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Analyze the major barriers for entry and exit into the airline industry. Explain how each barrier can foster either monopoly or oligopoly. What barriers, if any, do you feel give rise to monopoly that will allow the government to have to get involved to protect consumers?
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9

Perfect Competition
Learning Objectives
By the end of this chapter, you will be able to:
List the assumptions of perfect competition.
Diagram the relationship between a firm and the total market. Calculate profits, given quantity, marginal revenue, marginal cost, average cost, and price. Identify the profit-maximizing level of output.
Define the shutdown point in terms of price and average variable costs or total fixed costs and losses.
Describe the long-run supply curve for a constant cost industry, an increasing cost industry, an
increasing cost industry, and a decreasing cost industry.
Identify the long-run equilibrium for the firm and the industry under perfect competition.
Explain how economic rent might exist in perfect competition, even in long-run equilibrium.

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Section 9.1

Characteristics of Perfect Competition

CHAPTER 9

Introduction

C

onsider this. . . Some firms, like convenience stores and grocery chains, are open
24 hours a day. Others close at 6:00 or 7:00 P.M. Some bars and restaurants open
at 11:00 A.M. to cater to a lunch crowd, while others dont open until 4:00 P.M. for
the happy hour crowd. Some resorts are open year-round, while others close for business
during the off-peak season.
How can you explain this distinctly different behavior across firms that are in the same
industry? Any firm that makes production decisions will relate potential, or forecasted,
revenues to costs in order to determine output levels. However, the forecasted revenues
will depend on the market conditions faced by the firm. After studying the material in this
chapter you will be able to explain why firms in the same industry make different choices,
whether they choose to close at 7:00 P.M., close for the winter, or close permanently.
This chapter and the next two look at four different models, referred to as market structures. The model discussed in this chapter is perfect competition. Perfect competition is
the market structure in which there are many sellers and buyers, firms produce a homogeneous product, and there is free entry into and exit out of the industry. It is important to
keep in mind that this is a theoretical model. Real data does not exist, and the model does
not precisely describe reality. The model is useful, however, because it provides a point
of reference. It allows the development of tools of analysis that indicate what determines
price and quantity when conditions are close to those of perfect competition. The perfectly
competitive market is the abstract ideal to which we will compare other market structures.

9.1

Characteristics of Perfect Competition

T

here are six basic assumptions for the model of perfect competition. In developing
the theory, we assume that all firms in the market in which the product is sold possess these six characteristics.

The first assumption is that there is a large number of sellers (producers) in the
market. A large number means there are so many sellers of the product that no
single sellers decisions can affect price. For example, no single wheat farmer
can influence the price of wheat. A farmer could sell the entire crop or none of
the crop. The farmers decision wouldnt affect the price of wheat in any perceptible manner because the market for wheat is so large relative to any single
producer.
The second assumption is that there is a large number of buyers (consumers) in
the market. A large number means that no one buyer can affect the price in any
perceptible way. That is, no single purchaser has any market power.
The third assumption is that perfectly competitive firms produce a homogeneous product. Homogeneous means that the product of one firm is no different
from that of other firms in the industry. Since this is the case, purchasers have
no preference for one producer over another. If you are a miller and want to

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Section 9.1

Characteristics of Perfect Competition

CHAPTER 9

purchase wheat, you dont care if it was produced by Farmer Jones or Farmer
Smitha bushel of No. 1 winter wheat is a bushel of No. 1 winter wheat!
The fourth assumption, a very important assumption, is that there is free entry
into and free exit out of the market. This means that if one firm wishes to go into
business or if another firm wishes to cease production, either can do so without any kind of constraint. This assumption is crucial in distinguishing perfect
competition from monopoly, which we will examine in the next chapter.
The fifth assumption is that there is perfect knowledge. The sixth assumption is
that workers and other resources can easily move in and out of the industry. These
last two assumptions are even more unrealistic than the others because information is costly to acquire and resources are usually costly to move. The effect
of these two assumptions is that when economic profits exist, firms will find
out about these profits and enter the industry. Even though these assumptions
are unrealistic, the resulting model is valuable because it shows what adjustments would take place in an ideal setting.
If these six assumptions are met, a market will be perfectly competitive. These assumptions create a model market in which no firm or individual has the power to exert control
over the market. This means that neither buyer nor seller has any influence over price.
The six assumptions were first stated more than two centuries ago by Adam Smith in a
general outline of the perfectly competitive model in his book, An Inquiry Into the Nature
and Causes of the Wealth of Nations (1776). In the nineteenth century, the model of perfect
competition was the main way of looking at how firms and markets determined price and
output levels. The study of other market structures arose later.

Economics in Action: What Criteria Is Necessary for Perfect Competition?
Looking at the airline industry, the Khan Academy lists the criteria for perfection competition. Find
out how this criteria applies to any market at http://www.khanacademy.org/finance-economics/
microeconomics/v/perfect-competition.

Large Numbers on the Buyers Side
This chapter concentrates on developing a theory of firms in perfect competition, or competition on the sellers side of the market. Keep in mind, however, that we also assume
large numbers of buyersso many that no single firm possesses market power.
Concentrating on the firm should not obscure the importance of competition on the buyers side of the market. In order for markets to be competitive, there must be enough buyers that none can affect the market price by withholding purchases. Note also that perfect
competition and free markets are not necessarily the same. A free market means a market
that is free of government regulationthus a perfectly competitive market could also be
a free market, but the reverse is typically not the case.

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Section 9.2

Competitive Adjustment in the Short Run

CHAPTER 9

Check Point: Perfect Competition Assumptions







9.2

Many sellers
Many buyers
Homogenous product
Free entry to/exit from the market
Perfect knowledge
Resources move freely

Competitive Adjustment in the Short Run

S

ince the perfectly competitive firm is small relative to the market and its product is
the same as that of other firms, this firm views itself as having no influence on market
price. If the perfectly competitive firm wants to sell any of its output, it must sell at
the market price. A firm in perfect competition is referred to as a price taker because it has
no influence on price. It can sell any amount at the market-clearing price. The firm takes
that price as its selling price. If it sets a higher price, none of its output will be sold because
buyers will be able to purchase an identical product at the lower market price elsewhere.
On the other hand, it makes no sense to sell below the market price because the firm can
sell all it produces at that market price.

The market demand and supply curves and the firms resultant demand curve are
shown in Figure 9.1. (The graphs in this chapter are based on models first developed by
nineteenth-century British economist Alfred Marshall.) Market demand (D) and supply
(S) curves are such that the market equilibrium price is P1. If the market is in equilibrium, the perfectly competitive firm can sell as much of its product as it wishes at price
P1. From the firms viewpoint, the demand curve is perfectly elastic at price P1.

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Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

Figure 9.1: Elastic demand at market equilibrium
(a) Firm

(b) Market

Price

Price
S

D = P = AR = MR

P1

P1

D
0

x1

x2

x3

x 4 Quantity/
Time Period

0

Quantity/
Time Period

In perfect competition, a firms demand curve is perfectly elastic at the market equilibrium price.

The demand schedule a firm faces is also its average revenue schedule. If, for example, the
price consumers pay in the market is $15, the average revenue a seller receives per unit
sold is also $15. As price changes along a market demand curve, the average revenue that
sellers receive will also change. Total revenue of a firm is the price times the quantity sold
(TR 5 P 3 Q). Average revenue (AR) is total revenue divided by the quantity sold. It is the
revenue per unit sold, or the price of the product. A demand curve is an average revenue
curve. With perfect competition, price does not vary with output. Thus, AR 5 (P 3 Q)/Q
5 P is a constant. The firms perfectly elastic demand curve in Figure 9.1 is also a perfectly
elastic average revenue curve.

The Level of Output
Recall that a profit-maximizing firm always produces that quantity for which marginal
revenue is equal to marginal cost. Thus, we need to determine what the competitive firms
marginal revenue curve looks like. Marginal revenue for the nth unit is the change in total
revenue from selling one more unit:
MRn 5 TRn 3 TRn21

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Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

In Figure 9.1, the change in total revenue if sales increase from x1 to x2 (where x2 is one unit
more than x1) is P1(x2 2 x1). If sales increase from x2 to x3 the change in total revenue is P1
(x3 2 x2). In other words, in the case of a perfectly elastic demand curve, such as the firms
demand curve in Figure 9.1, D 5 P 5 AR 5 MR. The marginal revenue curve associated
with a perfectly elastic demand curve is the same as the demand curve. The demand curve
is always the average revenue curve for any market structure. The demand curve is equal
to the marginal revenue curve only in perfect competition. Remember the relationship
between average and marginal valuesif the average value doesnt change, the marginal
value must be the same as the average.
Using marginal cost and marginal revenue, we now can determine how a perfectly competitive firm will adjust its output to changed prices in the short run. The demand curves
for the market and a representative firm are depicted in Figure 9.2. A representative firm
is a typical firm in perfect competition, one of the many similar firms in this market. In Figure 9.2, the representative firms marginal cost curve is also shown. This firm maximizes
profit by producing quantity x1 when the price per unit is P1 because at that output level,
MR1 5 MC. Now assume the market demand increases to D2. The market price rises to P2.
The firms demand curve, average revenue curve, and marginal revenue curve change to
D2 5 AR2 5 MR2. The firm responds by increasing its output level to x2, where MR2 5 MC.

Figure 9.2: Profit maximization
(a) Firm
Price,
Cost

(b) Market
Price
MC

D2 = AR 2 = MR 2

P2

D1 = AR 1 = MR 1

P1

S

P2
P1

D1
0

x1

x2

Quantity/
Time Period

0

D2
Quantity/
Time Period

An increase in market demand causes the equilibrium price to rise. The demand curve the firm faces
adjusts by the amount of the increase in price, and the firm increases its output to equate MC and MR.
The adjustment process is such that the firms marginal cost curve is its short-run curve.

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Section 9.2

Competitive Adjustment in the Short Run

CHAPTER 9

Economics in Action: Plotting Profits and Perfect Competition
Free Econ Help uses graphs to explain perfect competition (where marginal cost equals marginal revenue) and how one can identify profit maximization. Follow the link to see at http://www.youtube
.com/watch?v5eh1cc6P-eeI.

The Supply Curve
Changes in market price cause the firm to increase or decrease production along its marginal cost curve until MR 5 MC. The profit maximizing priceoutput combinations generate a supply curve, which, as we have just seen, is also the marginal cost curve. In Figure
9.2, the firms short-run marginal cost curve is the same as its short-run supply curve. A
short-run supply curve is a supply curve for the period in which the size of the plant cannot be varied (the short run). In perfect competition, the short-run marginal cost curve is
the short-run supply curve. As the market price rose, the firm in Figure 9.2 increased its
output. The quantity which will be produced at each price is identified by the marginal
cost curve. Of course, no firm that seeks to maximize profit would choose to produce output at any price; there is a price below which the firm would lose money if it continued to
participate. As we shall see, we can identify the point on the marginal cost curve at which
the firm should cease production. The marginal cost curve (above the so-called shutdown
point) is also the supply curve for a competitive firm.
We can now look at the relationship between the firms supply (marginal cost) curve
and the market supply curve. The firms supply curve represents its output response to
increased market prices. Just as an industry is made up of all the firms that produce and
sell homogenous goods, the short-run supply curve of an industry is the sum of supply
curves for all firms in the industry. If we were to add the output (horizontally) across the
short-run supply curves for all firms, we would construct the short-run market (or industry) supply curve. The market supply curve is simply the aggregate of all the firms supply curves. The short-run market supply curve, then, is the aggregate of the portions of all
firms marginal cost curves that lie above their average variable cost curves. In the long
run, more firms can enter an industry as a response to economic profits. The market supply curve will shift to the right because it is made up of more individual supply curves.
On the other hand, as firms leave an industry due to losses, the market supply curve will
shift to the left, representing a decrease in supply. This decrease is due to the fact that there
are fewer individual supply curves to be summed.

Profits and Losses
We have just seen how a representative firm adjusts in the short run to changes in market
demand. We dont yet know whether the firm has a profit or a loss, or how large this profit
or loss is. To find out, we need to add the average cost curve to the graph. Also, in order
to decide if the firm should continue to produce if losses are encountered, we need to add
the average variable cost curve.

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Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

In Figure 9.3, the firm is maximizing profit by producing output x1 at price P1, where
P 5 MR 5 MC. The average cost of producing x1 is measured by distance x1C in
Figure 9.3. The total cost of producing x1 is represented by the area of the rectangle
0P1Cx1. Total revenue in Figure 9.3 is also the area of 0P1Cx1, so TR 5 TC. This firm is
therefore making zero economic profit, although it is meeting its opportunity costs.
Remember that total cost includes normal profit, which is the return on capital and enterprise necessary to keep firms in an industry.
The point at which the firm is making only a normal rate of return, or zero economic
profit, is the breakeven point. If there is zero economic profit then P 5 AC and so AC 5 P
5 MR 5 MC. The breakeven point occurs at the intersection of the average cost (AC) curve
and the marginal cost (MC) curve. If price rises above the breakeven point, the firm will
make an economic profit; if the price falls below breakeven, the result will be a negative
economic profit.

Figure 9.3: Firm earning zero economic profit
Price,
Cost
MC

P1

0

AC

C

D=AR=MR

x1

Quantity/Time Period

The average cost (AC) curve is used to determine if a firm is making an economic profit. If average
revenue (price) is equal to average cost, the firm is making zero economic profit.

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Section 9.2

CHAPTER 9

Competitive Adjustment in the Short Run

If the firms average cost (AC) curve is the one drawn in Figure 9.4, the average cost of
producing x1 is the distance x1A. Total revenue (TR) is still P1 3 x1, or the area of 0P1Bx1
Total cost is now the area of 0CAx1. Since TR . TC, there is an economic profit equal to the
area of CP1BA in Figure 9.4. On the other hand, if the firms average cost curve is the one
drawn in Figure 9.5, the average cost of producing x1 is the distance x1 A. Total revenue is
the area of 0P1Bx1 and total cost is the area of 0CAx1. In this case, TC . TR, so economic
losses are being incurred. The economic loss is equal to the area of P1CAB in Figure 9.5.

Figure 9.4: Firm earning an economic profit
Price,
Cost

MC
AC

P1
C

0

B

D=AR=MR

Profit
A

x1

Quantity/Time Period

If the firms average revenue is greater than its average cost at the level of output being produced, the
firm is making an economic profit.

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Section 9.3

CHAPTER 9

The Shutdown Decision

Figure 9.5: Firm suffering a loss
Price,
Cost
MC
AC

C
P1

0

A
Loss

D=AR=MR
B

x1

Quantity/Time Period

If the firms average cost is greater than its average revenue at the level of output being produced, the
firm is incurring a loss.

Should the firm of Figure 9.5 continue to produce, and, if so, for how long? It is suffering
a loss, which means the productive resources employed by this firm could earn more in
some other use. Revenues are less than opportunity costs. But keep in mind that this diagram shows the short run, which means that some input is fixed. This fixed input means
that there are fixed costs that cannot be eliminated. Fixed costs must be paid in the short
run even if production ceases. Because variable costs are the only ones under the firms
control in the short run, we need to include the average variable cost (AVC) curve to determine the conditions under which the firm should cease production.

9.3

The Shutdown Decision

T

he short-run cost curves of a firm are depicted with several equilibrium points in
Figure 9.6. At a price of P1, which represents a marginal revenue of MR1, the firm
maximizes profits by producing x1. At P1, the firm is making an economic profit
because total revenue (area of 0P1Ax1) is greater than total cost (area of 0C1Dx1). At price P2
5 MR2, the firm would produce x2 and make zero economic profit because total revenue

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Section 9.3

CHAPTER 9

The Shutdown Decision

(area of 0P2Bx2) is equal to total cost (area of 0C2Bx2). Notice that this Point B lies at the
intersection of the average cost and marginal cost curves. This, then, is the breakeven
point, and the firm makes zero economic profit.

Figure 9.6: The shutdown point
Price,
Cost
C4

MC
AC

G
A

P1

D
B

H

P3

0

MR 1

E

C3
C1
C 2 ,P 2

P4

AVC

MR 3

S

MR 4

F

x4

MR 2

x3

x2

x1

Output/Time Period

If a firms average revenue is greater than its average variable cost, the firm will be able to cover total
variable costs and make a payment toward total fixed costs. If price falls below average variable costs,
the firm will lose less money if it shuts down than if it continues to produce. The shutdown point in this
case is Point S at a price of P3.

Examine carefully what happens when price falls to P3 and marginal revenue falls to MR3.
The profit-maximizing or loss-minimizing output is now x3. At output level x3, economic
losses are incurred because total revenue is the area of 0P3Sx3, and total cost is the area of
0C3Ex3. Economic losses are thus represented by the rectangle P3C3ES. The firm needs to
answer this question: Should it produce and incur this loss or should it cease production?
Remember, if production is halted, fixed costs must still be paid. In Figure 9.6, if the market price is P3, the firm is earning a total revenue equal to the area of 0P3Sx3, and its total
variable costs (TVC 5 AVC 3 Q) are 0P3Sx3. At this priceoutput combination, marginal
revenue is equal to average variable cost. In other words, the firm is covering (exactly)
its total variable costs and losing an amount equal to its total fixed costs. It must pay the
fixed costs even if it shuts down, so at price P3 the firm is indifferent about shutting down
or continuing to produce. If the price falls below P3, the firm should shut down in order

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Section 9.3

The Shutdown Decision

CHAPTER 9

to minimize losses. By shutting down, it will lose only total fixed costs, instead of losing
total fixed costs plus some portion of variable costs (as it will if it continues to produce).
The minimum or low point on the AVC curve where it intersects the MC curve (Point S in
Figure 9.6) is called the shutdown point because if price falls below that point, the firm
loses less by ceasing production.
Consider price P4 (or MR4) in Figure 9.6. The MR 5 MC rule tells the firm that at P4 it
should produce output level x4. However, at x4 the firm is losing P4C4GF (0P4Fx4 2 0C4Gx4).
Total revenue of 0P4Fx4 does not cover the total variable costs of producing x4, which are
x4H times x4. In other words, the firm is losing more than its total fixed costs. It is making
variable cost outlays that it wouldnt have to make if it stopped production entirely. The
firm would be better off to shut down and only incur its fixed costs.
Because the firm shuts down, we need to modify the earlier statement that the firms marginal cost curve represents its short-run supply curve. That statement is not completely
correct. A firms short-run supply curve is represented by its marginal cost curve only
above the shutdown point (Point S in Figure 9.6). Below the shutdown point, the firm will
produce no output, so only the part of the marginal cost curve above the minimum point
on the average variable cost curve is the firms supply curve.
The model has just told us that in the short run, the firm will shut down when price falls
below average variable cost. It says nothing about the real-world timing of such a shutdown. The decision to shut down is more difficult in reality than in theory. It depends on
many factors, including time and anticipated changes. A few examples may illustrate such
problems.
First, imagine yourself the owner of a sporting goods store in a ski area or a beach resort.
Shutdown may be a seasonal decision. If revenues fall below average variable costs (clerks
wages, electricity, and so on) in the off-season, you may close up, bearing only your fixed
costs (such as rent on the store) until crowds return and your revenues increase. In this
case, shutdown does not mean you are moving your investments in plant and equipment
into other businesses. It simply means that you lose money in certain seasons and you lose
less money if you shut down. You fully intend to reopen for business when the snow flies
or the temperature sends people to the beaches. Past experience helps you to determine
when to shut down and when to reopen.
Second, imagine yourself the ownermanager of a steel mill. The price of steel has fallen
below your average variable costs of production. In the short run, you shut down (if laws
and union contracts allow you to do soa union contract might change labor from a variable to a fixed resource). The short run is too short a time period for you to vary your plant
size (which is one way of saying that you cant move your fixed resources in this time
period). If, however, you are convinced that this low price is permanent, you will begin
to liquidate. You will sell equipment and attempt to sell your buildings and other fixed
assets. As you do this, you are moving to the long run.
The short-run output decisions and profit determination for a perfectly competitive firm
can be illustrated with a simple example. Table 9.1 presents some production cost data for
a firm. Assuming that different market prices are the result of different market equilibrium situations, it is possible to determine the firms response to different prices. In Table
9....

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10

Monopoly
Learning Objectives
By the end of this chapter, you will be able to:
Define monopoly and calculate average revenue and marginal revenue, given data on price and
output. Diagram average revenue, marginal revenue, marginal cost, and average cost curves for a
monopolistic firm making an economic profit, a loss, and finally, a normal profit.
Describe the economic role of natural and artificial barriers to entry into an industry.
Explain why firms practice price discrimination.
Discuss how a monopolist misallocates resources in terms of price and costs.
Describe the costs associated with monopoly.
Explain facts and fallacies of monopoly organization.

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

CHAPTER 10

Introduction

C

onsider this. . . Do you ever cut coupons out of the local Value Mailer? Maybe
you have a membership tag on your key chain for your local grocery store. No
doubt youve seen shoppers with their coupons organized into binders and folders by product line so they can maximize the amount of money they save. Some retailers
promote double and triple coupon days. There are countless websites devoted to coupons: manufacturers sites offer printable coupons for their products, social network sites
enable shoppers to share current deals, and other sites teach shoppers how to save money
on grocery shopping by being very organized in coupon gathering. The author of one
such extreme couponing site, a self-described stay at home mom of two gorgeous baby
girls, (About Me, para. 1) teaches couponing classes to local community groups. She
estimates that she spends 90 minutes each week cutting, filing, and organizing her coupons to maximize her budget and estimates that she saves on average $300 a month. For
her time and effort, that comes to an equivalent wage of about $50.00 per hour take-home
pay. There arent many part-time jobs that pay that well!
The benefits to the coupon user are obvious. But why do stores issue coupons for a 50 cent
discount rather than simply reduce the price of the product by 50 cents for all shoppers?
And why doesnt everybody use coupons? After you study the material in this chapter,
you will be able to explain this behavior and analyze why stores and manufacturers use
coupons as promotional tactics.
Monopoly is at the other end of the market continuum from perfect competition, in the
sense that perfect competition involves many firms and monopoly involves just one. The
word monopoly is derived from the Greek words mono for one and polein for seller.
Monopoly is the market structure in which there is a single seller of a product that has no
close substitutes.
Although there are no pure monopolies, there are many firms that have some degree of
monopoly power. Monopoly power is the ability to exercise power over market price and
output. As you learned in the last chapter, firms in perfect competition are price takers.
In this chapter, you will see that, because it has some control over price, a monopoly is
a price searcher. A price searcher is a firm that sets price in order to maximize profits. A
price-searching firm has monopoly power. It searches for the pricequantity combination
that will maximize its profit.

10.1 Demand, Marginal Revenue, and Price and Output Under

Monopoly

A

perfectly competitive firm faces a perfectly elastic demand curve. As a result, price
(or average revenue) and marginal revenue are equal. However, a monopolistic
firm faces the market demand curve because the firm is the single seller and is,
therefore, the market. This distinction is very important because market demand curves
have negative slopes. Since the monopolists demand curve has a negative slope, its marginal revenue curve will lie below that curve. The commonsense explanation for why the
marginal revenue curve lies below the demand curve is that the monopolist cant simply

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CHAPTER 10

Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

choose any price at which to sell its products. A monopolist still has to follow the law
of demand and must lower price in order to sell more units of output. The price reduction applies to all units of output that the monopolist sells, not just the last, or marginal,
unit. Each additional unit sold adds to total revenue by the amount it sells for (its price)
but takes away from total revenue by the reduction in price on each unit sold. Thus, the
change in revenue (the marginal revenue) must be less than the change in price.
Some data illustrating the relationship among average, total, and marginal revenue for a
monopoly firm are presented in Table 10.1. When 3 units are sold, the total revenue is $186
(3 3 $62). In order to sell 4 units, the monopolist must reduce the price from $62 to $60. Total
revenue will then increase by $60 because an additional unit is being sold for $60. At the
same time, it will decrease by $6 because the other 3 units now sell for $2 less each (for $60
each rather than for $62). The net result is that the monopolist has added $54 ($60 2 $6) to
total revenue by reducing the price from $62 to $60. Note that marginal revenue is $54 and
price (average revenue) is $60 for 4 units. Marginal revenue has to be smaller than average
revenue whenever units other than the marginal one suffer a price reduction.
Table 10.1: Average, total, and marginal revenue for a monopolist
Units sold

Price (Average revenue) Total revenue

Marginal revenue

0

$65

0

0

1

64

$64

$64

2

63

126

62

3

62

186

60

4

60

240

54

5

58

290

50

6

56

336

46

7

54

378

42

8

52

416

38

9

50

450

34

10

48

480

30

The relationship between marginal revenue and demand is graphed in Figure 10.1. When
demand is inelastic, decreases in price will cause total revenue to decline. If total revenue
is declining, additions to total revenue must be negative. That is, marginal revenue is
negative. In Figure 10.1, a reduction in price below P1 will decrease total revenue because
marginal revenue will be negative. This region corresponds to the inelastic portion of the
demand curve. However, a reduction in price from P2 to P1 would increase total revenue
because the demand curve is elastic in this range.

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Figure 10.1: Demand and marginal revenue
Price

E d >1
P2
E d =1

P1

E d <1

P0

D = AR
0

x2

x1
MR

x0

Quantity/
Time Period

The marginal revenue curve lies below the average revenue curve when there is a negatively sloped
demand curve. For a linear demand curve, the marginal revenue curve will intersect the x-axis exactly
halfway between the origin and the point where the average revenue curve interests the x-axis.
Demand is elastic above P1 and inelastic below P1.

Profit Maximization
Think back to the discussion of demand elasticity and Cournots analysis of the mineral spring owners situation. In that problem, the monopoly owner of a mineral spring
with no production costs maximized profits by setting price where the price elasticity of
demand was unitary. We can now apply the profit maximization rule MR 5 MC to this
case. If costs were zero, the MC curve would lie along the horizontal axis. In Figure 10.1,
the monopolist would maximize profits by producing xl units (where MR 5 MC 5 0) and
selling them at price P1. Since monopolists are profit maximizers, they produce the quantity where MR 5 MC and sell the product for the maximum price that the market will pay.
The demand curve shows the limits of what price buyers are willing to pay for all levels
of output. The mineral spring monopolist will increase sales of water as long as marginal
revenue is positive, since it costs nothing more to produce another unit. You should note
that this does not mean the mineral spring monopolist sells as much as possible. Rather,
the monopolist sells the quantity that maximizes profit. The quantity at which profit is
maximized is where marginal revenue equals marginal cost.

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Price and Output Decisions Under Monopoly
In the more general case, where costs are positive, the monopolist finds the profitmaximizing level of output by equating marginal cost and marginal revenue. The perfectly competitive firm is a price taker. The monopoly firm is a price searcher. A monopolist searches for the profit-maximizing price, not the highest price. This process can be
seen by looking at the cost relationships graphically.
In Figure 10.2, a monopolist is producing a certain good for which the market demand
curve is D. The marginal revenue curve (MR), derived from D, and the average cost (AC)
and marginal cost (MC) curves are also given. The monopolist will maximize profit by
producing x1 units because at that level of output, MR 5 MC. If MR is greater than MC
(that is, if output is less than x1), the monopolist can increase profits by expanding output.
Additions to output will cause total revenue to increase by more than the increase in total
cost. On the other hand, if MR is less than MC (that is, if output is greater than x1,), the
monopolist will reduce output because additions to output add more to total cost than to
total revenue.

Figure 10.2: The profit-maximizing position of a monopolist
Price,
Cost

MC
P1
C1

A

AC

Economic
Profit
B

D
0

x1

MR

Quantity/
Time Period

The profit-maximizing monopolist will produce x1 units of output, where MC 5 MR. Since average cost
(C1) is less than average revenue (P1) for output level x1, this monopolist is making an economic profit.

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After choosing output level x1, the monopolist will search for the highest price it can
charge and still sell that amount of output. In Figure 10.2, this price is P1. The monopolist
can sell x1 units of output at price P1 because the demand curve in Figure 10.2 shows that
P1 is the maximum that consumers will pay for that level of output.
At P1 and x1, the monopolist is making an economic profit. The average revenue (price) is
P1, and average cost is C1. Since P1 is larger than C1, the monopolist is making a profit of
P1 2 C1 on each unit for a total profit of (P1 2 C1) 3 x1. In Figure 10.2, total cost is
represented by rectangle 0C1Bx1, and total revenue is represented by rectangle 0P1Ax1.
Total revenue minus total cost equals economic profit, or rectangle C1P1AB. Since the cost
curves include both explicit and implicit costs, the monopoly firm is making more than its
opportunity cost. That is, the firm is earning more than is necessary to keep its resources
employed in this industryit is making an economic profit.
Table 10.2 shows the revenue and cost data for a monopolist. The monopolist would maximize profits at an output level of 7 units, where MC 5 MR 5 $46. Price should be set at $52
because the demand curve (AR) indicates that 7 units will sell for $52 each. At a price of $52,
total revenue is $364 (7 3 $52) and total cost is $322 ($46 3 7), which means that the monopolist is making a profit of $42 ($364 2 $322). If you dont believe this is maximum profit, calculate the profit at each level of output from 1 to 10 units. You will see profit is maximized at
7 units because at that level, MR 5 MC. Actually, in this numerical example, the firm would
maximize profit at either 6 or 7 units. A unique point exists only when dealing with continuous functions that allow you to find a point somewhere between 6 and 7 units.
Table 10.2: Cost and revenue data for a monopolist
Output
and sales

Total cost
(TC)

Average
cost (AC)

Marginal
cost (MC)

Average
revenue
(AR)

Total
revenue
(TR)

Marginal
revenue
(MR)

Economic
profit

0

$60

$

$

$0

$0

$0

$60

1

100

100

40

58

58

58

42

2

136

68

36

57

114

56

22

3

168

56

32

56

168

54

0

4

200

50

32

55

220

52

20

5

235

47

35

54

270

50

35

6

276

46

41

53

318

48

42

7

322

46

46

52

364

46

42

8

372

461/2

50

51

408

44

36

9

429

472/3

57

50

450

42

21

10

490

49

61

49

490

40

0

The Monopolists Supply Curve
A supply curve shows how much output will be offered for sale at various prices. In order
to determine a supply curve, it is necessary to show that a firm will supply a unique quantity of output at any given price. This supply is, by definition, independent of demand.

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Section 10.1 Demand, Marginal Revenue, and Price and Output Under Monopoly

A monopoly firm does not have a supply curve in this sense. A monopolist sets the price
at the profit-maximizing level of output, so it doesnt make sense to ask how much will
be supplied at various prices. For a monopoly, the profit-maximizing output, where
MC 5 MR, will depend on the location and shape of the demand curve. A monopoly firm
therefore doesnt have a supply curve that is independent of demand.
To convince yourself that the monopolist does not have a supply curve, examine Figure
10.3. In part (a), two different prices, P1 and P2 are consistent with output x1, depending on
where the market demand curve is located (D1 or D2). The marginal revenue curves that
are derived from the demand curves D1 and D2 both intersect the monopolists marginal
cost curve at the same level of output. In part (b), two different output levels, x1 and x2, can
be produced at price P1, depending on whether market demand is represented by D1 or D2.

Figure 10.3: One output with two prices or one price for two outputs
(a)

(b)

Price,
Cost

Price,
Cost
MC
MC

P1

P1

D2
MR 2

D1

P2

D1

D2
MR 2
MR 1
0

x1

MR 1
Quantity/
Time Period

0

x1

x2

Quantity/
Time Period

It is possible to trace out a supply curve only if a unique price is associated with a certain output. In
graph (a), there are at least two prices, P1 and P2, consistent with output x1. In graph (b), there are at
least two outputs, x1 and x2, consistent with P1.

Figure 10.3 shows that, in the case of a monopolist, you cannot discuss supply independent of demand. There is no way to predict what the monopolist will do without knowing
the demand curve. The predictive powers of economists are, therefore, more limited in an
analysis of monopoly. In this case, economists cannot say that an increase in demand will
cause price to rise, ceteris paribus.

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Section 10.2 Profits and Barriers to Entry

CHAPTER 10

Economics in Action: Viewing the Market Through Revenue and Cost Graphs
The Khan Academy reviews marginal revenue, total revenue, marginal cost, and average total cost in
a monopoly through analyzing revenue and cost graphs at http://www.khanacademy.org/financeeconomics/microeconomics/v/review-of-revenue-and-cost-graphs-for-a-monopoly_DUP_1.

10.2 Profits and Barriers to Entry

I

f a monopolist is earning profits, other entrepreneurs will want some of those profits.
As a result, there will be pressure from new firms entering the industry. But wait! A
monopoly is a single seller producing a product that has no close substitutes. If there is
new entry, there is no longer a monopoly. If a monopoly is to persist, there must be some
forces at work to keep new firms from entering. Barriers to entry are natural or artificial
obstacles that keep new firms from entering an industry. Without such barriers, monopoly
cannot continue.

Economics in Action: And Then There Was One
What if the government wanted only one major player to take care of one product? Welcome to the
monopoly system. Discover how it differs from perfect competition at http://www.khanacademy.
org/finance-economics/microeconomics/v/monopoly-basics.

Natural Barriers
Economies of scale provide a natural barrier to entry. If the long-run cost curves are such
that the optimal-size firm is very large relative to the size of the market, there may be
room for only one cost-efficient firm in the industry. If there are great economies of scale,
one firm that is bigger than any of the others will be able to undersell the rest. In such a
case, the bigger firm will cut its price below that of its rivals and capture their customers.
Eventually the large firm will become the only firm in the industry. When just one firm
emerges in this way, the firm is called a natural monopoly. Natural monopolies exist in
very few industries.
Public utilities such as telephone companies, electric companies, and cable television
companies fit this category. The government recognizes that these are natural monopolies and therefore charters them and then regulates their prices and output levels. Some
economists argue that even public utilities are not really natural monopolies. Since the
occurrence of a natural monopoly is rare, most of the monopoly power that exists in our
economy is due to artificial barriers.

Artificial Barriers
An artificial barrier to entry is one that is contrived by the firm (or someone else) to keep
others out. It doesnt take much imagination to come up with a list of such barriers. The

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CHAPTER 10

least sophisticated, but perhaps the most effective example, would be the use of violence.
Suppose you want to have a monopoly on the illegal numbers racket in South Chicago.
If new entrepreneurs move in to reap some of these profits, you simply do away with
them and hence establish a monopolyvery effective! This sort of tactic may sound barbaric, but business history contains many examples of the use of violence to keep out competitors. In the early history of oil exploration and drilling in the United States, private
armies were often essential.
On a more civilized level, it may be possible to erect artificial barriers that are legal, or
at least quasi-legal. If exclusive ownership of all the raw materials in an industry could
be captured, entry could be controlled by refusing to sell to potential new entrants. The
firm of Alcoa enjoyed a monopoly before World War II because it controlled almost all the
known sources of bauxite, the essential ore for the production of aluminum.
A recent example of the use of artificial barriers could be found in the market for diamonds.
Through most of the 20th century the de Beers Company of South Africa controlled most of
the worlds diamond supply. This firm effectively controlled the mining and marketing of
new diamonds and wielded enormous influence over price. In this case, there was still
competition because all diamonds that had been produced in the past were potential competitors. If de Beers manipulated production to drive price too high, individuals might
enter the market as suppliers, selling diamonds they presently owned.
Another way to create artificial
barriers is to own the patent on
a process or machine that is vital
in production. Patent rights give
sole authority to use the process
or machine to the holder of the
patent. The problems with a
patent, however, are twofold:
First, a patent provides only a
finite period of protection. In
the United States plant and utility patents expire after 20 years
while design patents are good
for only 14 years. After that the
patent expires and everyone is
BananaStock/Thinkstock
entitled to use the idea. Second, Alcoa used to have a monopoly over bauxite, which is essential
to get a patent, detailed plans on in the production of aluminum.
how the item is produced must
be provided, and these plans are
available to potential competitors at the Library of Congress. So it appears a patent is not
a very effective entry barrier to anyone who is willing to risk a lawsuit brought by the
patent holder (and patent holders dont always win their cases). A good alternative to patents is secrecy. If a firm can keep its vital process or machine secret, it can keep new firms
out of its industry. Now you know why there is barbed wire around some research and
development offices, why you arent told the formula for Pepsi-Cola, and why corporate
spying is big business.

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Governmental Barriers to Entry
It is very difficult to be a monopolist because it is very hard to keep new entrants out of
an industryunless you can get the government to help you. Lets look briefly at two
industries where firms have significant market power: the steel industry and the taxicab
industry.
Suppose firms in the U.S. steel industry are earning economic profits. Firms that are producing steel in other countries see profits being earned and gear up to export steel to the
United States to earn some of these profits. In effect, the foreign steel firms are entering
the U.S. market. The domestic firms then appeal to Congress and/or the President to keep
the foreign firms out (to block their entry). Tariffs or quotas may be put into effect. These
tariffs or quotas serve as artificial barriers to entry for foreign firms by raising the price of
foreign goods or prohibiting their sale in the United States.
Next, consider the taxicab industry. You probably consider this to be a competitive industry since in any large city there are cabs from many companies on the street every day.
But, if you decide to start a cab business, you might be in for some trouble. Suppose you
already own a car, so the entry costs are relatively small. All you need to do is to mark
your car so that it can be recognized as a cab, and perhaps install a meter. However, you
will need a permit, which in some cities will be very difficult and expensive to obtain. If
you operate as an underground cab that avoids city regulations, you will make the existing cab owners very unhappy. In many cities, cabs are a monopoly enterprise, and it is
government that protects the monopoly.
In these examples, government supplied the artificial barriers to entry. Federal, state,
and local governments all restrict entry and thereby ensure protected market positions.
It should not be too surprising that many instances of corruption in government have
centered on the granting of monopoly privileges. A government official or agency protects
a monopoly by keeping competitors out. The monopolist is often willing to pay for this
with campaign contributions, favors, or outright bribes, such as direct cash payments, free
vacations, or jobs for relatives.
If monopoly power persists for a long period of time, there is very likely to be some explicit
or implicit government role in creating barriers to entry. Monopoly profits are a very powerful and attractive force, and new entry is very difficult for the monopolist alone to block.
As a result, monopolies usually try to enlist governmental support of one kind or another.

Global Outlook: Of Companies and Countries
Many multinational corporations are very large relative to the countries in which they operate. Some
companies may have worldwide net sales that are larger than the GDP of the country in which they
are operating. Table 10.3 ranks cities and countries by GDP and companies by gross sales. As you can
see, ExxonMobil is larger than Colombia. Wal-Mart is larger than Denmark and Israel combined. In
the top 100, there are 53 countries, 34 cities, and 13 corporations. This ranking is based on 2009 data,
and there may now be even fewer countries and more companies on the list. In 2011, Wal-Mart surpassed Norway and would rank as the worlds 25th biggest country in the world (Trivett, 2011). These
multinationals have a large amount of monopoly power in small host countries.
(continued)

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Section 10.2 Profits and Barriers to Entry

Global Outlook: Of Companies and Countries (continued)
Table 10.3: The worlds top 100 economies
Country/City/
Company

GDP/
Revenues

Country/City/
Company

GDP/
Revenues

Country/City/
Company

GDP/
Revenues

426
417
406
395
390
388
388
383
375

69
70
71
72
73
74
75
76
77

Chevron
Toronto, Canada
Detroit, USA
Peru
Portugal
Chile
Vietnam
Seattle, USA
Shanghai, China

255
253
253
245
245
242
240
235
233

369
363
362

78
79
80

230
223
215

361
357
344
338

81
82
83
84

336
329
324
321

85
86
87
88

Madrid, Spain
Total
Singapore,
Singapore
Sydney, Australia
Bangladesh
Mumbai, India
Rio de Janeiro,
Brazil
Denmark
Israel
Ireland
Hungary

320
318
317
315
304
302
301

89
90
91
92
93
94
95

Finland
General Electric
Kazakhstan
Volkswagen Group
ENI
AXA Group
Phoenix, USA

188
183
177
158
158
157
156

Minneapolis, USA
Sinopec-China
Petroleum
San Diego, USA

155
154

1
2
3
4
5
6
7
8
9

United States
14,204
China
7,903
Japan
4,354
India
3,388
Germ...

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11

Monopolistic Competition
and Oligopoly
Learning Objectives
By the end of this chapter, you will be able to:
Describe the characteristics of monopolistic competition.
Explain why interdependence is unique to oligopoly.
Understand why government policy is often necessary to assure the success of a cartel.
Use game theory to understand oligopolistic behavior.
Describe how and why equilibrium price and output under monopolistic competition and oligopoly differ from that of perfect competition.

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Section 11.1 What Is an Industry?

CHAPTER 11

Introduction

C

onsider this. . . Whats in a brand name? Do you have a favorite soap, aspirin,
breakfast food, or cola? When you get right down to it, a bar of soap is pretty much
a bar of soap. An aspirin is pretty much an aspirin and a cola is pretty much a cola.
Maybe including colas is taking it too farto some people one cola is not the same as any
other cola. A few decades ago Coke introduced a new cola, and some of its customers
revolted; some of them even hoarded cases of the original version of the cola. Coke eventually gave up and brought back the old favorite as Coca-Cola Classic. To these consumers,
one cola was definitely not the same as any other.
To the owner of a brand name, the important question is how much different is the product that has the brand identification. Is it a quarter different? Would you pay 25 cents more
for a bar of Dove soap? Would you pay a dollar more per bar? How much would you be
willing to pay to buy Tylenol over the generic acetaminophen? Perhaps two dollars more?
Clearly the value of the brand disappears at some price. Even a product with a brand
name is still subject to the forces of supply and demand in a competitive market.
We have just seen in Chapters 9 and 10 that there are no perfect real-world examples of
either perfect competition or monopoly. For many years, however, all real-world industries were analyzed in terms of these two models. In the 1930s, theories were developed
that filled out the spectrum between monopoly and perfect competition. Market structures between the two theoretical extremes are called imperfect competition. Economists
divide imperfect competition into monopolistic competition and oligopoly. We will study
these two market structures in this chapter.

11.1 What Is an Industry?

W

e have, up to this point, been using the term industry without carefully defining it. In general, an industry is a group of firms producing the same, or at least
similar, products. The difficulty with this definition is that it does not specify
how dissimilar products must be before they are thought of as being produced in different industries. Consider containers. Are firms producing glass bottles and aluminum cans
similar enough to be included in the container industry? How about firms making paper
cups or even pewter mugs? Most consumers regard pewter mugs and paper cups as quite
different. If you are willing to pay substantially more for a pewter mug than for a paper
cup, you regard them as being distinct products. What about a plastic Ronald McDonald
glass? Is it closer to a paper cup or a pewter mug? These questions demonstrate that whatever scope is assigned to an industry will be arbitrary to some extent. Some people, even
some economists, may disagree with a classification of two products as belonging to the
same industry or to different industries.
Cross elasticity of demand, a concept we discussed earlier, can be useful in determining
whether products belong to the same industry. If the cross elasticity of demand between
two products is positive, the goods are substitutes. Goods that are close substitutes have

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CHAPTER 11

a positive and very high cross elasticity of demand. If economists could agree on a value
of this cross elasticity that would define goods as belonging to the same industryagain
an arbitrary decisionthey could use that number to draw the boundaries between
industries.
The problem of assigning firms to industries is made even more difficult by the fact that
some multiproduct firms produce a variety of goods that might be included in different
industries. In which industry is a firm that produces coffee in addition to soap and cake
mixes? General Electric produces goods as unrelated as jet engines and toasters. Informed
judgments and somewhat arbitrary definitions are necessary in order to move from the
world of theory into the real world of industry studies.

11.2 Industry Structure

O

nce an industry has been defined, it is possible to determine its market structure, or
where it lies on the spectrum from perfect competition to monopoly. The structure
will depend on several characteristics of the industry. The degree of concentration
and conditions of entry are especially important characteristics. Entry affects concentration because high barriers to entry result in a more concentrated industry.

Economics in Action: Whats in Between?
There is a drastic difference between monopolies (one seller) and perfect competition (many sellers).
Are there opportunities for any markets that fall in between these two? The Khan Academy explains
the various markets at http://www.khanacademy.org/finance-economics/microeconomics/v/oligo
polies-and-monopolisitc-competition.

Concentration Ratios
Concentration refers to the extent to which a certain number of firms dominate sales in
a given market. Measures of concentration have, for many years, been a major tool of
industry studies. A concentration ratio is used by economists to provide a measure of
the distribution of economic power among firms in an oligopolistic market. To calculate
a concentration ratio, the economist lists all the firms in a particular industry in order of
decreasing size. The next step is to calculate the percentage of that industrys total sales
accounted for by a certain number of the largest firms. For example, a four-firm concentration ratio measures the percentage of sales accounted for by the four largest firms in
an industry. Other commonly used concentration ratios are for the largest firm, the three
largest firms, the eight largest firms, and so on. Most industry studies employ four-firm
ratios. Table 11.1 gives four-firm concentration ratios for a few industries.

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Section 11.2 Industry Structure

Table 11.1: Four-firm concentration ratios for selected industries
Product

Concentration ratio

Automobiles

94%

Chewing gum

93

Window glass

89

Sewing machines

82

Detergent (household)

80

Tires

71

Canned beer

66
Federal Trade Commission. (1990). Selected statistical series. Washington, DC: U.S. Government Printing Office.

It could be argued that the percentage of sales accounted for by the largest firms is not
the best measure of concentration in an industry. Concentration ratios might instead be
calculated using percentage of assets, percentage of employees, or value of shipments.
The various measures of concentration are all closely related, however, so the choice of a
ratio isnt crucial.
The more concentrated an industry, the more likely it is that there will be a recognized
interdependence and joint action of either a collusive or noncollusive nature. When the
four-firm concentration ratio exceeds 50%, the degree of interdependence in the industry
is likely to be very high.

Barriers to Entry
Entry conditions are the second characteristic affecting market structure. If barriers to
entry are high and the industry is highly concentrated, it is more likely that joint action
can be undertaken to create monopoly profits. You saw earlier that cartels are very unstable and that economic profits will strongly attract new firms into the industry. If concentration is high and entry is blocked, the existing firms will be in a better position to restrict
output, raise prices, and maintain persistent profits.
The rapid internationalization of world markets makes the maintenance of entry barriers
very difficult. It may be possible to limit entry in a domestic economy, but if free trade is
allowed or if movements to increase trade exist, these barriers will fall. Almost all arguments against more liberal trade policies, such as the North American Free Trade Agreement (NAFTA), come from those firms and labor unions in those firms that enjoy some
economic rents from the barriers to more open trade. One of the most effective antimonopoly policies is a policy of more open international trade.

The Herfindahl Index
The U.S. Justice Department has been using the Herfindahl Index, a summed index of
concentration, to replace the more traditional concentration ratios. The Herfindahl Index,
which was developed in 1950 by Orris Herfindahl in his Ph.D. dissertation at Columbia
University, takes into account the market shares of all of the firms in an industry, not just

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Section 11.2 Industry Structure

the market share of the few largest firms. Later in this chapter, we will look at how the
Herfindahl Index was used by the Justice Department in the 1980s.
The Herfindahl Index is the sum of the squares of market shares in an industry. The formula for this sum is
H 5 (S1)2 1 (S2)2 1 . . . 1 (Sn)2,
where H is the Herfindahl Index and S1 through Sn are the market shares of individual
firms 1 through n. These market shares total 100%. An industry that had 10 equal-sized
firms each having 10% of the market would have a Herfindahl Index of 1,000.
Table 11.2 shows how the Herfindahl Index is calculated for two industries and compares
each index to a four-firm concentration ratio. Note that both industries have four-firm
concentration ratios of 96%, but industry A has a much higher Herfindahl Index (8,116)
than industry B (2,308). These Herfindahl Index values imply that industry A is 3.5 times
more concentrated than is industry B. The table demonstrates that the Herfindahl Index
has a much higher value for industries that have a firm or group of firms that are relatively large. This higher value is the result of squaring the individual market shares to
construct the index.
Table 11.2: Sample calculations of the Herfindahl index
Industry A

Industry B

Firm

Market share
(%)

Square of
market share

Firm

Market share
(%)

Square of
market share

1

90

8,100

1

24

576

2

2

4

2

24

576

3

2

4

3

24

576

4

2

4

4

24

576

5

1

1

5

1

1

6

1

1

6

1

1

7

1

1

7

1

1

8

1

1

8

1

1

Four-firm concentration ratio = 96%.
Herfindahl Index = 8,116.

Four-firm concentration ratio = 96%.
Herfindahl Index = 2,308.

The Number Equivalent
M. A. Adelman has developed another way to interpret the Herfindahl Index. The number equivalent is the reciprocal of the Herfindahl Index (1 divided by the value of the
Herfindahl Index times 10,000). It shows the theoretical number of equal-sized firms that
should be found in an industry. Industry A in Table 11.2 should have 1.2 equal-sized firms,
and industry B should have 4.3. Adelman would conclude that, ceteris paribus, industry
B would be more competitive than industry A because A has a higher likelihood of collusion, or agreements between firms in an industry to set a certain price or share a market.

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11.3 Monopolistic Competition

T

he model of monopolistic competition describes an industry composed of a large
number of sellers. Each of these sellers offers a differentiated product, which is a
good or service that has real or imagined characteristics that are different from those
of other goods or services. This differentiation can take many forms. The salespeople
may be nicer, the packaging prettier, the credit terms better, or the service faster. It could
even be that a famous person is associated with the product, like Bill Cosby and Jell-O or
Michael Jordan and Nike. It is important to note that a product is differentiated if consumers perceive it as different. For example, chemists tell us that aspirin is aspirin, and there
is no real difference among the
various brands. Yet many consumers view the brands as different, showing a preference for
a brand such as Bayer, so aspirin
is a differentiated product.
In monopolistic competition,
the industry consists of a large
number of firms, each producing a differentiated product. A
very important assumption is
that entry into this industry is
relatively easy. New firms can
enter the industry and start sellDoug Pensinger/Getty Images
ing products that are similar to
Sellers in a single industry attempt to differentiate their
those already being produced.
products. Nike, for example, is associated with basketball star
In Edward Chamberlins origi- Michael Jordan.
nal description of monopolistic
competition, a market for a set
of goods that were differentiated but had a large number of close substitutes was called
a product group. Chamberlin characterized monopolistic competition as the large-group
case where there was rivalry between many firms in a product group.
You may have recognized monopolistic competition as a familiar market structure, since
retail firms often fit this model. Monopolistic competition is generally what comes to mind
when people think of competition. Perfect competition, with its homogeneous products,
simply does not fit the popular idea of competition in which firms are scrambling to make
their products different.

Short-Run Equilibrium
Short-run equilibrium of the monopolistically competitive firm is very similar to that of
the monopolistic firm. Figure 11.1 shows the demand curve for a representative firm in
monopolistic competition. When we depicted perfect competition, we started with the
market and derived the representative firms demand curve. In analyzing monopolistic
competition, we begin with a representative firm, rather than with the market. With product differentiation, each firm faces a unique demand curve. The firms demand curve in

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Section 11.3 Monopolistic Competition

Figure 11.1 is negatively sloped, unlike the perfectly elastic demand curve faced by the
perfectly competitive firm. The negative slope is a result of the differentiated nature of
the firms product. If the products price is raised, the firm will not lose all its customers
because some will continue to prefer this product to substitutes that are close but not perfect. Likewise, if the price is reduced, the firm will gain customers, but some customers
will remain loyal to the products produced by other firms.

Figure 11.1: Short-run profits in monopolistic competition
Price,
Cost
MC
AC
P1
C

A
Economic Profit
B

D = AR

MR

0

x1

Quantity/
Time Period

In the short run, an economic profit can exist for firms in monopolistic competition. Such profits will
cause new firms to enter the industry.

The relative elasticity of the demand curves is a measure of the degree of differentiation
within the industry. If the products are only slightly differentiated, then they are close
substitutes and each firms demand curve will be very elastic. If the products are highly
differentiated, the demand curve will be less elastic, indicating that the firm can more easily raise the price without losing many customers. Its customers dont change products
because they dont view them as substitutes. Think again of aspirin, for example. Some
people are willing to pay more for Bayer than for Brand X because they think it is different. The makers of Bayer are able to charge a higher price without losing a large number
of customers. Bayer will be limited in price flexibility by the amount of differentiation it
is able to create. As price goes higher and higher, fewer people will be willing to pay for
the differentiation. Some people may be willing to pay 10 cents more for Bayer than for a

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different brand, but if the price of Bayer is increased further, more and more people will
shift to the other brands.
The demand curve in Figure 11.1 has a negative slope, indicating product differentiation.
However, demand is very elastic, indicating that there are many good substitutes. Since
the demand (average revenue) curve is negatively sloped, the marginal revenue curve
will lie below it, for the same reasons it does in the case of monopoly. The firm will, of
course, maximize profits at price P1 and output x1, where marginal revenue is equal to
marginal cost. The firm in Figure 11.1 is earning an economic profit because average revenue, P1, exceeds average cost, C. Total revenue is represented by rectangle 0P1Ax1, and
total cost is represented by rectangle 0CBx1. Economic profit is thus the area of the shaded
rectangle CP1AB.
This analysis is very similar to the one developed in the preceding chapter for monopoly
in the short run. The most important difference is that the demand curve here is very flat.
The key to whether it is more like a perfectly competitive firm or more like a monopoly
depends on what happens in the long run in response to the economic profit.

Long-Run Equilibrium
What about long-run equilibrium in a monopolistically competitive industry? Figure 11.1
shows that a short-run equilibrium results in an economic profit.
Suppose, instead, that new firms can respond to these economic profits. Entry into
monopolistically competitive industries is assumed to be relatively easy. Thus, new firms
will enter the industry in response to the economic profits. As firms enter the industry,
the demand curve faced by any representative firm will shift to the left because the new
firms will be attracting customers away from firms already in the industry. This shift of
buyers is what happens, for example, when a new grocery store opens in an area. It draws
some customers away from the existing stores. The existing firms demand curves will
continue to shift down and to the left as new firms enter, and new firms will enter as
long as economic profits are to be made. Long-run equilibrium will occur when firms are
earning zero economic profit (or normal profit). Such an equilibrium is depicted in Figure
11.2. Price is P1 and output is x1. Total revenue and total cost are represented by rectangle
0P1Ax1. There are no economic profits being earned, and no additional firms will attempt
to enter this industry.

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Figure 11.2: Long-run equilibrium in monopolistic competition
Price,
Cost
MC

AC

A

P1

D = AR

MR

0

x1

Quantity/
Time Period

Since entry into a monopolistically competitive industry is relatively easy, there can be no long-run
economic profits. Firms will enter until all firms are earning only a normal profit.

Of course, too many firms might enter an industry due to a mistaken anticipation of economic profits. If this happens, firms will experience losses, and some firms will leave
the industry as the long-run adjustment proceeds. Figure 11.3 shows a monopolistically
competitive firm suffering a loss equal to rectangle P1CBA. Firms would respond to such
losses by leaving the industry. The demand curves faced by the remaining firms would
shift up and to the right until the equilibrium shown in Figure 11.2 was restored. The longrun adjustment process under monopolistic competition produces an equilibrium with
zero economic profits.

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Figure 11.3: Short-run losses in monopolistic competition
Price,
Cost
MC

C
P1

AC

B
Loss
A
D = AR

MR

0

x1

Quantity/
Time Period

Short-run losses, indicated by the shaded area, will cause some firms to exit the industry. Firms will exit
until the remaining firms are earning a normal profit, as in Figure 11.2.

Monopoly and Competition
As you can see, the model of monopolistic competition borrows from the model of monopoly and the model of perfect competition. In the short run, the monopolistically competitive firm is producing the profit-maximizing output and searching for the best price that
can be charged for this output. In the long run, the economic profits disappear as new
firms enter the industry. The demand curve of each firm then shifts to the left because
market demand is shared by more firms. This result is similar to the long-run outcome in
perfect competition. The market structure of monopolistic competition has some characteristics of monopoly and some of pure competition, which explains its name.

Excess Capacity
In long-run equilibrium, the monopolistically competitive firm chooses an output that
does not fully utilize existing plant size. The unutilized part of the production facilities, called excess capacity, is depicted in Figure 11.4. The profit-maximizing output is
x1, where MR = MC. This level of output is not, however, the output that would have
resulted under perfect competition. Under perfect competition, the firm would use the

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least-cost combination of inputs, where average cost is at a minimum. That output would
be socially optimal because represents maximum attainable allocative efficiency because
MC = P. That output is represented by x2 in Figure 11.4. In other words, in long-run equilibrium, the monopolistically competitive firm produces less than the quantity that would
efficiently use its full productive capacity.

Figure 11.4: Excess capacity
Price,
Cost
MC
AC

D 2 = AR 2 = MR 2

P1
P2

D 1= AR 1

MR 1

0

x1

x2

Quantity/
Time Period

Excess capacity results from the negative slope of the demand curve. As the demand curve becomes
more elastic, the excess capacity diminished. It disappears when the curve becomes perfectly elastic.

Is excess capacity a bad thing? To answer this question, it is necessary to consider what
causes excess capacity. The firm is producing less than the socially ideal output because
it maximizes profits by producing a lower output. This lower output results from the fact
that the demand curve for the monopolistically competitive firm slopes downward. You
can see this result by examining Figure 11.4. Begin with demand curve D1. The monopolistically competitive firm is producing quantity x1 at price P1. Now make the demand
curve more elastic by rotating it counterclockwise. As the demand curve becomes more
and more elastic and finally perfectly elastic, at D2 in Figure 11.4, the output will increase
toward the socially efficient output x2. Excess capacity is a result of the negative slope in
the demand curve. This negative slope, you recall, is a result of the product differentiation.
The excess capacity, therefore, results from product differentiation.

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It can be argued that excess capacity is not necessarily a bad thing. Consumers may be
willing to incur the extra cost in return for the perceived benefits of product differentiation. It would indeed be a very boring world without product differentiation. We might
all be wearing khaki-colored shirts, for example.
The major problem with this argument lies in separating desired from undesired product
differentiation. A consumer who is faced with a wide range of product choices but little
price competition is not able to choose whether or not to pay extra to get the differentiated product. This problem isnt likely to be too important, however, when there are many
firms, as in monopolistic competition. Consider aspirin. If the only products in the industry were Anacin, Bayer, Bufferin, and Excedrin, the consumer would probably not have
a low-price choice, since these brands compete almost exclusively by advertising rather
than by cutting prices. But the consumer actually does have a choice of lower-priced
generic brands of aspirin. So in choosing Anacin over Brand X, the consumer voluntarily
chooses product differentiation. In this case, product differentiation seems to be a good
thing because the consumer making the choice is maximizing individual utility. If, on the
other hand, there are no lower-priced products and the consumer must choose among
products that compete only through advertising, then the consumer does not really have
a choice about bearing the cost of the differentiation (unless, of course, he or she simply
does without the product altogether).

Product Differentiation and Advertising
The firm in monopolistic competition will try to differentiate its product in order to shift
its demand curve to the right and to make demand relatively more inelastic by developing
consumer lo...

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