Section 11 Review

Module 58

1. A producer chooses output according to the price-taking firm’s optimal output rule: produce the quantity at which price equals marginal cost. However, a firm that produces the optimal quantity may not be profitable.

Module 59

2. A firm is profitable if total revenue exceeds total cost or, equivalently, if the market price exceeds its break-even price—minimum average total cost. If market price exceeds the break-even price, the firm is profitable. If market price is less than minimum average total cost, the firm is unprofitable. If market price is equal to minimum average total cost, the firm breaks even. When profitable, the firm’s per-unit profit is P - ATC; when unprofitable, its per-unit loss is ATC - P.

3. Fixed cost is irrelevant to the firm’s optimal short-run production decision. The short-run production decision depends on the firm’s shut-down price—its minimum average variable cost—and the market price. When the market price is equal to or exceeds the shut-down price, the firm produces the output quantity at which marginal cost equals the market price. When the market price falls below the shut-down price, the firm ceases production in the short run. This generates the firm’s short-run individual supply curve.

4. Fixed cost matters over time. If the market price is below minimum average total cost for an extended period of time, firms will exit the industry in the long run. If market price is above minimum average total cost, existing firms are profitable and new firms will enter the industry in the long run.

Module 60

5. The industry supply curve depends on the time period (short run or long run). When the number of firms is fixed, the short-run industry supply curve applies. The short-run market equilibrium occurs where the short-run industry supply curve and the demand curve intersect.

6. With sufficient time for entry into and exit from an industry, the long-run industry supply curve applies. The long-run market equilibrium occurs at the intersection of the long-run industry supply curve and the demand curve. At this point, no producer has an incentive to enter or exit. The long-run industry supply curve is horizontal for a constant-cost industry. It may slope upward if the industry’s demand represents a significant portion of the overall demand for an input, resulting in an increasing-cost industry. It may even slope downward, as in the case of a decreasing-cost industry. But the long-run industry supply curve is always more elastic than the short-run industry supply curve.

7. In the long-run market equilibrium of a competitive industry, profit maximization leads each firm to produce at the same marginal cost, which is equal to the market price. Free entry and exit means that each firm earns zero economic profit—producing the output corresponding to its minimum average total cost. So the total cost of production of an industry’s output is minimized and productive efficiency is achieved. The outcome is also allocatively efficient because price equals marginal cost, and every consumer with willingness to pay greater than or equal to marginal cost gets the good.

Module 61

8. The key difference between a monopoly and a perfectly competitive industry is that a single, perfectly competitive firm faces a horizontal demand curve but a monopolist faces a downward-sloping demand curve. This gives the monopolist market power, the ability to raise the market price by reducing output.

9. The marginal revenue of a monopolist is composed of a quantity effect (the price received from the additional unit) and a price effect (the reduction in the price at which all units are sold). Because of the price effect, a monopolist’s marginal revenue is always less than the market price, and the marginal revenue curve lies below the demand curve.

10. At the monopolist’s profit-maximizing output level, marginal cost equals marginal revenue, which is less than market price. At the perfectly competitive firm’s profit-maximizing output level, marginal cost equals the market price. So in comparison to perfectly competitive industries, monopolies produce less, charge higher prices, and can earn profit in both the short run and the long run.

Module 62

11. A monopoly creates deadweight losses by charging a price above marginal cost: the loss in consumer surplus exceeds the monopolist’s profit. This makes monopolies a source of market failure and governments often make policies to prevent or end them.

12. Natural monopolies also cause deadweight losses. To limit these losses, governments sometimes impose public ownership and at other times impose price regulation. A price ceiling on a monopolist, as opposed to a perfectly competitive industry, need not cause shortages and can increase total surplus.

Module 63

13. Not all monopolists are single-price monopolists. Monopolists, as well as oligopolists and monopolistic competitors, often engage in price discrimination to make higher profit, using various techniques to differentiate consumers based on their sensitivity to price and charging those with less elastic demand higher prices. A monopolist that achieves perfect price discrimination charges each consumer a price equal to his or her willingness to pay and captures the total surplus in the market. Although perfect price discrimination creates no allocative inefficiency, it is practically impossible to implement.