EXAM 2 Study Guide
Chapter 11: Costs and Profit Maximization under Competition
Imagine that you are the owner of a stripper oil well and that you want to maximize your profit.
What price to set? What quantity to produce? When to enter and exit the industry?
What price to set?
Sometimes the firm doesn’t set prices – sometimes simply accepts price that is given by the market
If oil is $50 a barrel, can’t sell for $100 and why would you sell lower?
You cant sell any oil at a price above the market price and you can sell all your oil at the market
price. Thus to maximize profit, you sell at the market price.
The more and the better the substitutes, the more elastic the demand. 400,000 oil wells – demand
for oil is perfectly elastic (flat)
A perfectly elastic demand curve for firm output is a reasonable approximation when the product
being sold is similar across different firms and there are many buyers and sellers, each small
relative to the total market
Demand curves are more elastic in the long run
Long run: the time after all exit or entry has occurred
Short run: period before exit or entry can occur
Imagine you’re owner of the only grocery store in a small town. Can you raise prices? In short run
you could. But if raise prices too high, other sellers will set up shop.
*An industry is competitive when firms don’t have much influence over the price of their product
IF 1) product being sold is similar across sellers 2) there are many buyers/sellers, each small
relative to total market 3) there are many potential buyers
--A firm who sells unique items or who has a large share of the market for a homogenous product
will have influence on the price of product
What quantity to produce?
Profit = pi = total revenue – total cost
Total revenue = P X Q (price times quantity sold)
Total costs is the cots of producing a given quantity of output (include opportunity costs, not just
money costs) (average costs, marginal costs, fixed costs)
^include opportunity costs, costs of foregone alternatives
An explicit cost is a cost that requires a money outlay
Ex: lian runs a flower shop. Each month she spends money buying flowers from whole sellers. The
cost of flowers is an explicit cost of running her shop, like rent and electricity, which she pays out
of pocket by writing a check
An implicit cost is a cost that does not require an outlay of money
^giving up something of a value when she works as a florist – a cost of running a flower shop, even
though she is not writing anybody a check
Economic profit is total revenue minus total costs including implicit costs
Accounting profit is total revenue minus explicit costs
^Economic profits are typically less than accounting profits. Firms want to maximize economic
profit, not accounting profit. Accountants typically don’t take into account of all opportunity costs.
What am I giving up by following this strategy? Could these assets be used to make more profit if I
used them in another way?
Maximizing profit Fixed costs are costs that do not vary with output
Ex: must pay to drill the well (had to borrow money to start the well); no matter how many barrels
of oil it produces, still has to pay
Variable costs are costs that do vary with output
Ex: electricity, maintenance, costs for the barrels to store the oil, trucking costs to deliver oil
Total Cost = Fixed Costs + Variable Costs
Marginal Revenue is the change in total revenue from selling an additional unit
MR = change in TR / change in Q
For a firm in a competitive industry (the price of oil doesn’t change as the firm sells more barrels):
MR = Price
The owner of a small oil well has more choice from producing an additional barrel of oil
Notice that the profit maximizing quantity is where MR = MC and MR = P so therefore, to
maximize profit, a firm in a competitive industry increases output until P = MC
^ just right point between too little and too much
(students are often confused by why economists say that the profit maximizing output is 8 instead
of 7 barrels. Why produce the eighth barrel where P = MC and therefore no addition to profit?)
Profits and the Average Cost Curve
^just because the firm is doing the best it can doesn’t mean that it is doing very well
the average cost of production is simply the cost per barrel, that is, the average cost of producing
Q barrels of oil divided by Q:
AC = (TC)/Q
Profit = Total Revenue – total cost = TR – TC
Profit = (TR/Q – TR/Q) X Q
Or Profit = (P – AC) X Q
^used two equations to get this
LOOK ON PAGE 201
If P < AC then the firm is taking a loss
If P > AC then the firm is making a profit
When marginal cost is just below average cost, the average cost curve is falling, and when
marginal cost is just above average cost, the average cost curve is rising, so AC and MC must meet
at the minimum of the AC curve
Entry, Exit, and Shutdown Decisions
In the long run, firms will enter profitable industries (P>AC) and exit unprofitable industries.
Notice that at the intermediate point, when P = AC, profits are zero and there is neither entry nor
Zero profits or normal profits occur when P = AC. At this price the firm is covering all of its costs,
including enough to pay labor and capital their ordinary opportunity costs. No incentive to either
enter or exit the industry.
The short-run shutdown decision:
When should a firm shut down? IN the long run, a firm will exit an industry if price falls below
average costs, but exit typically takes a long time. Surprisingly, a firm may not want to shut down
even when P < AC. The shutdown does not immediately eliminate all costs (fixed costs) Like ex:
shutting down hotel in winter is less profitable than keeping it open with few tourists
Entry and Exit with Uncertainty and Sunk Costs: A firm should exit when P < AC only if it expects P to remain below AC for a substantial period of
time and it should enter only if P > AC and it expects P to stay above AC for a substantial period
The costs of drilling an oil well are sunk costs (a cost that once incurred can never be recovered).
Thus, for entry to be profitable, the firm must expect the price to stay above $17.
So if you expect your firm to be profitable in the future, it can sometimes make sense to keep
workers on, even when it is no profitable to do so today.
*firms must estimate the effect of their decisions on their lifetime expected profit.
A short delay has small costs but big benefits if a short delay will reveal more info about future
Entry, Exit, and Supply Curves
We will show how the slope of the supply curve can be explained by how costs change as industry
output increases or decreases.
Increasing cost industry: an industry in which industry costs increase with greater output; shown
with an upward sloped supply curve
Constant cost industry: an industry in which industry costs do not change with greater output;
shown with a flat supply curve
Decreasing cost industry: an industry with an increase in output; shown with a downward sloped
Constant Cost industries:
Ex: industry of domain name registrars (every website url is registered with DNA and assigned IP
Many competitors in industry (product being sold is similar across sellers)
There are many buyers and sellers, each small relative to the total market
There are many potential sellers
So, the domain name registration can expand without pushing up the price of its major inputs and
thus without raising its own costs. An industry that can expand or contract without changing the
prices of its input is called a constant cost industry.
1. price is driven down to the average cost of managing – normal levels
2. doesn’t change much when the industry expand sor contracts so the long-run supply curve is
When an increase in demand hits a constant cost industry, the price rises in the short run as each
firm moves up its MC curve. But the expansion of old firms and the entry of new firms quickly
push the price back down to average cost.
READ PAGE 207 GRAPHS
First response to an increase in demand – the price rises and every firm in industry responds by
The second response is that the above-normal profits attract new investment and entry
Increasing Cost Industries
Costs rise as industry output increases. The oil industry is an increasing cost industry because
greater quantities of oil can only be produced by using more expensive methods such as drilling
deeper, drilling in more inhospitable spots, or extracting oil from tar sands.
Page 209 graph
At any price below $17, the quantity supplied is zero.
Industry supply at any price is found by adding up the quantity supplied by each firm at that price.
As the price increases, each firm expands output by moving along its marginal cost curve. As the price of oil rises, it becomes fortiable to supply oil from north sea, Athabasca tar sands, and
other higher cost sources. (Chapter 3 – higher price encourages entry from higher-cost productions)
*any industry that buys a large fraction of the output of an increasing cost industry will also be an
increasing cost industry.
*greater demand for gas will push up the price of oil, which in turn raises the price of gas.
(electricity industry is also increasing cost industry)
A special case: the decreasing cost industry
Could firms costs decrease as the industry expands creating a decreasing cost industry with a
downward sloping supply curve?
Ex: carpets in Dalton, Georgia, computer technology Silicon Valley, Aalseemer flower
Once the cluster is established, constant or increasing costs are the norm.
Resulting virtuous circle made Dalton the cheapest place to make carpet in US – not because
Dalton had natural advantages but because it was cheaper to make carpets in a place where there
were already a lot of carpet makers
*rare and temporary
What price to set? Set price at market price
What quantity to produce? Maximize profit by producing quantity that makes P = MC
When to exit and enter an industry? In long run, firm enter if P > AC and exit if P < AC
A competitive industry
1) product being sold is similar across sellers
2) there are many buyers/sellers, each small relative to total market
3) there are many potential buyers
Constant cost industry, increasing cost industry, decreasing cost industry.
Chapter 12:Competition and the Invisible Hand
With the right institutions, individuals acting in their self-interest can generate outcomes that are
neither part of their intention nor design but that nevertheless have desirable properties.
We will show: how the conditions for profit maximization under competition lead entrepreneurs to
produce outcomes that they neither intend nor design but that nevertheless have desirable outcomes
We show that P = MC condition for profit maximization in a competitive market balances
production across firms in an industry in just the way that minimizes the total industry costs of
Second, we show that the entry (P > AC) and exit (P < AC) signals balance production across
different industries in just the way that maximizes the total value of production.
Invisible Hand Property 1: The mimization of total industry costs of production
Every firm in the same industry faces the same price. Thus, in a competitive market with N firms
(free market), this is true:
P = MC1 = MC2 = … = MCn
MC1: marginal cost of firm 1, MC2: marginal cost of firm 2
So produce less on Farm 2 and more on farm 1 if MC2 > MC1 and the opposite if MC1 > MC2
So it follows that the way to minimize the total costs of production is to produce just so much on
each farm so that the marginal costs are equalized MC1 = MC2
What if two different people own the farms? Is there still a way to organize if so that the marginal
costs could be equal? Yes Each farmer chooses the output levels that minimize total costs because Sandy chooses P = MC1
and Pat chooses P = MC2 (most profitable for them) so then MC1 = MC2
Adam Smith: “each individual is led by an invisible hand to promote an end which was no part of
Suppose they live in two different countries with no free trade between them so they face different
prices for corn MC1 does not equal MC2 total costs cant be at a minimum
Indivisible Hand Property 2: The Balance of Industries
Its this property that ensures that the right amount of corn is produced (could minimize total costs
of producing and still have too much or too little corn).
Recall that our condition to enter an industry is P > AC, which is equivalent to TR > TC. So, in a
competitive market, the incentives that entrepreneurs have to seek profit and avoid losses align
with the social incentive to move labor and capital out of low-value industries and into high-value
Notice that profits encourage entry, but what happens to price and profits when firms enter an
industry? As firms enter, supply increases and the price declines, which reduces profits.
*shows how the self-interest of entrepreneurs causes them to enter and exit the car, computer, corn,
apple, and other industries in such a way that the total value of all production is maximized. An
implication is that the profit rate in all competitive industries tends toward the same level.
According to the elimination principle, above-normal profits are eliminated by entry and below-
normal profits are eliminated by exit.
The elimination principle says that above-normal profits are temporary. Great ideas are soon
adopted by others. Since no one profits from the commonplace to earn above-normal profits, an
entrepreneur must innovate.
^serves as both a warning and an opportunity to entrepreneurs. In a dynamic economy, there is a
constant dance between elimination and innovation.
The Invisible Hand Works with Competitive Markets
Competitive markets do a good job of aligning self-interest with the social interest, but not all
markets are competitive.
If markets are competitive, the invisible hand doesn’t work well.
Page 229 – the “takeaway” helps to read
Chapter 13: Monopoly
Reason why HIV drugs (or other expensive things) are priced well above cost.
1. market power
2. the “you cant take it with you” effect
a. both these phrases effects make consumers with serious diseases insensitive to thep
rice of life-saving pharmaceuticals – that is, they will continue to buy in lage
quantities even when the price increases
3. the “other people’s money” effect
a. access to public or private health insurance
b. both phrases effect make the demand curve more inelastic
*the more inelastic the demand curve, more a monopolist will raise its price above marginal cost
Market power is the power to raise price above marginal cost without fear that other firms will
enter the market (ex: patented products can be duplicated)
patents, government regulations other than patents, economies of scale, exclusive access to
an important input, and technological innovation A monopoly is a firm with market power.
Even a firm with no competitiors faces a demand curve, so as it raises its price, it will sell fewer
units. So what is the profit-maximizing price?
Produce until marginal revenue equals marginal cost
Marginal Revenue, MR, is the change in total revenue from selling an additional unit
If the demand curve is a straight line, then the marginal revenue curve is a straight line that begins
at the same point on the vertical axis as the demand curve but with twice the slope. (PAGE 235
explains how to find marginal revenue) (revenue gain plus the revenue lost)
Marginal Cost, MC, is the change in total cost from producing an additional unit. To maximize
profit, a firm increases output until MR = MC.
Profit --- (P – AC) X Q Example on page 236-237
*Recall that a competitive firm earns zero or normal profits but a monopolist uses its market power
to earn positive or above-normal profits.
*recall that the fewer substitutes that exist for a good, the more inelastic the demand curve (like the
airplane example in the book – Washington, San Francisco, Dallas)
The Costs of Monopoly: Deadweight Loss
The monopolist gains less from monopoly pricing than the consumer loses. Monopolies are bad,
because when compared to compeititon, monopolies reduce total surplus (total gains from trade)
Competition maximizes total surplus, monopolies do not
PICTURE 13.5 – page 240
Some of the consumer surplus has been transferred to the monopolist as profit. But some of the
consumer surplus is not transferred (neither to consumers nor monopolist – deadweight loss)
The costs of Monopoly: Corruption and Inefficiency
In a monopolized economy, each firm wants to raise its prices, and the resulting cost increases are
spread throughout the economy, resulting in poverty and stagnation.
*good institutions channel self-interest toward social prosperity
The benefits of Monopoly: Incentives for Research and Development
In the US, researching, development, and successful testing the average new drugs costs a lot of
money (expectation of enjoying the monopoly profit that encourages firms to research and save
Monopolies when it increases innocation may increase economic growth (example with viodeo
games and how people will research new games)
Is there a way to eliminate the deadweight loss without reducing the invenctive to innovate?
Michael Kremer has an idea on page 243
Economies of scale are the advantages of large-scale production that reduce average cost as
Is there a way to have prices equal to marginal costs and to take advantage of economies of scale?
Yes, but not easy. When a monopolist sets the market price, a price control can increase output.
***Economies of scale mean that a monopoly producer can have lower costs of production than
competitive firms. Its cheaper to produce electricity for 100,000 with one large dam than with a
solar panel for each home. If economies of scale are large enough, the monopoly price can be lower
than the competitive price and the monopoly output can be higher than the competitive output.
A natural monopoly is said to exist when a single firm can supply the entire market at a lower cost
than two or more firms.
The monopolist produces more as the government-regulated price of its output falls. So what price should the government set? Natural answer would be Pr = MC, but really it should
be Pr = AC (the monopolist would just break even, output would then be larger than the monopoly
quantity but less than the optimal quantity).
When the monopolist’s profits are regulated, it doesn’t have much incentive to increase quantity
with innovative new products or to lower costs.
I Want my MTV Section page 246
Electric Shock Section and California’s Perfect Storm
government ownership is another potential solution the natural monopoly problem
new technologies meant that the generation of electricity was no longer a natural
monopoly; argue than unbundling generation from transmission and distribution could
open up electricity generation to competitive forces, and thereby, reducing costs
hoping to benefit from lower costs and greater innovation, CA deregulated wholesale
electricity prices in 1998
^mother nature was not the only one to blame; increased demand, reduced supply, and a
poorly designed dereguatliation plan had create perfect opportunity for generators of
electricity to exploit market power (faced elastic demand for product in 1999)
What happens to the incentive to increase price when demand becomes elastic?
*demonstrated that unbundling generation from transmission and distribution, which
remain natural monopolies, is tricky
Monopolies may be created when there is a significant barrier to entry
Barriers to entry are factors that increase the cost to new firms of entering an industry.
Table 13.1 is really helpful Brands/Trademarks can give a firm market power; monopolies can
arise when a firm innovated a product that no other firm can immediately duplicate (etc)
should be able to find marginal revenue given either a demand curve or a table of prices
given a demand and marginal cost curve, you should be able to find and label the
monopoly price, the monopoly quantity, and deadweight loss.
With the addition of an average cost curve, you should be able to find and label monopoly
Also be able to demonstrate why the markup of price over marginal cost is large the more
inelastic the demand
Are monopolies good or bad? Faced with a series of trade-offs
o Patent monopolies create a trade-off between deadweight loss and innovation. The
monopolist prices its product above marginal cost, but without the prospect of
monopoly profits, there might be no product at all.
o Natural monopolies also have trade-offs, this time between deadweight loss and
economies of scale Deadweight loss means that monopoly is not optimal, but when
economies of scale are large, competitive outcomes aren’t optimal either.
Instead monopolies are created to transfer wealth to politically powerful elites
Many monopolies are “unnatural” and neither support innovation nor take advantage of
economies of scale
Chapter 14: Price Discrimination
Price discrminiation: is selling the same product at different prices to different customers
Ex: the GSK reduced the price of Combivir in Africa for humanitarian reasons, but lowering prices
in poor countries can also increase profit The principles of Price Discrminiation
1. (a) if the demand curves are different, it is more profitable to set different prices in
different markets than a single price that covers all markets
i. example with Europe and Africa; if there was a single world price, the profit in
Europe and Africa would both be less (GSK would be getting less in Europe and
people in Africa wouldn’t buy it as much – more expensive)
2. (b) to maximize profit, the firm should set a higher price in markets with more inelastic
i. Remember: the more inelastic the demand curve, the higher the profit-maximizing
ii. Ex: the demand for combivir is more inelastic (less sensitive to price) in the
European market (so price is higher in eurpoe)
3. Arbritrage makes it difficult for a firm to set different prices in different markets, thereby
reducing the profit from price discrimination
i. Arbitrage: is taking advantage of price differences for the same good in different
markets by buying low in one market and selling high in another market
(smuggling is a special example)
The first principle tells us that a firm wants to set different prices in different markets. The second
principle tells us that a firm may not be able to set different prices in different markets. To succeed
at price discrimination, the monopolist must prevent arbitrage.
If it wants to profit from price discrimination, GSK must prevent Combivir that it sends to Africa
from being resold in Europe. They have a number of tools to discourage smuggling. (white and red
Markets can differ in more ways than geographically.
Services are difficult to arbitrage (massages)
The government taxes alcohol but subsidizes ethanol fuel. To prevent, to prevent entrepreneurs
from buying ethanol fuel and converting it to drinkable alcohol. The government requires that
ethanol fuel be poisoned.
Price Discrminination is common
In the movie theater, they charge more for young people (inelastic demand) than for
In the airlines, the business people (more inelastic) are typically less sensistive to the price
so they usually pay more; they might discover they have to fly out tomorrow so the ticket
is $600 instead of $200 (what a vactionner probably payed months in advance)
Harry potter fans – at first $35 hardback then $10 paperback (hardback doesn’t cost that
much more but the writer knows his fans will pay more once it first comes out)
“willingness to pay”
Universities and Perfect Price Discrimination
student aid is a way of charging different students different prices for the same good