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CHAPTER
Overview of Market Types
Economics
PRINCIPLES OF
N. Gregory Mankiw
© 2009 South-Western, a part of Cengage Learning, all rights reserved
In this section,
look for the answers to these questions:
 How do costs and market types
 Market type overview:
 Perfectly competitive market
 Monopoly
 Oligopoly
 Monopolistic Competition
1
Introduction: A Scenario
 Say you want to start your own business….
 You must decide how much to produce, what price
to charge, how many workers to hire, etc.
 What factors should affect these decisions?
 Your costs (studied in preceding chapter)
 How much competition you face
 We begin by looking at the costs and then different
types of market types.
FIRMS IN COMPETITIVE MARKETS
2
ACTIVE LEARNING
1
Brainstorming costs
You run General Motors.
 List 3 different costs you have.
 List 3 different
business decisions
that are affected
by your costs.
3
Total Revenue, Total Cost, Profit
 We assume that the firm’s goal is to maximize
profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output
THE COSTS OF PRODUCTION
the market
value of the
inputs a firm
uses in
production
4
Costs: Explicit vs. Implicit
 Explicit costs require an outlay of money,
e.g., paying wages to workers.
 Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
 Accounting profit
= total revenue minus total explicit costs
 Economic profit
= total revenue minus total costs (including
explicit and implicit costs)
THE COSTS OF PRODUCTION
5
The Production Function
 A production function shows the relationship
between the quantity of inputs used to produce a
good and the quantity of output of that good.
 It can be represented by a table, equation, or
graph.
 Example 1:
 Farmer Jack grows wheat.
 He has 5 acres of land.
 He can hire as many workers as he wants.
THE COSTS OF PRODUCTION
6
Example 1: Farmer Jack’s Production Function
Q
(no. of (bushels
workers) of wheat)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
THE COSTS OF PRODUCTION
2,000
1,500
1,000
0
1
2
3
4
5
No. of workers
7
Why MPL Is Important
 Recall one of the Ten Principles:
Rational people think at the margin.
 When Farmer Jack hires an extra worker,
 his costs rise by the wage he pays the worker
 his output rises by MPL
 Comparing them helps Jack decide whether he
would benefit from hiring the worker.
THE COSTS OF PRODUCTION
8
Why MPL Diminishes
 Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
 As Jack adds workers, the average worker has
less land to work with and will be less productive.
 In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
 Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
THE COSTS OF PRODUCTION
9
EXAMPLE 1: Farmer Jack’s Total Cost Curve
$12,000
Total
Cost
0
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
$10,000
Total cost
Q
(bushels
of wheat)
THE COSTS OF PRODUCTION
$8,000
$6,000
$4,000
$2,000
$0
0
1000
2000
3000
Quantity of wheat
10
Marginal Cost
 Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q
THE COSTS OF PRODUCTION
11
EXAMPLE 1: Total and Marginal Cost
Q
(bushels
of wheat)
0
Total
Cost
$1,000
∆Q = 1000
1000
$3,000
∆Q = 800
∆Q = 600
∆Q = 400
∆Q = 200
1800
Marginal
Cost (MC)
$5,000
2400
$7,000
2800
$9,000
3000 $11,000
THE COSTS OF PRODUCTION
∆TC = $2000
$2.00
∆TC = $2000
$2.50
∆TC = $2000
$3.33
∆TC = $2000
$5.00
∆TC = $2000
$10.00
12
EXAMPLE 1: The Marginal Cost Curve
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$12
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
2800
$9,000
$10.00
3000 $11,000
THE COSTS OF PRODUCTION
$0
0
1,000
2,000
3,000
Q
13
Why MC Is Important
 Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce
more or less wheat?
 To find the answer, Farmer Jack needs to
“think at the margin.”
 If the cost of additional wheat (MC) is less than
the revenue he would get from selling it,
then Jack’s profits rise if he produces more.
THE COSTS OF PRODUCTION
14
Fixed and Variable Costs
 Fixed costs (FC) do not vary with the quantity of
output produced.
 For Farmer Jack, FC = $1000 for his land
 Other examples:
cost of equipment, loan payments, rent
 Variable costs (VC) vary with the quantity
produced.
 For Farmer Jack, VC = wages he pays workers
 Other example: cost of materials
 Total cost (TC) = FC + VC
THE COSTS OF PRODUCTION
15
EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
THE COSTS OF PRODUCTION
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EXAMPLE 2: ATC and MC
When MC < ATC,
ATC is falling.
$175
$150
ATC is rising.
$125
Costs
When MC > ATC,
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
ATC
MC
$200
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
THE COSTS OF PRODUCTION
17
How ATC Changes as
the Scale of Production Changes
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
THE COSTS OF PRODUCTION
Q
18
In this section,
look for the answers to these questions:
 How do costs and market types
 Market type overview:
 Perfectly competitive market
 Monopoly
 Oligopoly
 Monopolistic Competition
19
Next Section….Market Types!




Perfectly competitive market
Monopoly
Oligopoly
Monopolistic competition
20
Characteristics of Perfect Competition
1. Many buyers and many sellers.
2. The goods offered for sale are largely the same.
3. Firms can freely enter or exit the market.
 Because of 1 & 2, each buyer and seller is a
“price taker” – takes the price as given.
FIRMS IN COMPETITIVE MARKETS
21
The Revenue of a Competitive Firm
 Total revenue (TR)
TR = P x Q
 Average revenue (AR)
TR
=P
AR =
Q
 Marginal revenue (MR):
The change in TR from
selling one more unit.
FIRMS IN COMPETITIVE MARKETS
∆TR
MR =
∆Q
22
MR = P for a Competitive Firm
 A competitive firm can keep increasing its output
without affecting the market price.
 So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.
MR = P is only true for
firms in competitive markets.
FIRMS IN COMPETITIVE MARKETS
23
Profit Maximization
 What Q maximizes the firm’s profit?
 To find the answer, “think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
 If MR > MC, then increase Q to raise profit.
 If MR < MC, then reduce Q to raise profit.
FIRMS IN COMPETITIVE MARKETS
24
MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.
So, increase Q
to raise profit.
Costs
MC
At Qb, MC > MR.
So, reduce Q
to raise profit.
MR
P1
At Q1, MC = MR.
Changing Q
would lower profit.
FIRMS IN COMPETITIVE MARKETS
Q a Q1 Q b
Q
25
MC and the Firm’s Supply Decision
If price rises to P2,
then the profitmaximizing quantity
rises to Q2.
The MC curve
determines the
firm’s Q at any price.
Costs
MC
P2
MR2
P1
MR
Hence,
the MC curve is the
firm’s supply curve.
Q1
FIRMS IN COMPETITIVE MARKETS
Q2
Q
26
A Competitive Firm’s SR Supply Curve
The firm’s SR
Costs
supply curve is
the portion of
its MC curve
If P > AVC, then
above AVC.
firm produces Q
where P = MC.
If P < AVC, then
firm shuts down
(produces Q = 0).
FIRMS IN COMPETITIVE MARKETS
MC
ATC
AVC
Q
27
A Firm’s Long-Run Decision to Exit
 Cost of exiting the market: revenue loss = TR
 Benefit of exiting the market: cost savings = TC
(zero FC in the long run)
 So, firm exits if TR < TC
 Divide both sides by Q to write the firm’s
decision rule as:
Exit if P < ATC
FIRMS IN COMPETITIVE MARKETS
28
A New Firm’s Decision to Enter Market
 In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.
 Divide both sides by Q to express the firm’s
entry decision as:
Enter if P > ATC
FIRMS IN COMPETITIVE MARKETS
29
Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other firms
enter or exit the market.
3) The number of firms in the market is
 fixed in the short run

(due to fixed costs)
variable in the long run
(due to free entry and exit)
FIRMS IN COMPETITIVE MARKETS
30
The SR Market Supply Curve
 As long as P ≥ AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
 Recall from Chapter 4:
At each price, the market quantity supplied is
the sum of quantities supplied by all firms.
FIRMS IN COMPETITIVE MARKETS
31
Entry & Exit in the Long Run
 In the LR, the number of firms can change due to
entry & exit.
 If existing firms earn positive economic profit,
 new firms enter, SR market supply shifts right.
 P falls, reducing profits and slowing entry.
 If existing firms incur losses,
 some firms exit, SR market supply shifts left.
 P rises, reducing remaining firms’ losses.
FIRMS IN COMPETITIVE MARKETS
32
The Zero-Profit Condition
 Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
 Zero economic profit occurs when P = ATC.
 Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
 Recall that MC intersects ATC at minimum ATC.
 Hence, in the long run, P = minimum ATC.
FIRMS IN COMPETITIVE MARKETS
33
Why Do Firms Stay in Business if Profit = 0?
 Recall, economic profit is revenue minus all costs
– including implicit costs, like the opportunity cost
of the owner’s time and money.
 In the zero-profit equilibrium,
 firms earn enough revenue to cover these costs
 accounting profit is positive
FIRMS IN COMPETITIVE MARKETS
34
SR & LR Effects of an Increase in Demand
…but then an increase
A firm begins in
profits
to zero
…leadingeq’m…
to…driving
SR
Over time,
profits
induce
entry,
in
demand
raises
P,…
long-run
andfirm.
restoring
long-run
eq’m.
profits for the
shifting
S to the
right, reducing P…
P
One firm
Market
P
S1
MC
Profit
S2
ATC
P2
P2
P1
P1
Q
(firm)
FIRMS IN COMPETITIVE MARKETS
B
A
C
long-run
supply
D1
Q1 Q2
Q3
D2
Q
(market)
35
Monopoly Introduction
 A monopoly is a firm that is the sole seller of a
product without close substitutes.
 In this chapter, we study monopoly and contrast
it with perfect competition.
 The key difference:
A monopoly firm has market power, the ability to
influence the market price of the product it sells.
A competitive firm has no market power.
MONOPOLY
36
Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws
MONOPOLY
37
Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower cost than could
several firms.
Example: 1000 homes
need electricity
ATC is lower if
one firm services
all 1000 homes
than if two firms
each service
500 homes.
MONOPOLY
Cost
$80
Electricity
ATC slopes
downward due
to huge FC and
small MC
$50
ATC
500
1000
Q
38
Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
But the demand curve
for any individual firm’s
product is horizontal
at the market price.
The firm can increase Q
without lowering P,
so MR = P for the
competitive firm.
MONOPOLY
P
A competitive firm’s
demand curve
D
Q
39
Monopoly vs. Competition: Demand Curves
A monopolist is the only
seller, so it faces the
market demand curve.
To sell a larger Q,
the firm must reduce P.
P
A monopolist’s
demand curve
Thus, MR ≠ P.
D
Q
MONOPOLY
40
Understanding the Monopolist’s MR
 Increasing Q has two effects on revenue:
 Output effect: higher output raises revenue
 Price effect: lower price reduces revenue
 To sell a larger Q, the monopolist must reduce
the price on all the units it sells.
 Hence, MR < P
 MR could even be negative if the price effect
exceeds the output effect (e.g., when Common
Grounds increases Q from 5 to 6).
MONOPOLY
41
Profit-Maximization
 Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
 Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to
pay for that quantity.
 It finds this price from the D curve.
MONOPOLY
42
Profit-Maximization
1. The profitmaximizing Q
is where
MR = MC.
Costs and
Revenue
MC
P
2. Find P from
the demand
curve at this Q.
D
MR
Q
Quantity
Profit-maximizing output
MONOPOLY
43
The Monopolist’s Profit
1. The profitmaximizing Q
is where
MR = MC.
2. Find P from
the demand curve
at this Q.
As with a
competitive firm,
the monopolist’s
profit equals
Costs and
Revenue
MC
P
ATC
ATC
D
MR
Q
Quantity
(P – ATC) x Q
44
The Welfare Cost of Monopoly
Competitive eq’m:
quantity = QC
P = MC
total surplus is
maximized
Monopoly eq’m:
quantity = QM
P > MC
deadweight loss
MONOPOLY
Price
Deadweight
MC
loss
P
P = MC
MC
D
MR
Q M QC
Quantity
45
Public Policy Toward Monopolies
 Increasing competition with antitrust laws
 Regulation
 Public ownership
 Doing nothing
MONOPOLY
46
Oligopoly
 Oligopoly: a market structure in which only a
few sellers offer similar or identical products.
 Strategic behavior in oligopoly:
A firm’s decisions about P or Q can affect other
firms and cause them to react. The firm will
consider these reactions when making decisions.
 Korean Example: Cell Phone Service Providers
47
Collusion vs. Self-Interest
 Both firms would be better off if both stick to the
cartel agreement.
 But each firm has incentive to renege on the
agreement.
 Lesson:
It is difficult for oligopoly firms to form cartels and
honor their agreements.
OLIGOPOLY
48
The Size of the Oligopoly
 As the number of firms in the market increases,
 the price effect becomes smaller
 the oligopoly looks more and more like a
competitive market
 P approaches MC
 the market quantity approaches the socially
efficient quantity
Another benefit of international trade:
Trade increases the number of firms competing,
increases Q, brings P closer to marginal cost
OLIGOPOLY
49
Public Policy Toward Oligopolies
 Recall one of the Ten Principles from Chap.1:
Governments can sometimes
improve market outcomes.
 In oligopolies, production is too low and prices
are too high, relative to the social optimum.
 Role for policymakers:
Promote competition, prevent cooperation
to move the oligopoly outcome closer to
the efficient outcome.
OLIGOPOLY
50
Characteristics & Examples
of Monopolistic Competition
Characteristics:
 Many sellers
 Product differentiation
 Free entry and exit
Examples:
 apartments
 books
 bottled water
 clothing
 fast food
 night clubs
MONOPOLISTIC COMPETITION
51
A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve.
At each Q, MR < P.
To maximize profit,
firm produces Q
where MR = MC.
The firm uses the
D curve to set P.
MONOPOLISTIC COMPETITION
Price
profit
MC
ATC
P
ATC
D
MR
Q
Quantity
52
A Monopolistic Competitor in the Long Run
Entry and exit
occurs until
P = ATC and
profit = zero.
Price
Notice that the
P = ATC
firm charges a
markup of price
markup
over marginal cost
and does not
MC
produce at
minimum ATC.
MONOPOLISTIC COMPETITION
MC
ATC
D
MR
Q
Quantity
53