Krugman AP Section 11 Notes

Econ: 58
Introduction to
Perfect Competition
Margaret Ray and David Anderson
What you will learn
in this Module:
• How a price-taking firm determines its
profit-maximizing quantity of output.
• How to assess whether or not a
competitive firm is profitable.
• Firms have no control over price.
Profit Maximization in PC
Optimal output rule:
produce the quantity
where MR=MC and
profit will be
I. Production and Profits
A. Firms are price-takers
1. P = MR
2. MR = D = AR (Average Revenue TR/Q)
3. Acronym = “Mr. Darp”
B. Profit maximization occurs at the output level where
MC = P
II. Graph Profit Maximization in PC
The profit
maximizing level of
output is found
where P = MC on
the graph.
III. Calculating Profits
A. Total profit
1. π= TR – TC
2. If TR>TC; positive profit
3. If TR < TC; negative profit
B. Profit per unit
1. If P > ATC; positive profit
2. If P < ATC; negative profit
3. If P = ATC; normal profit
If it produces, a perfectly competitive firm will
maximize profits at the output where:
A) Marginal revenue equals marginal cost
B) Marginal revenue equals price
C) Price equals average total cost
D) Price exceeds marginal cost
E) Price equals minimum average variable cost
Answer: A
A competitive firm operating in the short run is producing
at the output level at which ATC is at a minimum. If
ATC=$8 and MR=$9, in order to maximize profits (or
minimize losses), this firm should:
A) Increase output
B) Reduce output
C) Shut down
D) Do nothing; the firm is already maximizing profits
E) Liquidate assets and exit the industry
Answer: A
Econ: 59
Perfect Competition
Margaret Ray and David Anderson
What you will learn
in this Module:
• How to evaluate a perfectly competitive
firm’s situation using a graph.
• How to determine a perfect competitor’s
profit or loss.
• How a firm decides whether to produce
or shut down in the short run.
Perfect Competition Graphs
How is this
competitive firm
doing? Is it
earning a profit or
a loss?
Perfect Competition Graphs
• Profit maximizing
output = 5
• Profit per unit is
($8 - $6) = $2
• Profit is profit per
unit times the
number of units.
$2 x 5 = $10
Perfect Competition Graphs
A firm earning
a profit.
Perfect Competition Graphs
A firm
experiencing a
Perfect Competition Graphs
• A firm earning
a normal
• Also called
“Break Even”
price and
“Break Even”
I. The Short-run
Production Decision
A. When a firm is earning negative profits (a loss),
will it continue to produce in the short run?
1. Compare the losses from producing at P = MC
with the losses from shutting down (producing
B. The shut-down rule
1. Shut down if:
• TR < TVC
• P < AVC
Perfect Competition Graphs
• The shutdown price =
Point A
• Any price
above point A
the firm will
where P=MC
II. The Long Run
A. When a firm is earning negative profits (a loss), in the long run,
it will exit the industry.
B. Exit is different from shutting-down in the short run. Exit means
that all fixed inputs have been sold off in the long run. The firm
no longer exists.
C. On the other hand, if the price was consistently above the
break-even price for a while, eventually new firms would want
to enter the market. In the long run, new firms would be able to
acquire the necessary capital inputs and join the existing firms.
D. Remember that under the assumptions of perfect competition,
there is nothing to prevent the long-run entry or exit of firms.
The shut-down price is:
A) The price at which economic profit is zero
B) The minimum level of AVC
C) The intersection of the MC and ATC curves
D) The minimum level of AFC
E) Any price below ATC
Answer: B
During the summer, Alex runs a lawn-mowing service,
and lawn-mowing is a perfectly competitive industry. In
the short run, Alex will shut down his lawn-mowing
service rather than continue with it if:
A) The total revenues can’t cover the total fixed costs
B) The total revenues can’t cover the total variable costs
C) The total revenues can’t cover the total cost
D) The price exceeds the average total cost
E) Losses are smaller than the total fixed costs
Answer: B
If price is currently between average variable
cost and average total cost, then in the short
run a perfectly competitive firm should:
A) Shut down
B) Continue to produce to minimize losses
C) Raise price
D) Increase production to increase profit
E) Reduce production to increase profit
Answer: B
Econ: 60
Long-run Outcomes in
Perfect Competition
Margaret Ray and David Anderson
What you will learn
in this Module:
• Why industry behavior differs between
the short run and the long run.
• What determines the industry supply
curve in both the short run and the long
The Industry Supply Curve
• Each identical firm’s
short-run supply curve is
their MC curve starting
from the shut-down point
(AVC curve)
• The short-run supply
curve for the market is
the summation of the
firm supply curves
I. Short Run Industry Supply Curve
A. The assumptions of perfect competition tell us that there are
many small firms each producing an identical product. The
implication of these assumptions is that each firm’s cost
curves are identical as well
B. Individual firms supply the profit-maximizing level of output
determined by their MC curve (where P = MC, above AVC)
C. Total output supplied in the market is equal to the output
level of the firm times the number of firms in the industry.
II. Long-run Equilibrium
• At the long-run
equilibrium in a
perfectly competitive
industry, firms earn a
normal profit
Long-run Adjustment Process
At P = $8, P > ATC, profit, firms enter, Supply shifts right,
P falls, firm Q falls.
9000 10.000 Output
III. Long Run Industry Supply Curve
Long Run Industry Supply Curve Cont.
• When the entry of new firms does no affect the input costs in the
industry it is called a constant cost industry and the long-run supply
curve is horizontal
• It is probably more realistic to assume an increasing cost industry.
Entry of new firms increases the input costs for all firms.
• it is also possible for a market to have a downward sloping LRS
curve. This is when a market is a decreasing cost industry. This
would occur if entry of new firms actually caused inputs to become
less costly. The text provides the market for electric cars as
potentially a good example. As more firms produce the cars, the
infant industry of lithium batteries explodes and average costs (due to
economies of scale) fall as more batteries are produced.
IV. Efficiency in Long-run Equilibrium
The perfectly competitive outcome is efficient
1. Productive efficiency: ATC is minimum
2. Allocative efficiency: P = MC
B. Marginal cost is the same for all producers because price
is the same for all producers.
Efficiency in Long-run Equilibrium
C. Economic profit is equal to zero for all producers. All firms
earn a normal profit in the long run. Because this can only
happen at the minimum of ATC, we can say that firms
produce this product at the lowest possible average cost.
D. The market is efficient. All consumers who are willing to
pay the price that is greater than or equal to the sellers’
marginal cost will get to buy the good. In other words,
there is no deadweight loss in perfect competition
because all mutually beneficial transactions are made.
A curve that shows the quantity of a good or
service supplied at various prices after all
long-run adjustments to a price change have
been completed is a long-run:
A) Marginal revenue curve
B) Marginal cost curve
C) Industry supply curve
D) Production curve
E) Industry demand curve
Answer: C
If firms are experiencing economic losses in the
short run, firms will _____ the industry and
industry output will _____ and price will
______ in the long run.
A) exit; fall; rise
B) Exit; rise; fall
C) Enter; rise; rise
D) Enter; fall; rise
E) Exit; rise; rise
Answer: A
The market for beef is in long-run equilibrium at a price of
$3.25/pound. The announcement that mad cow disease has
been discovered in the US reduces the demand for beef
sharply, and the price falls to $2.00/pound. If the long-run
supply curve is horizontal, then when long-run equilibrium is
reestablished the price will be:
A) $3.25/pound
B) $2/pound
C) Greater than $2/pound, but less than $3.25/pound
D) $1.25/pound
E) $5.25/pound
Answer: A
Econ: 61
Introduction to Monopoly
Margaret Ray and David Anderson
What you will learn
in this Module:
• How a monopolist determines the profitmaximizing price.
• How to determine whether a monopoly is
earning a profit or a loss.
• How the monopoly outcome is different
from the long-run outcome in perfect
I. Monopoly Demand and MR
A. A Monopolist’s MR curve is
below the D curve because
the monopoly must lower
price to sell more.
B. Because the monopolist is
the only producer in the
market, the demand for the
good is the demand for the
monopolist’s good
II. Profit-maximizing P and Q
A monopoly
maximizes profit by
producing the output
level where MC =
B. The rule to
maximize profit is
the same, no matter
the market structure
III. The “Classic” Monopoly
IV. Elasticity of Demand for
IV. Monopoly versus
Perfect Competition
A. Monopolies create
B. P > MC
C. The monopolist can Pm = $14
earn positive
economic profits in Pc = $10
the long run
because there are
barriers to entry of
new firms
Profit = $12
Qm= 3
V. Monopoly vs. PC
Perfect Competition
The firm’s Demand Curve is
relatively INELASTIC
The firm maximizes profit
Long Run=Economic Profit
Productive Efficiency
(Firm is not forced to operate with
max productive efficiency)
Allocative Efficiency
(There is an underallocation of
The firm’s Demand curve is
Perfectly ELASTIC
The firm maximizes profit
Long Run=Normal Profit
Productive Efficiency
(Firm is forced to operate with
max productive efficiency)
Allocative Efficiency
(There is an optimal allocation of
A monopoly is likely to _____ units of output and
_____ price than a perfectly competitive firm.
A) Produce more; charge a higher
B) Produce fewer; charge a higher
C) Produce more; charge lower
D) Produce fewer; charge a lower
E) Produce equivalent; charge a higher
Answer: B
Because monopoly firms are the only firm in the
A) They can maximize total revenue, but cannot
maximize profit
B) They sell more at higher prices than at lower
C) They take the market-determined price as
given and sell all they can at that price
D) They charge the highest possible price
E) They can only sell more by lowering price
Answer: E
In the short run, a monopoly will stop producing
Answer: B
Econ: 62
Monopoly and Public Policy
Margaret Ray and David Anderson
What you will learn
in this Module:
• The effects of monopoly on society’s
• How policy-makers address the problems
posed by monopoly.
I. The Welfare Effects of a Monopoly
A. Total surplus under perfect competition is equal to: CSc
B. Total surplus under monopoly is equal to: CSm + PSm
C. Because of the deadweight loss, we can see that CSc > CSm +
D. What exactly is the deadweight loss?
1. It represents transactions (between Qc and Qm) that could
have been made, but are not made under monopoly.
2. This will always occur when the level of output restricted such
that Pm >MC.
3. Economists see this loss of total welfare as a major drawback
to monopoly and is an argument for regulation or prevention of
The Welfare Effects of a
II. Preventing Monopoly Power
A. Some monopolies arise due to mergers
and acquisitions of rival companies or due
to ownership of a critical production input.
The government has Antitrust Laws to deal
with the harmful effects of these types of
B. Natural Monopolies exist when the ATC of
producing the entire market demand is
lower if one firm exists. In this case it is
more efficient to allow the natural
monopoly and regulate it.
III. Dealing With A Natural Monopoly
A. The government can purchase and operate the firm.
Because the government is not in the business of
maximizing profit at Qm,Pm, prices should be lower for
consumers. If the government could operate the market
where Pc=MC, there would be no deadweight loss.
B. The government can regulate the price
C. Problems
1. The government is a very large bureaucracy and is not
always best at keeping costs low.
2. Waste and political favors could also cause prices to
Price Regulation
One government policy for dealing with a natural
monopoly is to:
A) Impose a price floor to eliminate the
deadweight loss
B) Impose a price ceiling to eliminate any
economic profit
C) Break it up into smaller firms
D) Impose fines on the monopolist
E) Impose taxes on the monopolist to eliminate
the producer surplus
Answer: B
A natural monopoly exists whenever a single firm:
A) Is owned and operated by the federal or local
B) Is investor-owned but has been granted the exclusive
right by the government to operate in a market
C) Earns economic profits in the long run
D) Has gained control over a strategic input of an
important production process
E) Experiences economies of scale over the entire
range of production that is relevant to its market
Answer: E
The pricing in monopoly prevents some mutually
beneficial trades from taking place. The value
of these unrealized mutually beneficial trades
is called:
A) Sunk costs
B) Opportunity costs
C) Producer surplus
D) Inequities
E) A deadweight loss
Answer: E
If regulation of a monopoly results in a price
equal to marginal cost, but price is below
average total cost:
A) The firm can still make an economic profit
B) The firm will earn only a zero economic profit
C) Efficiency is lost
D) The firm will require subsidization or it will go
out of business
E) Deadweight loss exists
Answer: D
If a monopoly is forced to charge a price equal
to marginal cost:
A) Output will fall
B) The deadweight loss will decrease
C) Consumer surplus will decrease
D) Other firms will enter the industry
E) Economic profit will grow
Answer: B
Micro: 27
Econ: 63
Price Discrimination
Margaret Ray and David Anderson
What you will learn
in this Module:
• The meaning of price discrimination.
• Why price discrimination is so prevalent
when producers have market power.
What is Price Discrimination?
Charging different
price to different
consumers for the
same product.
Price Discrimination
Lenny’s is a local restaurant
famous for their “Slam Grand”
breakfasts. There are only
two market segments that
enjoy the Slam Grand: senior
citizens and college students.
Assume that:
1) Lenny’s MC=$2
2) There are 100 seniors
willing to pay $4.
3) There are 100 college
students willing to pay $8.
Elasticity and Price
Why are some
consumers not as
willing or able to pay
for a product?
Hint: It has to do with
differences in price
elasticity of demand.
Perfect Price Discrimination
Perfect price
each consumer is
charged exactly
his/her maximum
willingness to pay.
Price discrimination is the practice of:
A) Offering differentiated products to
consumers with different tastes
B) Paying different prices to suppliers of the
same good
C) Equating price to marginal cost
D) Equating price to marginal revenue
E) Charging different prices to buyers of the
same good
Answer: E
Price discrimination leads to a ______ price in
the market with a _____ demand.
A) higher; less elastic
B) Higher; more elastic
C) Higher; perfectly elastic
D) Lower; less elastic
E) Lower; perfectly inelastic
Answer: A
Because tourist demand for airline flights is
relatively _____, small ______ in price will
result in relatively ______ in additional
A) inelastic; reductions; small increases
B) Elastic; reductions; large increases
C) Inelastic; increases; small decreases
D) Elastic; increases; small increases
E) Elastic; reduction; small increases
Answer: B

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