ECON 2010 Final
Assume that a pure monopolist and a purely competitive firm have the same unit costs. In this case, determine what is true with respect to (a) price, (b) output, and (c) profits. Which of the combinations listed are accurate?
- P(Monopoly) > P(Competition) - Q(Monopoly) < Q(Competition) - Profit(Monopoly) > Profit(Competition) EXPLANATION: With the same costs, the pure monopolist will charge a higher price, have a smaller output, and have higher economic profits in both the short run and the long run than the pure competitor. As a matter of fact, the pure competitor will have no economic profits in the long run even though it might have some in the short run.
Which of the following statements is true regarding the costs associated with owning and operating an automobile?
Fixed costs include insurance, and variable costs include gasoline. EXPLANATION: Fixed costs associated with owning and operating an automobile include the price of the car (probably monthly payments), insurance, a driver's license, a car license, and depreciation. Variable costs associated with owning and operating an automobile include the cost of gasoline and other basic maintenance expenses involved in owning and maintaining the automobile. Depreciation is also a variable cost since the more the car is driven, the more it depreciates.
What is marginal product?
Marginal product is the slope or the rate of change of the total product curve. When total product is rising at an increasing rate, marginal product is positive and rising. When total product is rising at a diminishing rate, marginal product is positive but falling. When total product is falling, marginal product is negative and falling. When the marginal product is above the average, the margin "pulls" the average up. When the marginal product is below the average, the margin "pulls" the average down. MP first rises because the fixed capital gets used more productively as added workers are employed. Each added worker contributes more to output than the previous worker because the firm is better able to use its fixed plant and equipment. As still more labor is added, the law of diminishing returns takes hold when the 3rd worker is added. When the third worker is added, the marginal product falls. Labor becomes so abundant relative to the fixed capital that congestion occurs and marginal product falls. At the extreme, the addition of labor so overcrowds the plant that the marginal product of still more labor is negative—total output falls.
Assume that the following cost data are for a purely competitive producer: TP AFC AVC ATC MC 0 na $0.00 $0.00 na 1 $60.00 $45.00 $105.00 $45.00 2 $30.00 $42.50 $72.50 $40.00 3 $20.00 $40.00 $60.00 $35.00 4 $15.00 $37.50 $52.50 $30.00 5 $12.00 $37.00 $49.00 $35.00 6 $10.00 $37.50 $47.50 $40.00 7 $8.57 $38.57 $47.14 $45.00 8 $7.50 $40.63 $48.13 $55.00 9 $6.67 $43.33 $50.00 $65.00 10 $6.00 $46.50 $52.50 $75.00 Will this firm produce in the long run: a. At a product price of $68.00? b. At a product price of $43.00? c. At a product price of $34.00? If it is preferable to produce, what will be the profit-maximizing or loss-minimizing output? a. At a product price of $68.00? b. At a product price of $43.00? c. At a product price of $34.00? What economic profit or loss will the firm realize per unit of output? a. At a product price of $68.00? b. At a product price of $43.00? c. At a product price of $34.00? d. In the table below, complete the short-run supply schedule for the firm (columns 1 and 2) and indicate the profit or loss incurred at each output (column 3). (1) (2) (3) (4) Price Single Firm P (+) or L (-) 1,500 Firms $24.00 29.00 34.00 41.00 46.00 57.00 68.00 e. Now assume that there are 1,500 identical firms in this competitive industry; that is, there are 1,500 firms, each of which has the cost data shown in the table. Complete the industry supply schedule (column 4 in the table above). f. Suppose the market demand data for the product are as follows: Price Total Quantity Demanded $24.00 17000 29.00 15000 34.00 13500 41.00 12000 46.00 10500 51.00 9500 56.00 8000 What will be the equilibrium price? What will be the equilibrium output for the industry? For each firm? What will profit or loss be per unit? Per firm? Will this industry expand or contract in the long run?
Will this firm produce in the long run: a. Yes b. Yes c. No If it is preferable to produce, what will be the profit-maximizing or loss-minimizing output? a. Profit-maximizing output = 9 units per firm b. Loss-minimizing output = 6 units per firm c. Not applicable output = 0 units per firm What economic profit or loss will the firm realize per unit of output? a. Profit per unit = $18 b. Loss per unit = $-4.5 c. Total loss = $-60 EXPLANATIONS: a. The rule is to produce at the level of output where marginal revenue equals (or is greater than if we are using integers) marginal cost as long as revenue is sufficient to cover variable cost (price is greater than average variable cost). In the case above, the market is competitive so marginal revenue equals the price of $68.00. From the table above, we can find where marginal revenue is equal to marginal cost, or if they don't equal each other, find the last unit where marginal revenue is greater than marginal cost. The firm will want to produce 9 units. We also need to verify that price exceeds average variable cost at this level of production. The answer is yes, average variable cost is less than the price, $68.00. At this level of production, the firm will earn a positive economic profit per unit of $18.00 (= (price of product) - (average total cost for the last unit produced)). The total economic profit equals $162.00 (=(number of units sold) × $(profit per unit)). b. The same process is applied here. The price of $43.00 is marginal revenue, and we compare this to marginal cost in the same manner as in part (a). The firm will produce 6 units of output if the average variable cost for 6 units is less than the price, $43.00. After comparing those, we see the firm will produce the 6 units of output. At this level of production, the firm will earn a negative economic profit per unit or loss per unit of $-4.50 (= (price of product) - (average total cost for the 6 unit). The total economic profit (loss) equals $12.00 (= (number of units sold) × (loss per unit)). c. We could go through the same exercise here; however, by recognizing that the price of $34.00 is below average variable cost at all levels of production, the firm will not produce. Thus, the firm shuts down and incurs a loss of $60.00 (fixed cost). d & e (1) (2) (3) (4) Price Single Firm P (+) or L (-) 1,500 Firms $24.00 0.00 -60.00 0.00 29.00 0.00 -60.00 0.00 34.00 0.00 -60.00 0.00 41.00 6.00 -39.00 9,000.00 46.00 7.00 -7.98 10,500.00 57.00 8.00 70.96 12,000.00 68.00 9.00 162.00 13,500.00 f. $46 10,500 EXPLANATION: To determine the equilibrium price, we look at the total quantity demanded schedule and the total quantity supplied schedule (for the 1,500 firms above) to find the price where quantity demanded equals quantity supplied. This occurs at a price of $46, where quantity demanded = 10,500 and quantity supplied = 10,500. The quantity 10,500 is the equilibrium output for the industry. Note that at prices below $46 quantity demanded exceeds quantity supplied and at prices above $46 quantity supplied exceeds quantity demanded. 7 units EXPLANATION: The equilibrium output for each firm is 7 units (= 10,500 (industry output)/1,500 (number of firms)). If the equilibrium price of $46 is below the average total cost for 7 units of output at the firm level, there will be a loss; otherwise, there will be a gain. Loss per unit = $1.14 EXPLANATION: The per-unit loss for the firm is $1.14 (= (price) - (average total cost for 7 units)). $7.98 EXPLANATION: The loss per firm is 7.98 (= 7 units produced) × ($1.14) (loss per unit)). Contract EXPLANATION: This industry will contract if there is negative economic profit (or economic loss). It will expand if there is positive economic profit. In this case, the industry will contract.
A firm in a purely competitive industry is currently producing 1,400 units per day at a total cost of $600. If the firm produced 1,200 units per day, its total cost would be $400, and if it produced 900 units per day, its total cost would be $375. a. What are the firm's ATC at these three levels of production? - At 1,400 units per day, ATC = - At 1,200 units per day, ATC = - At 900 units per day, ATC = b. If every firm in this industry has the same cost structure, is the industry in long-run competitive equilibrium? c. From what you know about these firms' cost structures, what is the highest possible price per unit that could exist as the market price in long-run equilibrium? d. If that price ends up being the market price and if the normal rate of profit is 10 percent, then how big will each firm's accounting profit per unit be?
a. - $0.43 - $0.33 - $0.42 EXPLANATION: The average total cost (ATC) is found by dividing total cost by the number of units being produced. ATC for 1,400 units is $0.43 (= $600/1,400). ATC for 1,200 units is $0.33 (= $400/1,200). ATC for 900 units is $0.42 (= $375/900). b. No EXPLANATION: No, because the firm is producing 1,400 units (as stated in the question), this industry cannot be in long-run equilibrium because it is not producing at the lowest ATC. c. $0.33 EXPLANATION: The highest possible price that could be supported in the long run is the lowest ATC in the industry. Given the information above, this is $0.33 after rounding. d. 3.30 cents per unit EXPLANATION: In the long-run, competitive firms will earn zero economic profit, so their accounting profit will equal the normal profit. Since the normal rate of profit is 10 percent and the firm will charge $0.33 for each unit in the long run, the accounting profit will be 3.33 cents per unit. This is 10 percent of the price (= 0.10 × $0.33).
Karen runs a print shop that makes posters for large companies. It is a very competitive business. The market price is currently $1 per poster. She has fixed costs of $250. Her variable costs are $1,500 for the first thousand posters, $1,200 for the second thousand, and then $800 for each additional thousand posters. a. What is her AFC per poster (not per thousand!) if she prints 1,000 posters? What if she prints 2,000 posters? What if she prints 10,000 posters? b. What is her ATC per poster if she prints 1,000? What if she prints 2,000? What if she prints 10,000? c. If the market price fell to 75 cents per poster, would there be any output level at which Karen would not shut down production immediately?
a. $0.250 $0.125 $0.025 EXPLANATION: To calculate average fixed cost (AFC) divide total fixed cost by the number of posters being produced (= total fixed cost/number of posters). Therefore, her AFC for 1,000 posters is $0.250 (= $250/1,000), for 2,000 posters $0.125 (= $250/2,000), and for 10,000 posters $0.025 (= $250/10,000). b. $1.75 $1.475 $0.935 EXPLANATION: Before we calculate the average total cost (ATC) per poster, we need to find the average variable cost (AVC) per poster using the information above. The AVC is found by dividing the total variable cost by the number of posters produced. The AVC for 1,000 posters is $1.50. This is the total variable cost of $1,500 divided by the number of posters, 1,000. The AVC for 2,000 posters is $1.35. This is the total variable cost of $1,500 for the first 1,000 and $1,200 for the second 1,000 divided by the total number of posters, 2,000. The AVC for 10,000 posters is $0.91. This is the total variable cost of $1,500 for the first 1,000 and $1,200 for the second 1,000 and $800 per 1,000 (or 8 × $800) for the next 8,000 divided by 10,000 posters. Now we can find her ATC, which equals the sum of her average fixed cost and her average variable cost (= AFC + AVC). The ATC for 1,000 posters is $1.75 (= $0.250 + $1.50). The ATC for 2,000 posters is $1.475 (= $0.125 + $1.35). The ATC for 10,000 posters is $.935 (= $0.025 + $0.91). c. No EXPLANATION: Since the price is 75 cents per poster, Karen will shut down because average variable cost never falls below, or is equal to, 75 cents per poster.
There are economies of scale in ranching, especially with regard to fencing land. Suppose that barbed-wire fencing costs $14,000 per mile to set up. a. How much would it cost to fence a single property whose area is one square mile if that property also happens to be perfectly square, with sides that are each one mile long? b. How much would it cost to fence exactly four such properties separately, which together would contain four square miles of area? c. Now, consider how much it would cost to fence in four square miles of ranch land if, instead, it comes as a single large square that is two miles long on each side. d. Which is more costly—fencing in the four, one-square-mile properties or the single four-square-mile property?
a. $56,000 EXPLANATION: The answer is 4 × $14,000, one length of fence for each side of the property, or $56,000. b. $224,000 EXPLANATION: The four squares below represent our four properties. Each of these costs $56,000 to fence. Thus, the cost of fencing these four properties equals $224,000 (= 4 × $56,000). c. $112,000 EXPLANATION: Here, we only need to fence the outside perimeter in the diagram below. First, recognize that each side of the square below is twice as long as the problem above (separate properties), which implies it is going to cost (2 × $14,000) to fence each side (2 miles long). There are four sides, so the total cost of fencing this area is $112,000 (= 8 × $14,000). d. Four, one-square-mile properties EXPLANATION: This implies that it is cheaper to fence a property of four square miles than four properties of one square mile. The cost savings come from the fact that we do not need to fence off the inner sides of the square miles (dashed lines).
A firm in a purely competitive industry has a typical cost structure. The normal rate of profit in the economy is 5 percent. This firm is earning $15 on every $150 invested by its founders. a. What is its percentage rate of return? b. Is the firm earning an economic profit? If so, how large? c. Will this industry see entry or exit? d. What will be the rate of return earned by firms in this industry once the industry reaches long-run equilibrium?
a. 10 percent EXPLANATION: Since the firm is earning $15 on every $150 invested, the percentage rate of return is 10 percent (= ($15/$150) × 100). b. Yes 5 percent EXPLANATION: Yes, the firm is earning an economic profit of 5 percent, which equals the difference between the actual percentage rate of return and the normal rate of profit in the economy. c. Entry EXPLANATION: This industry will see entry because the rate of return is greater than the normal rate of profit (economic profit is positive) that resources could earn on average in other industries. d. 5 percent EXPLANATION: In the long run, firms in this industry will earn the normal rate of profit, 5 percent. This is when entry of new firms stops.
There are 300 purely competitive farms in the local dairy market. Of the 300 dairy farms, 298 have a cost structure that generates profits of $48 for every $600 invested. a. What is the percentage rate of return for these 298 dairies? b. The other two dairies have a cost structure that generates profits of $44 for every $400 invested. What is their percentage rate of return? c. Assuming that the normal rate of profit in the economy is 10 percent, and firms cannot copy each other's technology, will there be entry or exit? d. Will the change in the number of firms affect the two that earn $44 for every $400 invested? e. What will be the rate of return earned by most firms in the industry in long-run equilibrium? f. If firms can copy each other's technology, what will be the rate of return eventually earned by all firms?
a. 8 percent EXPLANATION: The percentage rate of return for the firms is found by dividing profits by the amount invested. This is multiplied by 100 to convert into percentage form. The percentage rate of return for the 298 dairies is 8 percent (= ($48/$600) × 100). b. 11 percent EXPLANATION: The percentage rate of return for the 2 dairies is 11 percent (= ($44/$400) × 100). c. Exit d. Yes, because those two can claim a larger market share. EXPLANATION: There will be exit in this industry because the normal rate of profit is 10 percent and the 298 firms are only earning a return of 8 percent. That is, firms will exit this industry and invest their resources in other industries, which on average are earning 10 percent. This allow the two firms that are earning a rate of return of 11 percent on their investment to increase their market share. e. 10 percent EXPLANATION: To stop the exit of firms from this industry, the firms will need to earn a rate of return of 10 percent. This equals the normal rate of profit in the economy. f. 10 percent EXPLANATION: If firms can copy the technology used by the two more efficient firms, then all firms will end up earning the normal 10 percent rate of return after all firms have copied the better technology and expanded output until the increase in market supply brings down the market price low enough that all firms in the industry are earning the normal profit.
Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. a. Calculate the accounting profit for Gomez's pottery firm. b. Now calculate Gomez's economic profit.
a. Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs). b. Economic profit = $13,000 (= $72,000 of revenue - $37,000 of explicit costs - $22,000 of implicit costs). EXPLANATION: Explicit costs are the direct costs incurred from production: $37,000 (= $12,000 for the helper + $5,000 for rent + $20,000 for materials). Implicit costs are the costs that are indirectly incurred by the activity: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship).
You are a newspaper publisher. You are in the middle of a one-year rental contract for your factory that requires you to pay $500,000 per month, and you have contractual labor obligations of $1,000,000 per month that you can't get out of. You also have a marginal printing cost of $0.25 per paper as well as a marginal delivery cost of $0.10 per paper. a. If sales fall by 20 percent from 1,000,000 papers per month to 800,000 papers per month, what happens to the AFC per paper? b. What happens to the MC per paper? c. What happens to the minimum amount that you must charge to break even on these costs?
a. It RISES from $1.50 per paper to $1.88 per paper. EXPLANATION: The original average fixed cost (AFC) was $1.50, which equals the total fixed cost of $1.50 million divided by the number of papers sold (1 million, the original amount). Note here that labor is treated as a fixed cost because of the contractual obligation (you must pay even if production stops, assuming the company does not file for bankruptcy) (= $1.50 million/1 million). Now assuming sales fall by 20 percent to 800,000 papers sold, the new AFC is $1.88. This equals the total fixed cost of $1.50 million divided by the new number of papers sold, 800,000 (= $1.50 million/800,000). Thus, the AFC increases from $1.50 to $1.88 after the decrease in sales. b. MC does not change EXPLANATION: The marginal printing and marginal delivery costs are still the same; therefore, marginal costs do not change. c. It INCREASES from $1.85 per paper to $2.23 per paper. EXPLANATION: To break even before the decline in sales, the company needed to charge enough to cover the AFC, $1.50, and the AVC, $0.35, which is the sum of the printing cost and delivery cost per paper. Thus, the company needed to charge $1.85 per paper. To break even after the decline in sales, the company needs to charge enough to cover the AFC, $1.88, and the AVC, $0.35, which is the sum of the printing cost and delivery cost per paper (note this does not change because the cost is per paper). Thus, the company needs to charge $2.23 per paper.
Suppose that purely competitive firms producing cashews discover that P exceeds MC. a. Is their combined output of cashews too little, too much, or just right to achieve allocative efficiency? b. In the long run, what will happen to the supply of cashews and the price of cashews? c. Use a supply and demand diagram to show how that response will change the combined amount of consumer surplus and producer surplus in the market for cashews.
a. Too little EXPLANATION: The combined output is too little to achieve allocative efficiency. The marginal benefit of producing more cashews (as measured by P) exceeds the cost of the resources necessary to produce them. b. The supply of cashews will increase, and the price of cashews will decrease. EXPLANATION: In the long run, the supply of cashews will increase as firms enter (or expand) to capture the economic profits being earned. The increase in supply will reduce the price of cashews. c. Graph shows the supply curve shift down and right along the demand curve. Surplus increases. EXPLANATION: The increase in supply will unambiguously increase the combined area under the demand curve and above the supply curve (consumer surplus and producer surplus, respectively). See Figure 11.6b for reference.
A purely competitive firm finds that the market price for its product is $30.00. It has a fixed cost of $100.00 and a variable cost of $15.00 per unit for the first 50 units and then $35.00 per unit for all successive units. a. Does price equal or exceed average variable cost for the first 50 units? What is the average variable cost for the first 50 units? b. Does price equal or exceed average variable cost for the first 100 units? What is the average variable cost for the first 100 units? c. What is the marginal cost per unit for the first 50 units? What is the marginal cost for units 51 and higher? d. For each of the first 50 units, does MR exceed MC? What about for units 51 and higher? e. What output level will yield the largest possible profit for this purely competitive firm?
a. Yes $15.00 EXPLANATION: Yes, price ($30.00) exceeds average variable cost for the first 50 units, since AVC for the first 50 units is $15.00 per unit (= ($15.00 per unit × 50 units)/50 units). b. Yes $25.00 EXPLANATION: Yes, price ($30.00) exceeds average variable cost for the first 100 units, since AVC is $25.00 per unit (= ($15.00 per unit × 50 units + $35.00 per unit × 50 units)/100). c. $15.00 per unit $35.00 per unit EXPLANATION: The MC is $15.00 per unit for the first 50 units; the MC is $35.00 per unit for subsequent units. d. Yes No EXPLANATION: For each of the first 50 units, MR > MC since $30.00 > $15.00; for units 51 and up, MR < MC since $30.00 < $35.00. e. 50 units EXPLANATION: The firm will produce 50 units to maximize profit because the MC of the 51st unit exceeds marginal revenue.
The equality of P and MC means the firm is achieving
allocative efficiency, since the industry is producing the amount of product that equates society's valuation of that product and the price of the product. EXPLANATION: The equality of P and MC means the firm is achieving allocative efficiency; the industry is producing the right product in the right amount based on society's valuation of that product and other products.
The demand curve faced by a purely monopolistic seller is
downward sloping, whereas that facing the purely competitive firm is perfectly elastic. EXPLANATION: The demand curve facing a pure monopolist is downward sloping, while that facing the purely competitive firm is horizontal, or perfectly elastic.
Price can be substituted for marginal revenue in the MR = MC rule when an industry is purely competitive because
price is constant regardless of the quantity demanded. EXPLANATION: In pure competition, the demand curve is perfectly elastic; price is constant regardless of the quantity demanded. Thus, MR is equal to price. This being so, P can be substituted for MR in the MR = MC rule. (Note, however, that it is not good practice to use MR and P interchangeably, because in imperfectly competitive models, price is not the same as marginal revenue.)
In the long run in a purely competitive industry,
entry and exit of firms can occur. EXPLANATION: The entry and exit of firms in our market models can only take place in the long run. In the short run, the industry is composed of a specific number of firms, each with a plant size that is fixed and unalterable in the short run. Firms may shut down in the sense that they can produce zero units of output in the short run, but they do not have sufficient time to liquidate their assets and go out of business. In the long run, by contrast, the firms already in an industry have sufficient time to either expand or contract their capacities. More important, the number of firms in the industry may either increase or decrease as new firms enter or existing firms leave.
The firm should produce in the short run as long as price:
exceeds the average variable cost. EXPLANATION: As long as price exceeds the average variable cost, the firm should produce in the short run given fixed costs are present by definition.
Under which of these market classifications does each of the following most accurately fit? i. A supermarket in your hometown: ii. The steel industry: iii. A Kansas wheat farm: iv. The commercial bank in which you or your family has an account: v. The automobile industry:
i. Oligopoly EXPLANATION: Supermarkets are few in number in any one area; their size makes new entry very difficult; there is much nonprice competition. However, there is much price competition as they compete for market share, and there seems to be no collusion. In this regard, the supermarket acts more like a monopolistic competitor. Note that this answer may vary by area. Some areas could be characterized by monopolistic competition while isolated small towns may have a monopoly situation. ii. Oligopoly EXPLANATION: Oligopoly within the domestic production market. Firms are few in number; their products are standardized to some extent; their size makes new entry very difficult; there is much nonprice competition; there is little, if any, price competition; while there may be no collusion, there does seem to be much price leadership. iii. Pure competition EXPLANATION: There are a great number of similar farms; the product is standardized; there is no control over price; there is no nonprice competition. However, entry is difficult because of the cost of acquiring land from a present proprietor. Of course, government programs to assist agriculture complicate the purity of this example. iv. Monopolistic competition EXPLANATION: There are many similar banks; the services are differentiated as much as the bank can make them appear to be; there is control over price (mostly interest charged or offered) within a narrow range; entry is relatively easy (maybe too easy!); there is much advertising. Once again, not every bank may fit this model—smaller towns may have an oligopoly or monopoly situation. v. Oligopoly EXPLANATION: There are the "Big Three" automakers, so they are few in number; their products are differentiated; their size makes new entry very difficult; there is much nonprice competition; there is little true price competition; while there does not appear to be any collusion, there has been much price leadership. However, imports have made the industry more competitive in the past two decades, which has substantially reduced the market power of the U.S. automakers.
Identify the basic characteristics of each of the following market models: i. Pure competition: ii. Pure monopoly: iii. Monopolistic competition: iv. Oligopoly:
i. Pure competition: - Very large number of firms - No control over price EXPLANATION: Pure competition: very large number of firms; standardized products; no control over price: price takers; no obstacles to entry; no nonprice competition. ii. Pure monopoly: - One firm - Unique product - Much control over price EXPLANATION: Pure monopoly: one firm; unique product: with no close substitutes; much control over price: price maker; entry is blocked; mostly public relations advertising. iii. Monopolistic competition: - Differentiated products - Many firms - Some price control EXPLANATION: Monopolistic competition: many firms; differentiated products; some control over price in a narrow range; relatively easy entry; much nonprice competition: advertising, trademarks, brand names. iv. Oligopoly: - Few firms - Nonprice competition - Many obstacles to entry EXPLANATION: Oligopoly: few firms; standardized or differentiated products; control over price circumscribed by mutual interdependence: much collusion; many obstacles to entry; much nonprice competition, particularly product differentiation.
Assume that a pure monopolist and a purely competitive firm have the same unit costs. In the case of a pure monopolist, resources will be allocated
inefficiently, because the monopolist does not produce at the point of minimum ATC and does not equate price and MC. EXPLANATION: Because the monopolist does not produce at the point of minimum ATC and does not equate price and MC, its allocation of resources is inferior to that of the pure competitor. Specifically, resources are underallocated to monopolistic industries. Since a pure monopolist is more likely than the pure competitor to make economic profits in the short run and is, moreover, the only one of the two able to make economic profits in the long run, the distribution of income is more unequal with monopoly than with pure competition.
The basic model of pure competition reviewed in this chapter finds that in the long run all firms in a purely competitive industry will earn normal profits. If all firms only earn a normal profit in the long run, firms will develop new products or lower-cost production methods because they can
innovate and possibly earn an economic profit in the short run. EXPLANATION: Competition involves the never-ending attempts by entrepreneurs and managers to earn above-normal profits by either creating new products or developing lower-cost production methods for existing products. These efforts cause creative destruction, the financial undoing of the market positions of firms committed to existing products and old ways of doing business by new firms with new products and innovative ways of doing business. That is, if firms can innovate they can earn economic profits in the short run.
Explicit costs are payments the firm makes for:
inputs such as wages and salaries to its employees, whereas implicit costs are non-expenditure costs that occur through the use of self owned resources such as foregone income. EXPLANATION: Explicit costs are payments the firm must make for inputs to non-owners of the firm to attract them away from other employment, for example, wages and salaries to its employees. Implicit costs are non-expenditure costs that occur through the use of self-owned, self-employed resources, for example, the salary the owner of a firm forgoes by operating his or her own firm and not working for someone else.
Entry and exit help to improve resource allocation because
losses result in exit and release resources to flow to markets where there are profits. EXPLANATION: Entry and exit help to improve resource allocation. Firms that exit an industry due to low profits release their resources to be used more profitably in other industries. Firms that enter an industry chasing higher profits bring with them resources that were less profitably used in other industries. Both processes increase allocative efficiency.
The equality of marginal revenue and marginal cost is essential for profit maximization in all market structures because if
marginal revenue and marginal cost are equal, any other output level will result in reduced profits. EXPLANATION: If the last unit produced adds more to costs than to revenue, its production must necessarily reduce profits (or increase losses). On the other hand, profits must increase (or losses decrease) so long as the last unit produced—the marginal unit—is adding more to revenue than to costs. Thus, so long as MR is greater than MC, the production of one more marginal unit must be adding to profits or reducing losses (provided price is not less than minimum AVC). When MC has risen to precise equality with MR, the production of this last (marginal) unit will neither add nor reduce profits.
The costs of a purely competitive firm and a monopoly may be different because
monopolies might experience economies of scale not available to competitive firms. EXPLANATION: The monopolist, on the other hand, is the industry. When it increases the quantity it produces, price drops. When it decreases the quantity it produces, price rises. In these circumstances, MR is always less than price for the monopolist; to sell more the monopolist must lower the price on all units, including those it could have sold at the higher price had it not put more on the market. When the monopolist equates MR and MC, it is not selling at that price: The monopolist's selling price is on the demand curve, vertically above the point of intersection of MR and MC. Thus, the monopolist's price will be higher than the pure competitor's price.
The pure (profit maximizing) monopolist's demand curve is not
perfectly inelastic, because MR is negative when demand is inelastic, so MR = MC < 0. EXPLANATION: As long as the demand curve is inelastic, MR must be negative, and since the MC of any item cannot also be negative, the monopolist's profit must decrease if it produces here.
In long-run equilibrium, P = minimum ATC = MC. The equality of P and minimum ATC means the firm is achieving
productive efficiency. EXPLANATION: The equality of P and minimum ATC means the firm is achieving productive efficiency; it is using the most efficient technology and employing the least costly combination of resources.
Even though both monopolists and competitive firms follow the MC = MR rule in maximizing profits, there are differences in the economic outcomes because
pure competitors are small with no market power. EXPLANATION: In pure competition, MR = P because the firm's supply is so insignificant a part of industry supply that its output has no effect on price. It can sell all that it wishes at the price established by demand and the total industry supply. The firm cannot force the price up by holding back part or all of its supply.
The demand curve facing a
purely competitive firm is perfectly elastic, because the purely competitive firm may sell all that it wishes at the equilibrium price. EXPLANATION: The demand curve facing a pure monopolist is downward sloping, whereas the demand curve facing the purely competitive firm is horizontal, or perfectly elastic. This is so for the pure competitor because the firm faces a multitude of competitors, all producing perfect substitutes. In these circumstances, the purely competitive firm may sell all that it wishes at the equilibrium price, but it can sell nothing for even so little as one cent higher. The individual firm's supply is so small a part of the total industry supply that it cannot affect the price.
If a monopoly can experience economies of scale, it can
reduce the price below a pure competitor and improve resource allocation. EXPLANATION: Economies of scale may be such as to ensure that one large firm can produce at lower cost than a multitude of small firms. This is certainly the case with most public utilities. And in such industries as basic steel-making and car manufacturing, pure competition would involve a very high cost. On the other hand, monopolies may suffer from X-inefficiency, the inefficiency that a lack of competition allows. Monopolies may also incur nonproductive costs through "rent-seeking" expenditures. For example, they may try to influence legislation that protects their monopoly powers. The implications of the lower costs that economies of scale may give a monopolist are that a monopolist may not only produce at a lower cost than pure competitors but, in some cases, may also sell at a lower price. If such is the case, the misallocation of resources is reduced.
You are considering whether to drive your car or fly 1,000 miles to Florida for spring break. In making your decision you should consider:
the variable costs of the trip, the opportunity cost of your time, and the need for transportation in Florida. EXPLANATION: The costs of driving to Florida are the same variable costs (including depreciation) listed above. Going by plane, the variable cost is the cost of the ticket. It would probably be cheaper to drive but this would leave out the relevant implicit cost—your time and the wear and tear on you of driving there and back. The plane would be faster so that you can arrive sooner, stay longer, and be fresher on arrival. On the other hand, a car can be useful around Florida, saving the variable cost of renting one if you fly.
Consider the statement: "Even if a firm is losing money, it may be better to stay in business in the short run." This statement is:
true, if the loss is less than the fixed costs. EXPLANATION: This statement is true. A firm may want to stay in business even if it is losing money. For example, assume the firm has a fixed cost of $1,000, which it must pay even if it stops production. Now assume that average variable cost is $10 per unit and the price of the product is $15 per unit. Finally, assume that output equals 100 units using the MR = MC rule. This implies total revenue equals $1,500, variable cost equals $1,000, and total cost equals $2,000 (the sum of variable cost and fixed cost). The firm is losing money because profit equals - $500 (= $1,500 − $2,000). However, this loss is less than the fixed cost it would incur in the short run if it shut down, which equals $1,000. Thus, it is better to stay in business and lose $500 rather than close down and lose $1,000 in the short run.
The explicit costs of going to college include:
tuition costs and the cost of books, where implicit costs include forgone income. EXPLANATION: The explicit costs of going to college are the tuition costs, the cost of books, and the extra costs of living away from home (if applicable). The implicit costs are the income forgone and the hard grind of studying (if applicable).