adds less and
less to production so the marginal cost for each unit
increases.
Workers Total Prod Marg Prod Total Cost Marginal Cost
0 0 - $20 -
1 5 5 $30 10/5 = $2
2 13 8 $40 10/8 = $1.25
3 19 6 $50 10/6 = $1.6
4 23 4 $60 10/4 = $2.5
5 25 2 $70 10/2 = $5
6 26 1 $80 10/1 = $10 49
Aver
m RelationshipMP between Production and Cost
Quantity of labor Why is the ATC curve
MC U-shaped?
Costs (dollars)

•When the marginal cost is

below the average, it pulls
ATC the average down.
•When the marginal cost is
above the average, it pulls
Quantity of output
the average up.
The MC curve intersects the ATC curve at its lowest point.
Example:
•The average income in the room is $50,000.
•An additional (marginal) person enters the room: Bill Gates.
•If the marginal is greater than the average it pulls it up.
•Notice that MC can increase but still pull down the average.
50
Shifting Cost
Curves

51
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10What if Fixed
100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 Costs increase to
21 100 121 5 7 33.3 30.3
4 26 100 126 3 6.5 25 31.5
5 30
$200
100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
52
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
53
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 100 - - - -
1 10 200 110 10 10 100 110
2 16 200 116 6 8 50 58
3 21 200 121 5 7 33.3 30.3
4 26 200 126 5 6.5 25 31.5
5 30 200 130 4 6 20 26
6 36 200 136 6 6 16.67 22.67
7 46 200 146 10 6.6 14.3 20.9
54
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 100 110
2 16 200 216 6 8 50 58
3 21 200 221 5 7 33.3 30.3
4 26 200 226 5 6.5 25 31.5
5 30 200 230 4 6 20 26
6 36 200 236 6 6 16.67 22.67
7 46 200 246 10 6.6 14.3 20.9
Which Per Unit Cost Curves Change? 55
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 100 110
2 16 200 216 6 8 50 58
3 21 200 221 5 7 33.3 30.3
4 26 200 226 5 6.5 25 31.5
5 30 200 230 4 6 20 26
6 36 200 236 6 6 16.67 22.67
7 46 200 246 10 6.6 14.3 20.9
ONLY AFC and ATC Increase! 56
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 110
2 16 200 216 6 8 100 58
3 21 200 221 5 7 66.6 30.3
4 26 200 226 5 6.5 50 31.5
5 30 200 230 4 6 40 26
6 36 200 236 6 6 33.3 22.67
7 46 200 246 10 6.6 28.6 20.9
ONLY AFC and ATC Increase! 57
Shifting Costs Curves
If fixed costs change ONLY AFC and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 210
2 16 200 216 6 8 100 108
3 21 200 221 5 7 66.6 73.6
4 26 200 226 5 6.5 50 56.5
5 30 200 230 4 6 40 46
6 36 200 236 6 6 33.3 39.3
7 46 200 246 10 6.6 28.6 35.2
MC and AVC DON’T change! 58
Shift from an increase in a Fixed Cost
MC
ATC1

ATC
Costs (dollars)

AVC

AFC1
AFC
Quantity 59
Shift from an increase in a Fixed Cost
MC
ATC1
Costs (dollars)

AVC

AFC1

Quantity 60
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 What if the cost for
10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 variable resources
21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30
increase
100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
61
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
62
Shifting Costs Curves

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 11 100 110 10 10 100 110
2 18 100 116 6 8 50 58
3 24 100 121 5 7 33.3 30.3
4 30 100 126 5 6.5 25 31.5
5 35 100 130 4 6 20 26
6 43 100 136 6 6 16.67 22.67
7 55 100 146 10 6.6 14.3 20.9
63
Shifting Costs Curves

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 11 100 111 10 10 100 110
2 18 100 118 6 8 50 58
3 24 100 124 5 7 33.3 30.3
4 30 100 130 3 6.5 25 31.5
5 35 100 135 4 6 20 26
6 43 100 143 6 6 16.67 22.67
7 55 100 155 10 6.6 14.3 20.9
Which Per Unit Cost Curves Change? 64
Shifting Costs Curves

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 11 100 111 11 10 100 110
2 18 100 118 7 8 50 58
3 24 100 124 6 7 33.3 30.3
4 30 100 130 6 6.5 25 31.5
5 35 100 135 5 6 20 26
6 43 100 143 8 6 16.67 22.67
7 55 100 155 12 6.6 14.3 20.9
MC, AVC, and ATC Change! 65
Shifting Costs Curves

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 11 100 111 11 11 100 110
2 18 100 118 7 9 50 58
3 24 100 124 6 8 33.3 30.3
4 30 100 130 6 7.5 25 31.5
5 35 100 135 5 7 20 26
6 43 100 143 8 7.16 16.67 22.67
7 55 100 155 12 7.8 14.3 20.9
MC, AVC, and ATC Change! 66
Shifting Costs Curves
If variable costs change MC, AVC, and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 11 100 111
2 18 100 118 7 9 50 59
3 24 100 124 6 8 33.3 41.3
4 30 100 130 6 7.5 25 32.5
5 35 100 135 5 7 20 27
6 43 100 143 8 7.16 16.67 23.83
7 55 100 155 12 7.8 14.3 22.1
67
Shift from an increase in a Variable Costs
MC1
MC
ATC1
AVC1
ATC
Costs (dollars)

AVC

AFC
68
Quantity
Shift from an increase in a Variable Costs
MC1

ATC1
AVC1
Costs (dollars)

AFC
69
Quantity
70
71
Review
1. Difference between fixed and variable
resources
2. Define and give an example of the law of
diminishing marginal returns
3. Identify the three stages of returns
4. Explain how to calculate AVC, AFC, ATC,
and MC
5. Identify the difference between the short run
and the long run
6. List 10 names that start with “J”
72
Long-Run Costs

73
Definition and Purpose of the Long Run
In the long run all resources are variable.
Plant capacity/size can change.
Why is this important?
The Long-Run is used for planning. Firms use to identify
which plant size results in the lowest per unit cost.
Ex: Assume a firm is producing 100 bikes with a fixed
number of resources (workers, machines, etc.).
If this firm decides to DOUBLE the number of
resources, what will happen to the number of bikes it
can produce?
There are only three possible outcomes:
1. Number of bikes will double (constant returns to scale)
2. Number of bikes will more than double (economies of scale)
3. Number of bikes will less than double (diseconomies of scale) 74
Long Run ATC
What happens to the average total costs of a
product when a firm increases its plant capacity?
Example of various plant sizes:
•I make looms out of my garage with one saw
•I rent out building, buy 5 saws, hire 3 workers
•I rent a factor, buy 20 saws and hire 40 workers
•I build my own plant and use robots to build looms.
•I create plants in every major city in the U.S.

Long Run ATC curve is made up of all the

different short run ATC curves of various plant
sizes.
75
ECONOMIES OF SCALE
Why does economies of scale occur?
• Firms that produce more can better use Mass
Production Techniques and Specialization.
Example:
• A car company that makes 50 cars will have a very
high average cost per car.
• A car company that can produce 100,000 cars will
have a low average cost per car.
• Using mass production techniques, like robots, will
cause total cost to be higher but the average cost for
each car would be significantly lower.

76
Long Run AVERAGE Total Cost

Costs MC1
ATC1

$9,900,000

$50,000

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

77
Quantity Cars
Long Run AVERAGE Total Cost
Economies of Scale- Long
Costs MC1 Run Average Cost falls
ATC1 because mass production
MC2 techniques are used.
$9,900,000

ATC2
$50,000

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

78
Quantity Cars
Long Run AVERAGE Total Cost
Economies of Scale- Long
Costs MC1 Run Average Cost falls
ATC1 because mass production
MC2 techniques are used.
$9,900,000
MC3

ATC2
$50,000 ATC3

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

79
Quantity Cars
Long Run AVERAGE Total Cost
Constant Returns to Scale-
Costs MC1 The long-run average total
ATC1 cost is as low as it can get.
MC2
$9,900,000
MC3
MC4
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

80
Quantity Cars
Long Run AVERAGE Total Cost
Diseconomies of Scale-
Costs MC1 Long run average costs
ATC1 increase as the firm gets too
big and difficult to manage.
MC2
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

81
Quantity Cars
Long Run AVERAGE Total Cost
Diseconomies of Scale- The
Costs MC1 LRATC is increasing as the
ATC1 firm gets too big and
MC2
difficult to manage.
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

82
Quantity Cars
Long Run AVERAGE Total Cost
These are all short run
Costs MC1 average costs curves.
ATC1 Where is the Long Run
MC2
Average Cost Curve?
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

83
Quantity Cars
Long Run AVERAGE Total Cost

Costs
Economies of Constant Diseconomies
Scale Returns to of Scale
Scale

Long Run
Average Cost
Curve

0 1 100 1,000 100,000 1,000,0000

84
Quantity Cars
LRATC Simplified
The law of diminishing marginal returns doesn’t apply in
the long run because there are no FIXED RESOURCES.
Costs
Economies of Constant Diseconomies
Scale Returns to Scale of Scale

Long Run
Average Cost
Curve

85
Quantity
REAL WORLD ECONOMIES OF SCALE

86
87
4 Market
Structures

88
FOUR MARKET STRUCTURES
Perfect Monopolistic Pure
Competition Competition Oligopoly Monopoly

Every product is sold in a market that can be

considered one of the above market
structures.
For example:
1. Fast Food Market
2. The Market for Cars
3. Market for Operating Systems (Microsoft)
4. Strawberry Market
5. Cereal Market
89
Perfect
Competition
90
FOUR MARKET STRUCTURES
Perfect Monopolistic Pure
Competition Competition Oligopoly Monopoly
Imperfect Competition

Characteristics of Perfect Competition:

Examples of Perfect Competition: Avocado farmers,
sunglass huts, and hammocks in Mexico
• Many small firms
• Identical products (perfect substitutes)
• Easy for firms to enter and exit the industry
• Seller has no need to advertise
• Firms are “Price Takers”
The seller has NO control over price.
91
Law of One Price
In an efficient market, all identical goods must have
only one price.
Result: Each firm is a price taker. Firms have no
control of the price
Traffic Analogy
When there is heavy traffic,
why do all lanes seem to go the
same speed?
Cars leave slower lanes and
enter faster lanes.
Similarly, what happens in
perfectly competitive markets
if firms earn excessive profit?92
Perfectly Competitive Firms
Example:
• Say you go to Mexico to buy a hammock.
• After visiting at few different shops you find that
the buyers and sellers always agree on $15.
• This is the market price (where demand and
supply meet)
2. Is it likely that any shop can sell hammocks for $20?
3. Is it likely that any shop will sell hammocks for $10?
4. What happens if a shop prices hammocks too high?
5. Do you think that these firms make a large profit off
of hammocks? Why?
These firms are “price takers” because the sell their
products at a price set by the market.
93
Demand for Perfectly Competitive
Firms
Why are they Price Takers?
•If a firm charges above the market price, NO
ONE will buy. They will go to other firms
•There is no reason to price low because consumers
will buy just as much at the market price.
Since the price is the same at all quantities
demanded, the demand curve for each firm is…
Perfectly Elastic
(A Horizontal straight line)
94
The Competitive Firm is a Price Taker
Price is set by the Industry

P S P

$15 $15 Demand

D
5000 Q Q
Industry Firm
95
(price taker)
The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
revenue for selling an P
additional unit?
1st unit earns $15
2nd unit earns $15
Marginal revenue is $15 Demand
constant at $15 MR=D=AR=P
Notice:
• Total revenue increases
at a constant rate
• MR equal Average Q
Revenue Firm
96
(price taker)
The Competitive Firm is a Price Taker
Price is set by the Industry
What is the additional
For Perfect
revenue for selling an P
additionalCompetition:
unit?
1st unit earns $15
2nd unit earnsDemand
$15 = MR
Marginal revenue is Demand
constant at $15 (Marginal
$15
MR=D=AR=P
Notice: Revenue)
• Total revenue increases
at a constant rate
• MR equal Average Q
Revenue Firm
97
(price taker)
Maximizing
PROFIT!

98
Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11 99
Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output Profit
Maximizing
•Firms should continue to produce until the
additional revenue from each new output
Rule
equals the additional cost.
Example (Assume the price is $10)
MR=MC
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11 100
Lets put costs and revenue together
on a graph to calculate profit.

101
•How much output should be produced?
•How much is Total Revenue? How much is Total Cost?
•Is there profit or loss? How much?
P
$9 MC
8
7 MR=D=AR=P
6 Profit = $18 ATC
5 AVC
4
3 Don’t forget
2 that averages
1 Total Cost=$45 show PER UNIT
Total Revenue =$63 COSTS
1 2 3 4 5 6 7 8 9 10 Q
102
Suppose the market demand falls. What
would happen if the price is lowered from
$7 to $5?
The MR=MC rule still applies but now the
firm will make an economic loss.

The profit maximizing rule is also the

loss minimizing rule!!!

103
•How much output should be produced?
•How much is Total Revenue? How much is Total Cost?
•Is there profit or loss? How much?

MC
Cost and Revenue

$9
8
7 ATC
6
Loss =$7 AVC
5
4 MR=D=AR=P
3
2 Total Cost = $42
Total Revenue=$35
1
1 2 3 4 5 6 7 8 9 10 Q
104
Assume the market demand falls even
more. If the price is lowered from $5 to $4
the firm should stop producing.
Shut Down Rule:
•A firm should continue to produce as long
as the price is above the AVC
•When the price falls below AVC then the
firm should minimize its losses by shutting
down
•Why? If the price is below AVC the firm is
losing more money by producing than they
would have to pay to shut down.
105
SHUT DOWN! Produce Zero

MC
Cost and Revenue

$9
8 ATC
7
6
AVC
5
4
3 Minimum AVC
2
is shut down
1
point
1 2 3 4 5 6 7 8 9 10 Q
106
P<AVC. They should shut down
Producing nothing is cheaper than staying open.

MC
Cost and Revenue

$9
8
7 ATC
Fixed Costs=$10
6
AVC
5
TC=$35
4 MR=D=AR=P
3
2
TR=$20
1
1 2 3 4 5 6 7 8 9 10 Q
107
Profit Maximizing Rule
MR = MC
Three Characteristics of MR=MC Rule:
1. Rule applies to ALL markets
structures (PC, Monopolies, etc.)
2. The rule applies only if price is
above AVC
3. Rule can be restated P = MC for
perfectly competitive firms (because
MR = P) 108
Practice

109
Should the firm produce? Yes
#1 What output should the firm produce? 10
What is TR at that output? What is TC? TR=$140
How much profit or loss? Profit=$40 TC=$100

$20
MC
Cost and Revenue

15
14 MR=D=AR= P
ATC
10
AVC
6
5

0 6 7 10 Q 110
What output should the firm produce? Zero Shutdown
#2 What is TR at MR=MC point?$45
What is TC at MR=MC point?$55
(Price below AVC)

How much profit or loss? Loss=Only Fixed Cost $5

$20
MC
ATC
Cost and Revenue

15
AVC
11
10
9 MR=D=AR=P
5

0 5 7 Q 111
What output should the firm produce? 6
#3 What is TR at that output? $90
What is TC? $120
How much profit or loss? Loss= $30
$40
MC
Cost and Revenue

30
ATC
20 AVC
19
15 MR=D=AR=P
10

0 Q 112
6 8
113
Imperfect
Competition

114
Memorizing vs. Learning
12-35711131-71923
Try memorizing the above number
How effective is memorizing it?
The point: If you try to MEMORIZE
all the graphs of economics you will
forget them. You must LEARN them!
4 Market
Structures
116
FOUR MARKET STRUCTURES
Perfect Monopolistic Pure
Competition Competition Oligopoly Monopoly

Imperfect Competition

Every product is sold in a market that can be

considered one of the above market structures.
For example:
•Fast Food Market
•The Market for Cars
•Market for Operating Systems (Microsoft)
•Strawberry Market
•Cereal Market
117
Monopoly

118
Characteristics of
Monopolies

119
5 Characteristics of a Monopoly
1. Single Seller
• One Firm controls the vast majority of a
market
• The Firm IS the Industry
2. Unique good with no close substitutes
3. “Price Maker”
The firm can manipulate the price by changing
the quantity it produces (ie. shifting the supply
curve to the left).
Ex: Georgia electric companies
120
5 Characteristics of a Monopoly
4. High Barriers to Entry
• New firms CANNOT enter market
• No immediate competitors
• Firm can make profit in the long-run
5. Some “Nonprice” Competition
• Despite having no close competitors,
monopolies still advertise their products
in an effort to increase demand.
121
Examples of
Monopolies

122
What do you already know about
monopolies?
True or False?
1. All monopolies make a profit.
2. Monopolies are usually efficient.
3. All monopolies are bad for the economy.
4. All monopolies are illegal.
5. Monopolies charge the highest price
possible
6. The government never prevents
monopolies from forming. 123
124
Four Origins of Monopolies
1. Geography is the Barrier to Entry
Ex: Nowhere gas stations, De Beers Diamonds, Atlanta
Braves, Cable TV, Mercedes-Benz Stadium Hot
Dogs…
-Location or control of resources limits competition
and leads to one supplier.
2. The Government is the Barrier to Entry
Ex: Water Company, Firefighters, The Army,
Pharmaceutical drugs, rubix cubes…
-Government allows monopoly for public benefits or
to stimulate innovation.
-The government issues patents to protect inventors
and forbids others from using their invention.
125
(They last 20 years)
Four Origins of Monopolies
3. Technology or Common Use is the Barrier to Entry
Ex: Microsoft, Intel, Frisbee, Band-Aide…
-Patents and widespread availability of certain products
lead to only one major firm controlling a market.

4. Mass Production and Low Costs are Barriers to Entry

Ex: Electric Companies (Snapping Shoals)
• If there were three competing electric companies
they would have higher costs.
• Having only one electric company keeps prices low
-Economies of scale make it impractical to have
smaller firms.
Natural Monopoly- It is NATURAL for only one firm to
produce because they can produce at the lowest cost.126
Drawing
Monopolies
127
Good news…
1. Only one graph because the
firm IS the industry.
2. The cost curves are the same
3. The MR= MC rule still applies
4. Shut down rule still applies

128
The Main Difference
• Monopolies (and all Imperfectly
competitive firms) have downward
sloping demand curve.
• Which means, to sell more a firm must
lower its price.
• This changes MR…
THE MARGINAL REVENUE
DOESN’T EQUAL THE PRICE!
129
Combine the Demand of an industry
with the costs of a firm.
MC
Price

ATC
What about MR?

130
Quantity
Combine the Demand of an industry
with the costs of a firm.
MC
Price

ATC

MR
131
Quantity
Why is MR less than P Qd TR MR
Demand? $11 0 0 -

132
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10

133
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10
$9 2 18 8
$9 $9

134
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$8 $8 $8

135
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$7 4 28 4
$8 $8 $8
$7 $7 $7 $7

136
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$7 4 28 4
$8 $8 $8
$6 5 30 2
$7 $7 $7 $7
$6 $6 $6 $6 $6

137
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$7 4 28 4
$8 $8 $8
$6 5 30 2
$7 $7 $7 $7 $5 6 30 0
$6 $6 $6 $6 $6
$5 $5 $5 $5 $5 $5

138
Why is MR less than P Qd TR MR
Demand? $11 0 0 -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$7 4 28 4
$8 $8 $8
$6 5 30 2
$7 $7 $7 $7 $5 6 30 0
$6 $6 $6 $6 $6 $4 7 28 -2

$5 $5 $5 $5 $5 $5
$4 $4 $4 $4 $4 $4 $4
139
Why is MR less than P Qd TR MR
Demand? $11 0 - -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$7 4 28 4
$8 $8 $8
$6 5 30 2
$7 $7 $7 $7 $5 6 30 0
$6 $6 $6 $6 $6 $4 7 28 -2

$5 $5 $5 $5 $5 $5
$4 $4 $4 $4 $4 $4 $4
140
Why is MR less than P Qd TR MR
Demand? $11 0 - -
$10 1 10 10
$10
$9 2 18 8
$9 $9 $8 3 24 6
$8 $8 MR
$8 IS LESS THAN $7 4 28 4
$6 5 30 2
$7 $7 $7 $7 PRICE $5 6 30 0
$6 $6 $6 $6 $6 $4 7 28 -2

$5 $5 $5 $5 $5 $5
$4 $4 $4 $4 $4 $4 $4
141
Why is MR below Demand?
P
$10
9
8
7
6
5
4 D
3
2
1
Q
1 2 3 4 5 6 7

MR 142
Why is MR below Demand?
P At price $10, TR = $10
$10 When price falls to $9, MR =$8
9 What happens to MR when
8 price falls to $8?
7
6
5
4 D
3
2
1
Q
1 2 3 4 5 6 7

MR 143
Why is MR below Demand?
P At price $10, TR = $10
$10 When price falls to $9, MR =$8
9 What happens to MR when
8 price falls to $8?
MR CURVE IS LESS
7
6
5
THAN
DEMAND CURVE!!!
4 D
3
2
1
Q
1 2 3 4 5 6 7

MR 144
Calculating
Marginal Revenue

145
Calculate TR and Marginal Revenue
Quantity Price TR MR
0 $16
1 15
2 14
3 13
4 12
5 11
6 10
7 9
8 8
9 7
10 6
146
Calculate TR and Marginal Revenue
Quantity Price TR MR
0 $16 0
1 15 15
2 14 28
3 13 39
4 12 48
5 11 55
6 10 60
7 9 63
8 8 64
9 7 63
10 6 60
147
Calculate TR and Marginal Revenue
Quantity Price TR MR
0 $16 0 -
1 15 15 15
2 14 28 13
3 13 39 11
4 12 48 9
5 11 55 7
6 10 60 5
7 9 63 3
8 8 64 1
9 7 63 -1
10 6 60 -3
148
Calculate TR and Marginal Revenue
Quantity Price TR MR
0 $16 0 -
1 15 15 15
2 14 28 13
3 13 39 11
4 12 48 9
5 11 55 7
6 10 60 5
7 9 63 3
8 8 64 1
9 7 63 -1
10 6 60 -3
149
Plot the Demand, Marginal Revenue, and
Total Revenue Curves
P
$15

10

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
TR
$64

40

20

Q 150
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Demand and Marginal Revenue Curves
What happens to TR when MR hits zero?
P
$15

10

5
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
TR
$64 MR
40
Total Revenue is
at it’s peak when
20 MR hits zero
TR
Q 151
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Elastic vs. Inelastic
Range of Demand Curve

152
Elastic and Inelastic Range
P Elastic Inelastic
Total Revenue Test $15
If price falls and TR
increases then 10

demand is elastic.
5
D
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Q
TR A monopoly
$64 MR will only
Total Revenue Test
If price falls and 40 produce in
TR falls then the elastic
demand is inelastic.
20 range
TR
Q 153
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Maximizing
Profit

154
What output should this monopoly produce?
MR = MC
How much is the TR, TC and Profit or Loss?
P
$9 MC
ATC
8
7
Profit =$6
6
5
D
4
3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 155
Conclusion: A monopolists produces where
MR=MC, buts charges the price consumer are
willing to pay identified by the demand curve.
P
$9 MC
ATC
8
7
6
5
D
4
3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 156
What if cost are higher?
How much is the TR, TC, and Profit or Loss?
MC
P ATC
$10
9 AVC
8
7
6 D
5 TR= $90
4 TC= $100
MR
3 Loss=$10
6 7 8 9 10 Q 157
TR= $70
Identify and Calculate: TC= $56
Profit/Loss= $14
Profit/Loss per Unit= $2
P MC

$10 ATC
9
8
7
D
6
5 MR
4
1 2 3 4 5 6 7 8 9 10 Q 158
Are Monopolies
Efficient?
159
Monopolies vs. Perfect Competition
P S = MC

CS
In perfect competition,
Pp CS and PS are
c PS maximized.

Q
Qpc 160
Monopolies vs. Perfect Competition
P S = MC

At MR=MC,
P A monopolist will
produce less and
P
m
p charge a higher price
c

D
MR
Q
Q Qpc 161
Monopolies vs. Perfect Competition
Where is CS S = MC
P and PS for a
monopoly?
CS
P Total surplus falls.
m
Now there is
PS DEADWEIGHT
LOSS

Monopolies underproduce and over D

charge, decreasing CS and
MR
increasing PS.
Q
Q 162
Are Monopolies Productively Efficient?
Does Price = Min ATC? No. They are not
producing at the lowest
cost (min ATC)
P
$9 MC
ATC
8
7
6
5
D
4
3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 163
Are Monopolies Allocatively Efficiency?
Does Price = MC? No. Price is greater.
The monopoly is under
producing.
P
$9 MC
ATC
8
7
6
5
Monopolies are NOT efficient!
4
D

3
2 MR
1 2 3 4 5 6 7 8 9 10 Q 164
Monopolies are inefficient because
they…
1. Charge a higher price
2. Don’t produce enough
• Not allocatively efficiency
3. Produce at higher costs
• Not productively efficiency
4. Have little incentive to innovate
Why?
Because there is little external pressure to
be efficient 165
Natural Monopoly
One firm can produce the socially optimal quantity
at the lowest cost due to economies scale.
P
It is better to have only
one firm because ATC is
falling at socially
optimal quantity
MC
ATC

MR D
Qsocially Q 166
2007 FRQ #1
Unit 4:
Imperfect
Competition
168
A monopoly produces where MR=MC, buts
charges the price set by the demand curve.
How much is the TR, TC and Profit or Loss?
P
MC
ATC
$10
Profit =$20
9
8
D
7
6
5 MR
16 17 18 19 20 Q 169
Regulating
Monopolies
170
Why Regulate?
Why would the government regulate
an monopoly?
1. To keep prices low
2. To make monopolies efficient

How do they regulate?

•Use Price controls: Price Ceilings
•Why don’t taxes work?
•Taxes limit supply and that’s the problem 171
Where should the government
place the price ceiling?
1.Socially Optimal Price
P = MC (Allocative Efficiency)

OR
2. Fair-Return Price (Break–Even)
P = ATC (Normal Profit)
172
Regulating Monopolies
Where does the firm produce if it is
P
unregulated?
MC

Pm ATC

D
MR

Qm Q 173
Regulating Monopolies
PriceOptimal
Socially Ceiling at Socially Optimal
= Allocative Efficiency
P
MC

Pm ATC
Pso

D
MR

Qm Qso Q 174
Regulating Monopolies
Price Ceiling
Fair Return meansatnoFair Returnprofit
economic
P
MC

Pm ATC
Pso
Pfr
D
MR

Qm Qso Qfr Q 175

Regulating Monopolies
Unregulated
Socially
P
Optimal MC
Fair
Return
Pm ATC
Pso
Pfr
D
MR

Qm Qso Qfr Q 176

Regulating a Natural Monopoly
What happens if the government sets a price ceiling
to get the socially optimal quantity?
P
The firm would make a
loss and would require a
subsidy
MC

Pso
ATC

MR D
Qsocially optimal Q 177
Price
Discrimination
178
Price Discrimination
Definition:
Practice of selling the same products
to different buyers at different prices

Examples:
•Airline Tickets (vacation vs. business)
•Movie Theaters (child vs. adult)
•All Coupons (spenders vs. savers)
•BI football games (students vs. parents)
179
PRICE DISCRIMINATION
•Price discrimination seeks to charge each
consumer what they are willing to pay in an
effort to increase profits.
•Those with inelastic demand are charged
more than those with elastic
Requires the following conditions:
1. Must have monopoly power
2. Must be able to segregate the market
3. Consumers must NOT be able to resell
product 180
P Qd TR MR
$11 0 0 -

181
Results of Price P Qd TR MR
Discrimination $11 0 0 -
$10 1 10 10
$10

182
Results of Price P Qd TR MR
Discrimination $11 0 0 -
$10 1 10 10
$10
$9 2 19 9
$10 $9

183
Results of Price P Qd TR MR
Discrimination $11 0 0 -
$10 1 10 10
$10
$9 2 19 9
$10 $9 $8 3 27 8
$10 $9 $8

184
Results of Price P Qd TR MR
Discrimination $11 0 0 -
$10 1 10 10
$10
$9 2 19 9
$10 $9 $8 3 27 8
$7 4 34 7
$10 $9 $8
$10 $9 $8 $7

185
Results of Price P Qd TR MR
Discrimination $11 0 0 -
$10 1 10 10
$10
$9 2 19 $9
$10 $9 $8 3 27 $8
$7 4 34 $7
$10 $9 $8
$6 5 40 $6
$10 $9 $8 $7 $5 6 45 $5
$10 $9 $8 $7 $6 $4 7 49 $4

$10 $9 $8 $7 $6 $5
$10 $9 $8 $7 $6 $5 $4
186
P Qd TR MR
$11 0 0 -
$10 1 10 10
$10
$9 2 19 $9
$10 $9 $8 3 27 $8
WHEN PRICE
$7 4 34 $7
$10 $9 $8
DISCIMINATING
$6 5 40 $6
$10 $9 $8 $7 MR = D$5 6 45 $5
$10 $9 $8 $7 $6 $4 7 49 $4

$10 $9 $8 $7 $6 $5
$10 $9 $8 $7 $6 $5 $4
187
Regular Monopoly vs.
Price Discriminating Monopoly
P
MC

Pm
ATC

MR
Qm Q 188
A perfectly discriminating can charge each person
differently so the Marginal Revenue = Demand

P
MC

ATC

MR
Q 189
A perfectly discriminating can charge each person
differently so the Marginal Revenue = Demand
Identify the Price, Profit, CS, and DWL
P
MC

ATC

D =MR

Qnm Q 190
A perfectly discriminating can charge each person
differently so the Marginal Revenue = Demand
Identify the Price, Profit, CS, and DWL
P
MC

ATC

D =MR
Price Discrimination results in several
prices, more profit, no CS, and a higher
socially optimal
Q
quantity Q
nm 191
Can You Do The Following?
1.Draw a monopoly making a profit at
long-run equilibrium and identify
price, quantity, and profit.
2. Draw a perfectly competitive
industry AND firm at long-run
equilibrium
3. Draw a price discriminating
monopoly at equilibrium and label
price, quantity, MR, and profit
192
Monopolistic
Competition

193
Perfect Monopolistic Pure
Competition Competition Oligopoly Monopoly

Characteristics of Monopolistic
Competition:
•Relatively Large Number of Sellers
•Differentiated Products
•Some control over price
•Easy Entry and Exit (Low Barriers)
•A lot of non-price competition
(Advertising) 194
Examples:
1. Fast Food Restaurants
2. Furniture companies
3. Jewelry stores
4. Hair Salons
5. Clothing Manufacturers

195
“Monopoly” + ”Competition”
Monopolistic Qualities
• Control over price of own good due
to differentiated product
• D greater than MR
• Plenty of Advertising
• Not efficient
Perfect Competition Qualities
• Large number of smaller firms
• Relatively easy entry and exit
• Zero Economic Profit in Long-Run
since firms can enter
196
Differentiated Products
•Goods are NOT identical.
•Firms seek to capture a piece of the
market by making unique goods.
•Since these products have substitutes,
firms use NON-PRICE Competition.
Examples of NON-PRICE Competition
• Brand Names and Packaging
• Product Attributes
• Service
• Location
• Advertising (Two Goals)
1. Increase Demand
2. Make demand more INELASTIC 197
Differentiated Products

198
Review
1. Identify the 4 market structures.
2. Explain why D is greater than MR.
3. Define Price Discrimination.
4. List characteristics of monopolistic
competition.
5. List Monopolistic Qualities.
6. List Competitive Qualities.
7. List examples of non-price competition.
8. List two goals of advertising.
9. Name 10 types of Candy.

199
Drawing Monopolistic
Competition

200
Monopolistic Competition is made up of
prices makers so MR is less than Demand
In the short-run, it is the same graph as a
monopoly making profit
P
MC
ATC
P1

In the long-run, new firms will Denter,

driving down the DEMAND for firms
already in the market.
MR
Q1 Q 201
Firms enter so demand falls until there is no
economic profit

P
MC
ATC
P1

MR
Q1 Q 202
Firms enter so demand falls until there is no
economic profit
Price and quantity falls and TR=TC
P
MC
ATC

PLR

MR
QLR Q 203
LONG-RUN EQUILIBRIUM
Quantity where MR =MC up to Price = ATC
P
MC
ATC

PLR

MR
QLR Q 204
Why does DEMAND shift?
When short-run profits are made…
– New firms enter.
– New firms mean more close substitutes and
less market shares for each existing firm.
– Demand for each firm falls.
When short-run losses are made…
– Firms exit.
– Result is less substitutes and more market
shares for remaining firms.
– Demand for each firm rises.

205
What happens when there is a loss?
In the short-run, the graph is the same as a
monopoly making a loss
ATC
P
MC

P1

In the long-run, firms will leave, D

driving
up the DEMAND for firms already in the
market. MR
Q1 Q 206
Firms leave so demand increases until there
is no economic profit

ATC
P
MC

P1

MR
Q1 Q 207
Firms leave so demand increases until there
is no economic profit
Price and quantity increase and TR=TC
ATC
P
MC
PLR

MR
QLR Q 208
Are Monopolistically
Competitive Firms
Efficient?

209
LONG-RUN EQUILIBRIUM
Not Allocatively Efficient because P ≠ MC
Not Productively Efficient because not producing
at Minimum ATC
P
MC ATC
PLR

MR
QLR QSocially Q 210
Optimal
LONG-RUN EQUILIBRIUM
This firm also has EXCESS CAPACITY
P
MC ATC
PLR

MR
QLR QSocially Q 211
Optimal
Excess Capacity
• Given current resources, the firm
can produce at the lowest costs
(minimum ATC) but they decide not
to.
• The gap between the minimum ATC
output and the profit maximizing
output.
• Not the amount underproduced
212
LONG-RUN EQUILIBRIUM
The firm can produce at a lower cost but it
holds back production to maximize profit
P
MC ATC
PLR

Excess D
Capacity
MR
QLR QProd Q 213
Efficient
Practice Question
Assume there is a monopolistically
competitive firm in long-run equilibrium. If
this firm were to realize productive
efficiency, it would:
A) have more economic profit.
B) have a loss.
C) also achieve allocative efficiency.
D) be under producing.
E) be in long-run equilibrium.
214
Advantages of
MONOPOLISTIC COMPETITION
• Large number of firms and product
variation meets societies needs.
• Nonprice Competition (product
differentiation and advertising) may
result in sustained profits for some
firms.
Ex: Nike might continue to make above
normal profit because they are a well
known brand.
215
FOUR MARKET MODELS

216
Graphing
1. Draw the graph for a monopolistic
competitive fast food restaurant making
$400 total profit by selling 200 burgers
at $4 each. Label D, MR, MC, Price,
and Quantity.

2. Show shifts that will occur in the

long-run and identify TR, TC, and
profit.
217
Unit 4:
Imperfect
Competition
Oligopoly
FOUR MARKET MODELS
Perfect Monopolistic Pure
Competition Competition Oligopoly Monopoly

Characteristics of Oligopolies:
•A Few Large Producers (Less than 10)
•Identical or Differentiated Products
•High Barriers to Entry
•Control Over Price (Price Maker)
•Mutual Interdependence
•Firms use Strategic Pricing
Examples: OPEC, Cereal Companies,
Car Producers
HOW DO OLIGOPOLIES OCCUR?
Oligopolies occur when only a few large
firms start to control an industry.
High barriers to entry keep others from
entering.
Types of Barriers to Entry
1. Economies of Scale
•Ex: The car industry is difficult to enter
because only large firms can make cars
at the lowest cost
2. High Start-up Costs
3. Ownership of Raw Materials
Game Theory
The study of how people behave in
strategic situations

An understanding of game theory helps

firms in an oligopoly maximize profit.
Game theory helps predict human
behavior
THE ICE CREAM MAN SIMULATION
1. You are a ice cream salesmen at the beach
2. You have identical prices as another salesmen.
3. Beachgoers will purchase from the closest
salesmen
4. People are evenly distributed along the beach.
5. Each morning the two firms pick locations on
the beach

Where is the best

location?
Where should you put your firm?
A B

Firm A decides where to goes first.

• What is the best strategy for choosing a
location each day?
• Can you predict the end result each day?
• How is this observed in the “real-world”?
Why learn about game theory?
•Oligopolies are interdependent since
they compete with only a few other
firms.
• Their pricing and output decisions
must be strategic as to avoid
economic losses.
•Game theory helps us analyze their
strategies.
SIMULATION!
The Prisoner’s Dilemma
Charged with a crime, each
prisoner has one of two choices:
Deny or Confess
Prisoner 2
Deny Confess

Both Deny = 5
Deny Years in jail each Confess = Free
Deny =20 Years
Prisoner 1
Confess = Free Both Confess= 10
Confess Deny = 20 Years Years in jail each
Game Theory Matrix
You and your partner are competing firms. You
have one of two choices: Price High or Price Low.
Without talking, write down your choice
Firm 2
High Low

High Both High = Low = $30

$20 Each High = 0
Firm 1
High = 0 Both Low=
Low
Low = $30 $10 each
Game Theory Matrix
Notice that you have an incentive to collude but
also an incentive to cheat on your agreement
Firm 2
High Low

High Both High = Low = $30

$20 Each High = 0
Firm 1
High = 0 Both Low=
Low
Low = $30 $10 each
Dominant Strategy
The Dominant Strategy is the best move to make
regardless of what your opponent does
What is each firm’s dominate strategy?
Firm 2 No Dominant
High Low Strategy

High $100, $50 $80, $90

Firm 1
Low $50, $40 $20, $10
Nash Equilibrium
The equilibrium reached when each
player takes their best action, given the
actions taken by the other players.

In other words, neither player has an

incentive to change his or her action.

230
What did we learn?
1. Oligopolies must use strategic
pricing (they have to worry about
the other guy)
2. Oligopolies have a tendency to
collude to gain profit.
(Collusion is the act of cooperating with
rivals in order to “rig” a situation)
3. Collusion results in the incentive to
cheat.
4. Firms make informed decisions
based on their dominant strategies
2007 FRQ #3
Payoff matrix for two competing bus companies
2009 FRQB #3
Payoff matrix for two competing bus companies
Oligopoly
Graphs
Because firms are interdependent
There are 3 types of Oligopolies
1. Price Leadership (no graph)
2. Colluding Oligopoly
3. Non Colluding Oligopoly
#1. Price
Leadership
Example: Small Town Gas Stations
To maximize profit what will they do?

OPEC does this with OIL

Price Leadership
•Collusion is ILLEGAL.
•Firms CANNOT set prices.
•Price leadership is a strategy used by
firms to coordinate prices without
outright collusion
General Process:
1. “Dominant firm” initiates a price change
2. Other firms follow the leader
Price Leadership
Breakdowns in Price Leadership
•Temporary Price Wars may occur if
other firms don’t follow price
increases of dominant firm.
•Each firm tries to undercut each
other.
Example: Employee Pricing for Ford
#2. Colluding
Oligopolies
Cartel = Colluding Oligopoly
A cartel is a group of producers that
create an agreement to fix prices high.
1. Cartels set price and output at an
agreed upon level
2. Firms require identical or highly
similar demand and costs
3. Cartel must have a way to punish
cheaters
4. Together they act as a monopoly
Firms in a colluding oligopoly act as a
monopoly and share the profit
P
MC
ATC

MR
Q
#3.
Non-Colluding
Oligopolies
Kinked Demand Curve Model
The kinked demand curve model shows how
noncollusive firms are interdependent
If firms are NOT colluding they are likely to
react to competitor’s pricing in two ways:
1. Match price-If one firm cuts it’s prices, then
the other firms follow suit causing inelastic
demand
2. Ignore change-If one firm raises prices,
others maintain same price causing elastic
demand
If this firm increases it’s price, other firms
will ignore it and keep prices the same
As the only firm with high prices, Qd for this firm
P will decrease a lot
Elas
P1 tic
Pe

D
Q1 Qe Q
If this firm decreases it’s price, other firms
will match it and lower their prices
Since all firms have lower prices, Qd for this firm
P will increase only a little
Elas
P1 tic
Pe
P2

In
ela
s
tic D
Q1 Qe Q2 Q
Where is Marginal Revenue?
MR has a vertical gap at the kink. The result is that
MC can move and Qe won’t change. Price is sticky.
P

MC
Pe

MR D
Q Q
Market Structures
Venn Diagram
Perfect Competition Monopolistic Competition

No Similarities

Oligopoly Monopoly
Name the market structure(s) that it is
associated with each concept
1. Price Maker (Demand > MR)
2. Collusion/Cartels
3. Identical Products
4. Price Taker (Demand = MR)
5. Excess Capacity
6. Low Barriers to Entry
7. Game Theory
8. Differentiated Products
9. Long-run Profits
10. Efficiency
11. Normal Profit
12. Dead Weight Loss
13. High Barriers to Entry
14. Firm = Industry
15. MR=MC Rule
Perfect Competition Monopolistic Competition

No Similarities

Oligopoly Monopoly
Re
d os cks ta
ca mo Perfect Competition Monopolistic Competition il S
o to
Av am •Identical Products •Excess Advertising re
.H s
T. J •No advantage •Low barriers to entry •Differentiated Products
•D=MR=AR=P •No Long-Run Profit •Excess Capacity
•Both efficiencies •Price = ATC •More Elastic Demand than
•Price-Taker Monopoly
•1000s •100s

•MR = MC •Price Maker (D>MR)

No Similarities •Shut-Down Point •Some Non-Price Competition
•Cost Curves •Inefficient
•Motivation for Profit

•Collusion
•Strategic Pricing
•Price Maker (D>MR) •Unique Good
(Interdependence)
•High Barriers •Price Discrimination
•Game Theory
•Ability to Make LR Profit •1
•10 or less
Ap Ca •Inefficient
pl rs
ia Oligopoly cal s
nc
es
Monopoly Lo litie
i
Ut