Review for Final Part 1

1
Review for FinalPart 1
2
Final is comprehensive

• Material is covered fairly evenly from all four
  units.
• Around 50 multiple choice questions
• Problems will look like ones you've seen before
  on paper homework or exams, but with different
  numbers.

3
Studying

• Online practice problems still available.
• Exam 1-3 multiple choice questions are available
  in Comer 308. You have to look at them there.
  You cant photocopy them. (I'll add exam 4 when
  tests are returned.)
• I will announce some extra office hours via email.

4
Review notes

• Focus on more difficult material from earlier
  units
• Please review all your notes to study for final,
  not just these visuals.

5
Shifts in Demand

• Shifts in the demand curve take place if one
• of the factors behind the demand curve
• changes
• income
• prices of available goods,
• tastes or preferences,
• special influences.

6
Supply Shifters

• Changes in costs of inputs
• Technological change
• Government policy
• Special factors (climate, culture)

7
Movement along supply curve
P
S
As price rises, all other things held constant,
the quantity supplied increases.
Q
8
Shift of supply curve
P
If the price of an input falls, the supply curve
shifts out (supply increases).
S
S
Q
9
S
P
S'
D
Q
A shift in Supply causes a movement along the
demand curve. Demand doesn't change but quantity
demanded changes because of the price change.
10
P

S
D
D'
Q
A shift in Demand causes a movement along the
supply curve. Supply doesn't change but quantity
supplied changes because of the price change.
11
Market Equilibrium
A market equilibrium comes at the place where
quantity demanded equals quantity supplied.
Equilibrium takes place at the intersection of
the supply and demand curves.
12
Graphical Representation of Equilibrium
.
.
5
.
S
P
Surplus
.
.
.
4
.
Equilibrium
3
.
.
.
2
Shortage
.
.
1
D
.
.
.
.
Q
5
15
20
10
13
Shifts in curves change equilibrium
Supply increases Price down, Quantity up.
P
S
S
P
P
D
Q
Q
Q
14
Shifts in curves change equilibrium
Supply decreases Price Up Quantity Down
P
S
S
P
P
D
Q
Q
Q
15
Shifts in curves change equilibrium
Demand Increases
P
S
(Note that TR increases because both P and Q
increase.)
P
P
D
D
Q
Q
Q
16
Shifts in curves change equilibrium
P
S
Demand Decreases
(Note that TR falls because both P and Q fall.)
P
P
D
D
Q
Q
Q
17
Four Possible Outcomes

• Supply decrease Price Up, Quantity Down
• Supply increase Price Down, Quantity Up
• Demand increase Price Up, Quantity Up
• Demand decrease Price Down, Quantity Down

18
Elasticities
We may want to know how much supply and demand
respond to changes in price.
Example If the price of apples increases by
10, how many fewer apples will consumers buy?

19
Price Elasticity of Demand
The price elasticity of demand measures how much
the quantity demanded of a good changes when its
own price changes.
It is the percentage change in quantity demanded
divided by the percentage change in price.
20
Calculating Elasticities
Change in quantity demanded
_________________________
ED

Change in price
If a 1 increase in price causes a 5 decrease in
quantity demanded, what is the elasticity of
demand?
21
Calculating Elasticities
Change in quantity demanded
_________________________
ED

Change in price
5
ED
____

5
1
(By convention, the minus sign is dropped on the
ED.)
22
More Examples
A 10 decrease in price causes a 5 increase in
quantity demanded.
10
5
_____
(1/2)
0.50
23
Elastic and Inelastic Demand
If demand is price elastic, ED is greater than
1.0. If demand is price inelastic, ED is less
than 1.0.
24
Unit-Elastic Demand
When percent change in price equals percent
change in quantity demanded we have unit-elastic
demand.
ED 1.0
25
Calculating Elasticity of Demand, Example.
As price falls from 10.00 to 8.00 per unit, the
quantity demanded increases from 100 to 105
units. Calculate the elasticity of demand, using
the initial points as base. change in price
2/10100 20 change in q 5/100100
5 Ed 5/20 .25
26
Calculating Elasticity of Demand, Example.
As price falls from 12.00 to 8.00 per unit, the
quantity demanded increases from 95 to 105
units. Calculate the elasticity of demand, using
the mid-points as base.
27
Percent Change in Price
change
12 - 8
_________
40
100
(12 8)/2
midpoint
28
Percent Change in Quantity Demanded
change
105 - 95
_______
100
10
(10595)/2
midpoint
29
Putting together the elasticity
10
_____
ED
0.25
40
30
Caution!
If the demand curve is a straight line, the
elasticity of demand does not stay constant along
the length of the line!
31
Elasticity along a straight line
P
Above the mid-point, ED gt1
.
At the mid-point, ED 1
Below the mid-point, ED lt 1
Q
32
Extremes of Elasticity
D
Perfectly Inelastic Demand
P
D
Perfectly elastic demand
Q
33
Elasticity and Revenue
Total Revenue is QxP, price times quantity sold.
34
If Demand increases, both P and Q increase and
TR must also increase. If Demand decreases, both
P and Q decrease and TR must also decrease.
When Supply increases, P falls and Q rises.
What happens to TR? When Supply decreases P
rises and Q falls. What happens to TR?
35
To figure out what happens when Supply shifts, we
have to know which effect is biggest, the change
in price or the change in quantity. The
elasticity tells us which effect is biggest.
36
If demand is elastic, which effect is biggest,
the percent change in price or the percent change
in quantity? Ed
change in q change in p
____________
gt 1 (elastic)
change in q is biggest for elastic demand
37
If demand is inelastic, which effect is biggest,
the percent change in price or the percent change
in quantity? Ed
change in q change in p
____________
lt 1 (inelastic)
change in p is biggest for inelastic demand
38
If demand is elastic, TR will move in the same
direction as quantity. (That means TR for
elastic demand moves in the opposite direction
of price, because Demand slopes down.) If demand
is inelastic, TR will move in the same direction
as price. (That means TR for inelastic demand
will move in the opposite direction of quantity.)

39
For elastic Demand, TR increases when price falls
or quantity increases. For inelastic Demand,
TR increases when price rises or quantity falls.
40
When demand is elastic
Total revenue increases as the price falls, when
demand is elastic. Total revenue increases as
supply increases when demand is
elastic. Remember Price falls when supply
increases!
41
Demand is elastic, TR increases as S
increases and price falls
P
Total Revenue PxQ
S
S'
P1 P2
D
Q
Q1 Q2
42
When demand is inelastic
Total revenue decreases as the price decreases,
when demand is inelastic. Total revenue
decreases as supply increases when demand is
inelastic. Remember Price falls when Supply
increases.
43
Demand is inelastic. TR falls as supply
increases and price falls.
P
S

S'
TR
TR
TR
Q
44
Elasticity Problems -- The Basics
If demand is elastic, total revenue moves the
same way as supply. If demand is elastic total
revenue moves the opposite way as price.
Elastic demand is anything with an Ed gt1
45
Elasticity Problems -- the basics
If demand is inelastic, total revenue moves the
opposite way from supply. If demand is
inelastic, total revenue moves the same way as
price.
Inelastic demand is anything with Edlt1
46
Special case When Ed 1
When demand has unitary elasticity, an increase
or decrease in supply has no effect on total
revenue. (TR stays the same.)
47
Questions
A decrease in supply is observed to increase
total revenue, you know that demand must
be __________________. An increase in supply is
observed to increase total revenue, you know that
demand must be _________________.
inelastic
elastic
48
Questions
A decrease in supply is observed to
decrease total revenue, you know that demand must
be __________________. An increase in supply is
observed to decrease total revenue, you know that
demand must be _________________.
elastic
inelastic
49
Questions
A decrease in supply is observed to have
no effect on total revenue, you know that demand
must have _________________.
unitary elasticity
50
Elasticity of Supply
Change in quantity supplied
_________________________
Es

Change in price
If change in quantity supplied is greater than
change in price, then supply is elastic. ES gt
1


51
Special cases
ES1
ES 0
ES infinity
52
When Supply is a Straight Line

• Supply is inelastic if it crosses the horizontal
  axis.
• Supply is elastic if it crosses the vertical
  axis.
• It has unitary elasticity if it goes through the
  origin.

53
ES lt 1
ES1
ES gt 1
54
Effect of a Sales Tax
Sometimes the government puts a tax on specific
commodities such as gasoline, tobacco, and
alcohol. Policy analysts will want to know
How will the tax affect the market price
and quantity? Who will end up paying for the
tax, the producers or the consumers?
55

• Heres how to work these problems.
• If Supply and Demand are normal
• (i.e. neither perfectly inelastic nor
• perfectly inelastic)
• Supply shifts up by the amount of the tax.
• Price rises by less than the tax.
• The group with the lowest elasticity
• (consumers or producers) pays the greater
• share of the tax.

56
General Rules on Tax Shifting
When demand is less elastic than supply, the
consumers pay the greater share of the sales
tax. When demand is more elastic than
supply, producers pay the greater share of
the sales tax.
57

• Special cases
• Perfectly inelastic demand Price rises
• by full amount of tax. Consumers pay all.
• 2) Perfectly elastic demand. Price doesnt
• rise at all. Producers pay all.
• Perfectly elastic supply. Price rises
• by full amount of tax. Consumers pay all.
• 4) Perfectly inelastic supply. Price doesn't
• change at all. Producers pay all.

58
Price Floors
S
P
A price floor is a legally set minimum price.
Price floors above market equilibrium lead
to surpluses.
Pmin
D
Q
59
Price Ceilings
S
P
A price ceiling is a legally set maximum price.
Price ceilings above market equilibrium lead
to shortages.
Pmax
D
Q
60
Subsidies
Sometimes the government subsidizes production of
a product. A subsidy given to producers shifts
the supply curve out.
61
The Importance of ED
When demand is relatively elastic, more of the
subsidy goes to producers because price does not
fall as much. When demand is relatively
inelastic, consumers receive most of the
benefit because price falls a lot.
62
Externalities
If there are externalities, the
market equilibrium is not efficient because
it does not capture all relevant costs (or all
relevant benefits in the case of positive
externalities). If there are externalities,
people outside the market are affected by the
transactions in the market but their welfare is
not represented in CS or PS.
63
Suppose that a firm is located along a river.
The firm uses water from the river to cool its
machinery and returns the water to the river
several degrees warmer, which has led to a
decline in the fish population downstream of the
firm.
The externality (the dead fish) is a relevant
cost of production that is not captured by the
market equilibrium. If a relevant cost is
ignored, that means the market price is too low
and market quantity too high. If the firm had to
pay the cost for the dead fish, supply would
decrease. In this case, if the government fines
the firm to account for societys cost of the
dead fish, efficiency in this market would
increase.
64
Suppose that an increase in the college-educated
population increases job opportunities and
community well-being for everyone.
In this case, the externality (increased job
growth for all) is a relevant benefit of
consumption that is not captured by the market
equilibrium. If a relevant benefit is ignored,
that means the market price is too high and
market quantity too low. In this case, to reach
the socially optimal level of output, the
government will employ strategies to decrease
the price of education to those who consume
it and to increase the quantity. They can do
this via reduced-cost loans or grants to students
to defray tuition costs, or by building
state-subsidized universities.
65
Average and Marginal Cost
MC intersects AC and AVC at each minimum. AC
gets closer to AVC as output increases
MC
AC
AVC
Output (y)
66
Perfect Competition
Market Efficiency The market is efficient
under perfect competition in the absence of
externalities. It is efficient because price
MC. Reservation prices of the marginal buyer
reservation price of the marginal seller and all
relevant costs and benefits are captured by the
market.
67
Opportunity Costs

• In determining their reservation price, suppliers
  consider their opportunity costs.
• If Jamie can earn 10 an hour as a student
  worker, she will normally not be willing to give
  up work for another job paying less than that.

68
Jamie can earn extra money washing cars for 5
per car
Calculate her Marginal Benefit from washing cars.
She will be willing to wash cars so long as the
extra benefit is at least as large as her
opportunity cost (10). How many hours (at most)
would she work washing cars?
69
The Production Function
The production function relates inputs to output
in physical terms. The production function,
along with input prices, will determine the
costs of producing output.
70
Average Product
To find average product, divide total product (or
output) by the input level.
71
Marginal Product
Marginal product tells you how much extra output
you get from each extra unit of input. To
calculate marginal product, take the change
in total product (or output) and divide by the
change in input.
72
Example
73
Costs

• Total Cost (TC) Variable Costs (VC) Fixed
  Costs (FC)
• AC (ATC) TC divided by output or AC AVC AFC
• AVC VC divided by output
• AFC FC divided by output

74
Variable Costs
Total variable costs the amount spent on
variable inputs. Price of input 1 X Amount of
variable input 1 Price of input 2 X Amount of
variable input 2 Price of input 3 X Amount of
variable input 3 etc. In our homework, there
was only one variable input.
75
Variable Cost
Variable cost is what is spent on
variable inputs. If there is only one variable
input, VC PxX Where Px is the input price
and X is the amount used. Some
books use TVC for VC where T
stands for total.
76
More on Variable Cost
If there are two or more variable inputs VC
Px1X1 Px2X2 Px3X3 . .. Where Px1 is the
input price for one of the variable inputs and
X1 is the amount of that input used, Px2 is the
input price for the next variable input and X2 is
the amount of the second input used, and so on.
77
Average Variable Cost
AVC Variable Cost divided by output.
78
Fixed Cost
Fixed cost doesnt change as output changes, in
the short run. .
79
Average Fixed Cost
AFC FC/output. Some books used TFC for
FC AFC falls as output increases.
80
Marginal Cost
Marginal cost is the change in VC divided by the
change in output. It can also be calculated
using the change in TC divided by the change in
output.
81
Profit-Maximizing Decision Rule
In perfect competition, the rule is MC output
price If there are two points where MCPy then
pick the one with higher output. Also, check that
PygtAVC (else firm should shut down)
82
Perfect Competition Illustration of firm-level
demand
P
P
S
d
D
q
Q
Entire Market
One firm
83
Marginal Revenue
Marginal revenue is the extra amount a firm will
earn from selling one more unit of its output.
Under perfect competition, the marginal revenue
will therefore by equal to ___________.
product price
Formal definition Marginal revenue is
the change in total revenue resulting from a one
unit increase in output.
84
Goal of Profit Maximizing
The firms goal is assumed to be
maximizing profit. Remember that profit
is Firm Profit PyY - TC
Where Y is firm output.
85
On the graph
We find the point where Marginal Revenue or price
(as shown by the flat demand curve, d), hits MC.
The profit-maximizing output is found at this
point. Profit, or loss, per unit is the vertical
distance between MR and AC at that point. On
the following graph, the unit profit is shown by
the solid orange line.
86
Graphically Profit gt0
Profit gt 0
MC
AC
d
p
q
87
Graphically Profit 0
MC
Profit 0
AC
p
d
q
88
Zero-profit point
The zero-profit point occurs at the minimum point
of the AC curve. This point is also called the
break-even point.
89
Graphically Profit lt 0i
Profit lt 0
MC
AC
p
d
q
90
Recall

• In economics, total costs include opportunity
  costs.
• Thus, a firm earning 0 profit is in fact
  covering its opportunity costs.
• Accounting Profit Opportunity Costs Economic
  Profit

91
Producing at a Loss
Would a rational, profit-maximizing producer ever
produce at a loss? Remember that TC is the sum
of VC and fixed costs, which do not change in
the short run even if nothing is produced.
92
Producing at a loss, continued
In the short run, firms will produce at a loss so
long as that loss is less than total fixed
costs. In other words, they compare the loss
they would get from not producing (the
total fixed costs) with the loss they would
get if they produce.
93

• At the point where price MC for
• a perfectly competitive firm, Total
• Revenue 2000, VC 2100 and
• FC 100. What should this firm do?
• Shut down
• Produce and make a profit
• Produce because the loss is less than
• Fixed costs
• d) Change its output level

94
Covering Variable Costs
In the short run, producers will produce so
long as the TR is greater than the total variable
costs. The shutdown point comes where revenues
just equal variable costs, or losses from
production are equal to the fixed costs.
95
AVC and Price
If TR VC (total variable costs), then Price
AVC. Why?
TR PyY, so divide both sides by Y to get this
equivalency.
96
Shutdown Rule
When the price falls below the minimum AVC, the
firm will shut down.
On a table, find the shutdown point by looking
at the AVC entries and finding the smallest one.
The shutdown price is equal to the lowest AVC.
The output level is found by reading across
the table to find the output level.
97
Graphically
AC
MC

AVC
ps
shutdown point
98
The Firms Supply Curve
AC
MC

AVC
ps
shutdown point
99
The firms supply curve, cont.
The firms supply curve is the portion of
its marginal cost curve beyond the shutdown
point. (Shown in green on the preceding graph.)
100
From Firm to Industry
The market supply curve for a good is
the horizontal sum of all the individual
firms supply curves.
101
short run and long run
In the short run, demand shifts produce greater
price adjustments and smaller quantity
adjustments than in the long run.
102
Factor Adjustments
In the short run, supply can only be
adjusted using variable factors. The fixed
factors (such as equipment and factory buildings)
cannot change. In the longer run, the fixed
factors can also be adjusted, and firms can enter
or exit the industry. Hence, supply tends to be
more elastic in the long run than in the short
run.
103
What happens when demand increases?
In the short run There will be an increase in
price and output per firm will rise. The
increased price will bring higher profits for
each firm in the industry.
104
When firms earn economic profits
New firms will enter the industry in the longer
run. The long run supply curve is more elastic
than the short run. The increased number of
firms will bring more output to the industry.
In most cases, the new entrants will also bid up
the price of inputs, so that the AC curves will
rise.
105
When Demand Increases
In the long run, total output will increase,
firm numbers will increase, economic profits
will return to zero, and price will increase
unless long-run supply is perfectly elastic (as
would be the case in a constant cost industry
only).
106
When demand decreases
In the short run, firms will go from an
equilibrium of zero profits to economic losses.
In the longer run, some firms will leave the
industry. Long run response is lower total
output, fewer firms, a return to zero economic
profits, and a lower price (unless long-run
supply is perfectly elastic, e.g. the constant
cost industry).
107
Long Run Equilibrium
If entry and exit are completely open in an
industry, firms that are operating at a loss will
eventually close down.. As firms exit, supply
contracts (shifts to the left) and price rises.
Hence, in the long-run price cannot remain
below the minimum AC of the firms in an industry
108
Long Run Equilibrium
Similarly, if profits are too high in
a particular industry, new firms will
eventually be attracted into the market, causing
supply to shift to the right (increase) and price
to fall.
109
Special Cases
In a constant cost industry, output can be
doubled by doubling costs. In this case, the
long-run supply curve is horizontal (perfectly
elastic). Changes in demand will have no impact
on price in the long-run.
110
Market Surplus
Total market surplus is CS PS In this example,
it is the large triangle in pale
orange. Height is 16. Base is 20. Area ½
2016 160
111
Price Ceiling or Floor
If we set a price floor or ceiling, we reduce
total surplus. At a price ceiling of 4, only
10 units would be produced. The blue triangle
is the loss of surplus. Its area
is ½(12-4)(20-10) 40 Similarly, if we set a
price floor of 12, only 10 units would be
purchased. The surplus loss would again be
40.
112
Recall

• When price is set below equilibrium, the quantity
  sold is determined from the Supply curve,
  corresponding to the marginal sellers
  reservation price.
• When price is set above equilibrium, the quantity
  is determined from the Demand curve,
  corresponding to the marginal buyers reservation
  price.
• Surplus loss will be a triangle with height equal
  to the difference between equilibrium quantity
  and the new quantity. Its base will be the
  difference between the ceiling/floor and the
  marginal buyers/sellers reservation price for
  that quantity.

113
Price Floors and Ceilings

• May give greater surplus to one group or the
  other (consumers or producers)
• But they cause a reduction in total market
  surplus
• They result in lower quantity sold

114
Surplus and Sales Tax

• When a sales tax is imposed, the Supply curve
  shifts up by the amount of the tax, quantity
  (normally) falls and price (normally) rises.
• Market surplus is normally reduced (bad)
• Tax revenues are gained (good).
• Tax revenue per unit taxquantity sold after
  the tax is imposed.
• Net loss in welfare is computed as
• Pre-tax surplus
• (post tax surplus taxes)

115
Subsidies

• Subsidies also cause a deadweight loss
• Subsidies increase quantity sold, raise price
  received by producers (market price subsidy),
  and lower the price to consumers. Hence, both
  consumers and producers benefit from subsidies.
• Subsidies are paid for from taxes
• The cost is (per unit subsidy X quantity sold
  after the subsidy).
• The gain in surplus to producers and consumers
  will be less than the cost of the subsidy.
• Dead weight loss is found by taking market
  surplus before the subsidy and subtracting from
  it (market surplus after the subsidy cost of
  the subsidy).

116
Industry Structure

• Perfect Competition Many firms produce an
  identical output. No firm can affect market
  price.
• Monopolistic competition A large number of
  firms produce slightly differentiated products.
• Oligopoly An industry is dominated by a few
  firms.
• Monopoly A single firm produces all the output
  (with no close substitutes).

117
Profit
For all firms Profit TR - TC To maximize
profit, all firms set MR MC
118
Marginal Revenue

• Under perfect competition, MR price of the
  output
• Under other structures, MR is always less than
  price because firm-level demand is not perfectly
  elastic and the price falls for every unit of
  output increase in sales.
• Since all firms set MRMC to maximize profits, if
  MRlt price, then MClt price.
• Any time a firm-demand is downward sloping, then
  MClt price at the profit-maximizing point.

119
Calculate Marginal Revenue

• Marginal Revenue is the change in TR divided by
  the change in quantity (table)
• For linear inverse demand
  P A Bquantity
• MR A 2Bquantity

120
Examples

• P 200 5q MR 200 10q
• P 30 2 q MR 30 4q
• P 50 20q MR 50 40q

121
Working with MR

• Demand is elastic if MRgt0
• Demand is inelastic if MRlt0
• MR 200 10q is positive for quantity less than
  20, negative for quantities greater than 20.
• So Demand is elastic for quantities less than 20,
  inelastic for quantities more than 20.

122
Marginal Revenue -- Table
123
Perfect Competition
Short-Run Equilibrium P MC. May have an
economic profit, may break-even, or may have an
economic loss. Long-Run Equilibrium P MC, P
AC ZERO ECONOMIC profits This is the only
industry structure where PMR and thus the only
industry structure where PMC
124
Monopoly
Short-Run Equilibrium We set MR MC PgtMR so
therefore PgtMC Will usually have an economic
profit (e.g. PgtAC) Long-Run Equilibrium Same
as short run since no firms can enter the
market.
125
Monopolistic Competition
Short-Run Equilibrium We set MRMC PgtMR, PgtMC
Will usually have an economic profit (e.g.
PgtAC). Looks like a monopoly. Long-Run
Equilibrium We set MRMC PgtMR, PgtMC But PAC.
Zero economic profit.
126
Profit Max and the Monopolist
We calculate the MC, which is the change in Total
Cost divided by the change in output. It cannot
be a negative number. We calculate the MR, which
is the change in Total Revenue divided by the
change in output. It can be a negative
number. We find the point where MRMC. In a
table, we then read across to find price and
quantity to define the profit-maximizing point
(as in homework).
127
Study Questions
Look at this diagram. What sort of firm is
this? ______________ What is the
profit-maximizing quantity? _______________ What
will the price be?______ What is Marginal
Cost? _______ What is Average Cost?
_______ What is the Marginal Revenue? ___________
monopoly
600
16
8
12
8
128
More about this diagram
To find profit-maximizing point, we find the
place where MR MC
Then, we read the quantity off the
horizontal axis -- 600
We find the price from the demand curve.
129
Other Information
Total Revenue is price quantity. 16600
9600 Total Cost ACquantity 12600
7200 Profit TR-TC 9600-7200 2400
Another way to calculate Profit
(Price-AC)quantity (16-12)600 2400
130
Another Example
What is the maximum profit this firm can
earn each day?
Price8 AC 6 Output 30 Max Profit
(8-6)30 60
131
Oligopoly
No stable equilibrium. May resemble a monopoly
if firms collude. May move toward zero economic
profits. Depends.
132
Imperfect Competition
Imperfect Competition prevails in an industry
whenever individual sellers have some measure of
control of their output price. Under
imperfect competition, the firm faces a downward
sloping demand curve.
133
The Level of Control
Imperfect competition does not mean that a firm
has absolute control over price. If a product
with many substitutes (or even one close
substitute) is priced well above the
substitutes, few if any consumers will buy it.
134
Graphical Depiction
Firm Level Demand Curves
p
p
d
d
q
q
perfect competition
imperfect competition
135
Monopoly
Monopoly means one seller. In this
extreme form of imperfect competition, there is
only one firm producing and selling a
product. For a monopoly, the firm demand curve
is the same as the market demand curve.
136
Oligopoly
Oligopoly means few sellers. The
important feature is that each firm can affect
the market price. Oligopolies are common in
the United States e.g. automobiles,
appliances, breakfast cereals, airlines.
Oligopolies can engage in rivalry, where each
firm competes fiercely for market share, or they
can collude (illegal in U.S.) and behave as a
monopoly.
137
Oligopoly
Oligopolies can produce identical products (crude
oil) or branded products (appliances). The
latter situation is sometimes called a
differentiated oligopoly.
138
Monopolistic Competition
A large number of sellers produce
differentiated products (branded products). New
firms can enter this sort of industry easily.
139
How do Monopolies and Oligopolies Arise?
There are two main reasons Economies of
scale in production Barriers to entry
140
Monopolistic Competition
Another form of imperfect competition,
Monopolistic Competition, arises when entry and
exit are relatively easy but the product is
differentiated (branded).
141
How does monopolistic competition arise?
The product must be differentiated. Entry and
exit of firms must be easy.
142
A Natural Monopoly
A natural monopoly is the result of an industry
in which AC always decreases with output level.
These are industries characterized by high fixed
costs, so that the decrease in AFC as output
increases is so large that it keeps pushing AC
down.
143
Cost Curves of a Natural Monopoly
AC
MC
q
144
Cost and Industry Structure
Industry structure can be largely determined by
the relationship between the size of the market
and the point at which a typical firms AC
curve starts to rise.
145
Because of the shape of the AC curve,
this industry would likely be a monopoly.

AC minimum
AC curve (firm)
D (market)
quantity
146
Because of the shape of this AC curve,
this industry would likely be competitive.

AC curve (firm)
D (market)
quantity
147
Because of the shape of this AC curve,
this industry would likely be an oligopoly.

AC curve (firm)
D (market)
quantity
148
Game Theory

• Useful for understanding the behavior of firms in
  imperfect competition.
• Involves players, strategies, and payoffs.

149
Game Theory Example
Does Ace have a dominant strategy? Does
Deuce? Why is this game an example of Prisoners
Dilemma?
150
If the table is confusing

• Examine the players one by one.
• Look at Aces options. The company can 1)
  advertise or 2) not advertise.
• If its rival advertises, then Ace would earn
  2,000 by advertising and 1,000 if it doesnt,
  making advertising Aces best choice.
• If its rival doesnt advertise, then Ace would
  earn 3,500 by advertising and 3,400 if it
  doesnt, making advertising Aces best choice.
• Because advertising is Aces best choice in both
  situations, advertising is Aces dominant
  strategy.

151
Now work the problem for Deuce

• Look at Deuces options. The company can 1)
  advertise or 2) not advertise.
• If its rival advertises, then Deuce would earn
  2,500 by advertising and 1,500 if it doesnt,
  making advertising Deuces best choice.
• If its rival doesnt advertise, then Deuce would
  earn 5,000 by advertising and 4,600 if it
  doesnt, making advertising Deuces best choice.
• Because advertising is Deuces best choice in
  both situations, advertising is Deuces dominant
  strategy.

152
In this problem

• Both Ace and Deuce have a dominant strategy,
  advertise.
• But if they both advertise, they earn less than
  if they both chose not to advertise.
• But in the absence of collusion or outside
  intervention, neither firm will select not
  advertising, because of the payoffs, explained
  previously.
• This game thus has the form of a prisoners
  dilemma.

153
Prisoners Dilemma

• Each player has one dominant strategy.
• When they play the dominant strategy, they are
  both worse off than they would be if they played
  the dominated strategy.
• But without intervention or collusion, they will
  play their dominant strategy or risk losing more
  if the other firm plays its dominant strategy.

154
A Different Game
155
Payoffs for the Orcs

• If the trolls join Sauron The Orcs get 2,500 if
  they join Sauron, and 100 if they dont, so
  their best choice in this case is to join Sauron.
• If the trolls dont join Sauron The Orcs get
  2,000 if they join Sauron and 200 if they
  dont, so joining Sauron is again the Orcs best
  choice.
• For the Orcs, joining Sauron is a dominant
  strategy. It pays off higher than the
  alternative, whatever the Trolls do.

156
For the Trolls

• If the Orcs join Sauron The Trolls get 2,500 if
  they join Sauron and 1,500 if they dont, so in
  this situation, they do better joining Sauron.
• If the Orcs dont join Sauron The Trolls get
  3,500 if they join Sauron and 5,000 if they
  dont join Sauron, so in this case the Trolls are
  better off if they dont join Sauron.
• The Trolls do not have a dominant strategy. In
  one case (Orcs join Sauron) they are better off
  joining Sauron. In the other case (Orcs dont
  join Sauron), they are better off not joining
  Sauron.

157
Solution to Orc-Troll Game

• Since the Orcs have a dominant strategy (join
  Sauron), they will play it.
• The Trolls know the Orcs will play their dominant
  strategy, so they know the Orcs will join Sauron.
• If the Orcs join Sauron, the trolls should also
  join Sauron.
• So the solution to this game is Orcs and Trolls
  both join Sauron.
• If at least one of the 2 players has a dominant
  strategy, the game will have a Nash
  equilibrium.

158
Marginal Revenue for a Monopoly
Because price falls as output increases, MR for
a monopolist must be found by taking the change
in total revenue and dividing by the change in
output. TR is price times output.
? TR ?Y
______
MR
159
Marginal Revenue of a Monopolist
Remember the relationship between elasticity and
TR we learned earlier? When demand is elastic,
TR rises as output increases. When demand is
inelastic, TR falls as output increases.

160
Marginal Revenue of a Monopolist
When demand is inelastic, TR falls as output
increases. If TR is falling, then MR would be
negative. Thus, a monopolist would not produce
in the inelastic portion of its demand curve.

161
Profit-Maximizing Point
The profit-maximizing point for a
monopolist occurs where MR MC. In this case,
not only quantity but price will be determined.
162
Steps
Calculate MR and MC for each level of
output. Find output level where MRMC. Read
price that corresponds to that output level from
the demand curve.
163
Graph of profit-maximizing
MC
p
AC
d
MR
q
164
For a monopoly
Price gt MC Price gt MR Price (usually) gt minimum
AC in long run
165
Monopolies and Supply
A monopolist does not have a supply curve. Supply
for a monopolist is a single point.
166
Profits for monopoly
MC
p
AC
Profit is the pink rectangle.
d
MR
q
167
Graphing monopoly rents
Draw a line to where MC intersects demand. The
portion of the profit above that line is
monopoly rent.
MC
p
AC
d
MR
q
168
Dead-weight loss.
Dead-weight loss from a monopoly is the triangle
to the right of the monopoly profits.
MC
p
AC
d
MR
q
169
Monopoly rent and dead-weight loss come from
consumer surplus lost to monopoly.
If the industry were competitive, price would
equal MC. Consumer surplus would be the yellow
triangle shown here.
MC
AC
pc
d
qc
170
Under Monopoly, Consumer Surplus is smaller.
The orange triangle is consumer surplus under
monopoly. Part of the lost surplus is monopoly
rent. Part is dead-weight loss.
MC
p
AC
pc
d
qc
q
171
Strategic Interaction
When only a few firms operate in market, they
will probably recognize their interdependence.
Strategic interaction occurs when each firms
business plan depends on the behavior of its
rivals.
172
Collusive Oligopoly
When firms in an oligopoly actively cooperate
with each other, they engage in collusion. Two
or more firms jointly set their prices or
outputs, divide the market, or make other
business decisions together.
173
Cartel
One type of collusive oligopoly is a cartel. A
cartel is an organization of independent firms,
producing similar products, that work together to
raise prices and restrict output. Cartels are
illegal in the U.S., but firms are often tempted
to engage in tacit collusion.
174
The problem of cheating
Cartels may fall apart if firms are tempted to
cheat, either by undercutting prices or producing
more than their share of the total output.
175
Monopolistic Competition
Under monopolistic competition, there are many
firms and entry into the industry is relatively
easy. The difference between perfect
competition and monopolistic competition is that
the product is not identical, hence each firm
faces a downward sloping demand for its own
product.
176
Examples of Monopolistic Competition
Shampoos, frozen foods, detergent, cosmetics,
magazines, etc. Differentiated by products
intrinsic attributes. Gas stations, restaurants,
grocery stores. These firms are often
differentiated by location.
177
Product Differentiation
Because of product differentiation, each firm in
monopolistic competition faces a downward sloping
demand curve, as in a monopoly. The difference
is that new firms can easily enter the market if
the profits earned by one firm are too high.
178
Short-run situation for firm under monopolistic
competition
Solution looks like regular monopoly
p
d
mr
q
179
Long-Run Equilibrium for Monopolistic Competition.
priceAC pricegtMC profits 0 price is not at
the minimum point of AC curve.
MC
AC
p
d
mr

q
180
Measuring Waste from Imperfect Competition
We can measure the efficiency loss
from imperfect competition by looking at consumer
surplus. If the industry could be competitive,
then price is set where supply (representing MC)
equals demand.
181
Competitive Solution
Consumer Surplus
MC
AC
p
MR
d
q
182
Monopoly Solution
Consumer Surplus
MC
AC
pm
pc
MR
d
qm
qc
183
Monopoly Solution
Consumer Surplus plus extra profits. Some of
the lost area of consumer surplus goes to
monopoly profits.
MC

pm
pc
MR
d
qc
qm
184
Dead-Weight Loss
The orange triangle is dead-weight loss. This
area of former consumer surplus does not go into
profits to the monopoly. It is just lost.
MC
pm
pc
MR
d
qc
qm