CHAPTER 8: ANALYSIS OF PERFECTLY COMPETITIVE

MARKETS
A. Supply Behavior of the Competitive Firm
1. A perfectly competitive industry is characterized by many small firms, each so small that no
single firm can affect market price. Firms produce a homogeneous product so that
consumers view all firms outputs as perfect substitutes. These two characteristics
together lead individual firms to perceive demand as perfectly elastic. Finally, competitors
can easily enter or exit the industry.

2. Firms operating in perfectly competitive markets are price-takers; this means they take
the market price as given and choose the output that maximizes profit.

3. The supply curve for an individual competitive firm is its marginal cost curve above
minimum AVC; quantity supplied will be zero when price falls below minimum AVC.

4. The zero-profit point occurs where price is equal to minimum ATC. At this point,
economic profits are zero and P = MC = min ATC.

5. The shutdown point occurs where price is equal to minimum ATC. If price falls below
this point, firms can minimize their losses in the short run by producing no output and
paying only their fixed costs. If price is below AVC and a firm continues to produce,
losses will include not only fixed costs but also a portion of variable costs.

B. Supply Behaviour in Competitive Industries

1. The supply curve for a competitive market can be found by horizontally adding the
quantity supplied by each firm in the market at each price.

2. In the short run, firms in a perfectly competitive industry can earn economic profits,
break even, or earn losses. However, in the long run, the break-even point defines
competitive equilibrium. Firms will enter the market when prices are higher (attracted by
positive economic profit), shifting the short-run industry supply curve out and lowering
the price along the market demand curve; firms will (eventually) exit the market in
response to lower prices (repelled by negative profit), shifting the short-run industry
supply curve in and raising the price along the market demand curve. Thus the zero
economic profit condition must be expected by all firms in a perfectly competitive industryP
= MR = MC = min ATC in the long run.

3. The long-run industry supply may be upward-sloping if increased competition leads to

increases in input prices; may be downward-sloping if increased competition leads to
decreases in input prices; or may be horizontal if increased competition leads to no
change in input prices.

D. Efficiency and Equity of Competitive Markets

1. Allocative efficiency occurs when no possible reorganization of production can make
anyone better off without making someone else worse off. This means that there can be
no reallocation of resources without lowering the utility of at least one person in the
economy.
2. If we assume that utility can be approximately measured by the dollar value that people
are willing to pay, perfectly competitive markets lead to P = MC = MU, and thereby
produce allocatively efficient solutions to the problem of resource allocation.

3. Perfectly competitive markets serve to synthesize the needs and desires of buyers with
the marginal costs of production represented by the supply curve, producing allocatively
efficient solutions to resource allocation problems. However, providing an efficient market
is not an easy task; externalities and monopolies are important sources of inefficiency, to
name a few. Market failures can and do occur. Further, efficiency is not the only goal of
an economic system. In fact, many societies encourage government intervention in
markets in order to promote equity, or fairness, in the distribution of resources. There is
no guarantee that equitable distributions are necessarily efficient or that efficient
distributions are necessarily equitable.
CHAPTER 9: IMPERFECT COMPETITION AND ITS
POLAR CASE OF MONOPOLY
A. Patterns of Imperfect Competition
1. Imperfect competition exists in a market when firms have been able to gain some control
over the price of output. Recall that, in a perfectly competitive industry, firms produce a
standardized product. This, combined with the fact that they are all very small, means
that firms are price-takers. Imperfect competition describes any market setting in which
firms have a degree of price-setting ability. This means that instead of the perfectly
elastic demand curve, imperfect competitors face a downward-sloping demand curve for
their products, which have been differentiated in some way.

2. Imperfect competition takes many forms, which can be placed roughly in the
following three categories:
a. A monopoly is a single seller of a unique product.
b. An oligopoly includes a relatively small number of sellers of a similar product; because
there are just a few competitors in the industry, mutual interdependence is a critically
important factor in describing the behaviour of competitors.
c. A monopolistically competitive industry has many sellers of close substitutes. Firms take their
market power from downward-sloping demand curves which allow them to choose both a
profit-maximizing price and quantity of output to produce.

3. Firms differentiate their products in many different ways. Some physically change the
characteristics or outward appearance of their products. For example, automakers
produce cars in every conceivable color, size, shape, and style, and frequently introduce
new lines. Others try to change the image of their products in the minds of consumers.
For example, producers of soft drinks spend millions of dollars each year to convince
consumers that Coke and Pepsi taste significantly different. There are other ways a firm
can make its product different from those of its competitors and create a market
niche. Sometimes location, quality, special services, and so on, can allow firms to have
greater control over price.

4. There are two primary sources of market imperfections. First, production costs and
economies of scale can help to determine the size of firms in an industry. Economies of scale
exist when a firms per unit production costs fall as output increases; this means that
larger firms will have a cost advantage over smaller ones. The extent of concentration in
an industry will be determined by the significance of economies of scale. Second, in
many industries barriers to entry exist that limit the ability of new firms to compete. Legal
restrictions, such as patents, franchises, and import restrictions all provide some amount of
monopoly power to producers. In other cases, high entry costs exist due to the
importance of advertising and the significance of reputation effects. Brand proliferation
on the part of existing firms can leave little room for a new rival to further differentiate
the product. All of these factors make it much more difficult for rivals to enter a market,
and limit the amount of competition that exists.

B. Marginal Revenue and Monopoly

1. Because the monopolist is the only producer of a unique product, the relevant demand
curve for the firm is the entire market demand curve. The position of the firm relative to
the market is very different from a situation of perfect competition, where the firm is so
small that it perceives its demand as being perfectly elastic.
2. Marginal revenue is defined as the addition to total revenue that comes when a firm sells
an additional unit of output. Because the demand curve slopes downward for the
monopolist, the market price at which all units are traded must fall in order for the firm to
sell additional units of output. This means that the sale of a marginal unit increases
revenues by the amount of the sale; this increase is offset to some extent because prices
on all previous units must also fall. Remember that in our discussion thus far, there is a
single price in the market at which all units are traded.

3. A clear relationship exists between marginal revenue, demand, and elasticity.

Remember from chapter 4 that a linear, downward-sloping demand curve is elastic at the
top, unit-elastic at the midpoint, and inelastic at the bottom. When demand is elastic,
total revenue increases as prices fall, but at a decreasing rate. This means that marginal
revenue is positive, but declining. When demand is unit-elastic, total revenue remains
constant as prices fall. This means that marginal revenue is zero; the increase in revenue
due to the marginal sale are exactly offset by the decrease in revenue due to the price cut
on previous units produced. Finally, when demand is inelastic, total revenue decreases as
prices fall. This means that marginal revenue is negative. Now, the increases in revenue
due to the marginal sale are more than offset by the decreases in revenue due to the price
cut on previous units produced. The marginal revenue curve will lie below the demand
curve, and marginal revenue is always less than price.

4. The monopolist will choose the profit-maximizing level of output where marginal
revenue is equal to marginal cost. This means that the firm should expand output as long
as the addition to revenue is greater than the addition to costs. Given an upward-sloping
marginal cost curve and a downward-sloping marginal revenue curve, once equality is
reached, further increases in output will result in costs that exceed revenues at the
margin. This would not be smart!

5. Since the monopolist is a price-setter, we must also determine a profit-maximizing

strategy for price. The monopolist will seek to set the highest price that the market will
bear. This price will be found by looking to the demand curve. Remember that the
demand curve describes the maximum price that buyers are willing and able to pay for a
particular quantity of output.

6. The perfectly competitive example can be thought of as a polar case of imperfect

competition. With imperfect competition, the profit-maximizing level of output for the
firm occurs where MR = MC. We learned in Chapter 8 that the profit-maximizing level
of output for the perfectly competitive firm occurs where P = MC. However, notice that
with perfect competition, P = MR. The perfect competitor is a price-taker. Once the
market determines the price, the firm can sell all the units it has for that price. Each time
the firm sells another unit, revenues change by the market price. Thus, a general rule has
been established: Any profit-maximizing firm will choose its optimal level of output where MC =
MR.

7. The marginal analysis presented in this chapter generalizes many decision-making

scenarios. The marginal principle states that people will maximize their incomes or profits
or satisfactions by counting only the marginal costs and benefits of a decision. Past, or
sunk, costs can be ignored if they do not have an impact on marginal costs or benefits.
CHAPTER 12: HOW MARKETS DETERMINE INCOMES
A. Income and Wealth
1. The theory of the distribution of income is concerned with (1) the determination of income,
and (2) the allocation of total product among factors of production. Both of these
questions are important; we need to understand how income is generated in an economy,
and then how these wages, rent, interest, and profits are distributed across the owners of
labour, land, capital, and entrepreneurial ability.

2. Income is a flow of money; wealth is a stock of accumulated economic assets. Remember

that a stock measure of any economic variable describes the total quantity of the variable
at a particular point in time; a flow measure describes the accumulation of an economic
variable over a period of time. Both of these measures are important in describing how the
returns to factors are distributed across a society.

3. Sometimes, governments take actions to redistribute income and wealth in a society.

This decision is a normative one and usually occurs when policymakers have determined
that there is significant inequity in the distribution of income and wealth, or when some
market failure has occurred. The two most popular tools used to achieve this
redistribution are taxes and transfer payments. Governments collect money as taxes and
return it to people in the form of direct payments that are not in return for current goods
and services.

B. Input Pricing by Marginal Productivity

1. The demand for any factor of production is a derived demand, which means that the
demand for the factor depends upon, or is derived from, the demand for the final
product that it helps to produce. For example, the demand for coal miners depends upon
the demand for coal. Increased concern over acid rain and other ecological problems has
decreased the demand for coal, and hence decreased the demand for coal miners. The
demand for computer chips depends upon the demand for computers. The explosion in
the popularity and use of personal computers in the past decades has increased the
demand for computers, and hence increased the demand for computer chips.

2. The demand for any input depends directly, and most importantly, upon the
productivity of that factor. Take a moment to review some of the production theory
from Chapter 6: A production function describes how inputs are transformed into
output. Production can be measured in several ways, but the key to our analysis is
marginal product, which is defined as the addition to total output that occurs when a
firm hires an additional unit of an input. Remember that the law of diminishing returns
states that as additional units of an input are added to a production process in the short
run, eventually marginal product will fall. This means that the marginal product schedule
is downward-sloping, at least over some levels of output. Given this description of the
production process, the demand for an input will be defined by its marginal revenue product
(MRP). Marginal revenue product measures the addition to total revenue that occurs when
a firm hires an additional unit of an input. MRP translates marginal product, which is
measured in output units, to a meaningful dollar figure. To calculate MRP, multiply the
marginal product of the input by the marginal revenue.

3. The derived demand for any factor in a perfectly competitive industry is the
(multiplicative) product of the price of output and the marginal product at each level of
factor employment; this is simply a consequence of the horizontal demand curve faced
by perfect competitors, which guarantees that price equals marginal revenue. However, in
an imperfectly competitive industry, P > MR because the firm must lower the price of all
units sold in order to sell additional units of output. (Remember that the imperfect
competitor is able to charge the maximum price that the market will bear at the optimal
level of output.)

5. The market demand curve for any input is the horizontal sum of the derived demand
curves of all firms employing that input. Likewise, the market supply curve for any input
is the horizontal sum of the supply curves of all factor owners selling that input.

6. As in any other market we have discussed, given demand and supply curves, we can
describe an equilibrium price and quantity exchanged in the market for a factor of
production. Thus, the distribution of income in an economy is at least in part determined
by market forces. Individuals and households sell the factors that they own in input
markets; relative scarcity in these input markets combines with need to determine the
returns to resource owners.