Review for Exam 4

1. Review for Exam 4 Exam Date: April 20, 2006

2. Format • about 20-22 multiple choice questions worth 3 points each. • Short problems similar to those on the homework. • Fill-in-the blanks.

3. 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.

4. Profit For all firms: Profit = TR - TC To maximize profit, all firms set MR = MC

5. 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 P=MR and thus the only industry structure where P=MC

6. Monopoly Short-Run Equilibrium: We set MR = MC P>MR so therefore P>MC Will usually have an economic profit (e.g. P>AC) Long-Run Equilibrium: Same as short run since no firms can enter the market.

7. Monopolistic Competition Short-Run Equilibrium: We set MR=MC P>MR, P>MC Will usually have an economic profit (e.g. P>AC). Looks like a monopoly. Long-Run Equilibrium: We set MR=MC P>MR, P>MC But P=AC. Zero economic profit.

8. 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 MR=MC. In a table, we then read across to find price and quantity to define the profit-maximizing point.

9. 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

10. 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.

11. Other Information Total Revenue is price * quantity. $16*600 = $9600 Total Cost = AC*quantity $12*600 = $7200 Profit = TR-TC = $9600-$7200 = $2400 Another way to calculate Profit (Price-AC)*quantity = ($16-$12)*600 = $2400

12. Another Example What is the maximum profit this firm can earn each day? Price=$8 AC = $6 Output = 30 Max Profit = ($8-$6)*30 = 60

13. Oligopoly No stable equilibrium. May resemble a monopoly if firms collude. May move toward zero economic profits. Depends.

14. 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.

15. 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.

16. Graphical Depiction Firm Level Demand Curves p p d d q q perfect competition imperfect competition

17. 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.

18. 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.

19. Oligopoly Oligopolies can produce identical products (crude oil) or branded products (appliances). The latter situation is sometimes called a “differentiated oligopoly.”

20. Advertising Firm advertising would not be much use under perfect competition where each firm produces an identical product and has only a tiny share of the market. Advertising can be a form of rivalry among competitors in an oligopoly. It can also serve as a barrier to new entrants into an imperfectly competitive market.

21. Advertising Advertising may provide some benefits to consumers if it gives them information about products.

22. Monopolistic Competition A large number of sellers produce differentiated products (branded products). New firms can enter this sort of industry easily.

23. How do Monopolies and Oligopolies Arise? There are two main reasons: Economies of scale in production Barriers to entry

24. How does monopolistic competition arise? The product must be differentiated. Entry and exit of firms must be easy.

25. 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.

26. Cost Curves of a Natural Monopoly AC MC q

27. 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” firm’s AC curve starts to rise.

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

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

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

31. Monopolies Chapter 9

32. 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. Δ TR ΔY ______ MR =

33. Marginal Revenue of a Monopolist Remember the relationship between elasticity and TR we learned in chapter 4? When demand is elastic, TR rises as output increases. When demand is inelastic, TR falls as output increases.

34. 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.

35. 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.

36. Steps Calculate MR and MC for each level of output. Find output level where MR=MC. Read price that corresponds to that output level from the demand curve.

37. Graph of profit-maximizing MC p* AC d MR q*

38. For a monopoly Price > MC Price > MR Price (usually) > minimum AC in long run

39. Monopolies and Supply A monopolist does not have a supply curve. Supply for a monopolist is a single point.

40. Profits for monopoly MC p* AC Profit is the pink rectangle. d MR q*

41. 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*

42. 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*

43. 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

44. 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 q* qc

45. Chapter 10 Other forms of imperfect competition

46. Oligopolies Oligopolies are common in the U.S.

47. Concentration Ratio The four-firm concentration ratio is defined as the percent of total industry output that is accounted for by the largest four firms. Similarly, one can define an eight-firm (or other number) concentration ratio.

48. Strategic Interaction When only a few firms operate in market, they will probably recognize their interdependence. Strategic interaction occurs when each firm’s business plan depends on the behavior of its rivals.

49. 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.

50. 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.