Ln10 2013 Microeconomics Notes - Chapter 9 - Ms

SIM Global Education
9
MARKET STRUCTURE
There are several different forms of market structure, ranging from one extreme – where only firm is
the only firm producing a particular good or service – to the other extreme where there are thousands
or even millions of firms producing the same good or service. Economists judge whether an industry is
“competitive” or not by a variety of means. Simply counting the number of firms in an industry is not
necessarily a good indication of the level of competitiveness. What if an industry has tens of thousands
of firms, and yet the largest firm has a 95% share of the entire market. [Think: The software industry!]
9.01 CONCENTRATION RATIOS

A useful way to determine the competitiveness, or lack thereof, of an industry is to measure what
proportion of the market is dominated by the largest firms. Such a measure is known as a
Concentration Ratio. If, for example, the top three firms in an industry have 40% of the sales value
(market share) of that industry, we can denote this by: CR3 = 40% (i.e. 40% of the market is
concentrated in the hands of the three largest companies). If the six largest firms collectively capture
77% of the sales in an industry, the concentration ratio would read: CR6 = 77%. If, as in the above
paragraph, the biggest company alone has a 95% share of the market, the concentration ratio would
be written: CR1 = 95%.
These ratios tend to be national rather than world-wide, although within the industrialised world the
ratios tend to be remarkably similar from country to country.
By rule of thumb, if: CR1 > 90% the industry is regarded as being dominated by a monopoly
and if: CR4 < 40% the industry is deemed to be “competitive”
(i.e. what we in Economics courses call Perfect Competition]
but if: CR4 > 40% the industry is considered to be dominated by an oligopoly
Market
Share 100 %
CR1 = 95%: A Monopoly
75 %
CR4 = 68%: An Oligopoly
50 %
CR10 = 23%: Competitive

25 %
1 2 3 4 5 6 7 8 9 10 11 12
Number of firms
Ranked from largest to smallest
Microeconomics 301
9.02 THE HERFINDAHL-HIRSCHMANN INDEX

Another way of measuring the extent to which an industry is competitive or not is by means of the
Herfindahl-Hirschmann Index. This index is the sum of the squares of all market shares:
i=n
2
HHI = Σ si
i=1
The more competitive the industry, the closer the HHI will be to zero; the less competitive the industry,
the closer the index will be to unity.
An industry with ten firms, each having a 10% share of the market, would have an HHI of 0.1:
i=n
2 2 2 2 2 2 2 2 2 2 2
HHI = Σ si
i=1
= 0.1 + 0.1 + 0.1 + 0.1 + 0.1 + 0.1 + 0.1 + 0.1 + 0.1 + 0.1
= 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 = 0.1
An industry with ten firms, one of which has a 91% share of the market with the others each having a
1% share, would have an HHI of 0.8109:
i=n
2
HHI = Σ si
i=1
2 2 2 2 2 2 2 2
= 0.9 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01 + 0.01
2 2
= 0.81 + 9(0.0001) = 0.8109
The Herfindahl-Hirschmann Index has an advantage over Concentration Ratios, as it always rises when
mergers take place, no matter how small is the market share of the merging firms is. Concentration
Rations only rise if mergers take place which involve one of the biggest ex ante firms included in the
ratio.
9.03 THE LERNER MONOPOLY INDEX

Yet another way of trying to measure the competitiveness of a n industry is to examine the difference
between the market price odf the good and the marginal cost of producing that good. You will
remember from first year principles, of course, that in Perfect Competition, the Price is forced down to
the Marginal Cost; whereas with a Monopoly, the selling price is considerably above Marginal Cost.
An examination of the difference between Price and MC in any industry, therefore, gives a signal to
how competitive the industry actually is.
[Price – Marginal Cost]

L=
Price
As with the HHI, the closer to unity that the Lerner Monopoly Index is, the less competitive is the
industry being examined; and the closer the index is to zero (i.e. the closer price is to MC) then the
more competitive that industry is.
In an industry where the Marginal cost is $2 and the selling price is $2.10 would have a very low
Lerner Monopoly Index:
$2.10 - $200
L= = 0.048
$2.10
On the other hand, in an industry where the Marginal cost is $2 and the selling price is $20, the
Lerner Monopoly Index would be very high:
$20.00 - $200
L= = 0.90
$20.00
302 Microeconomics
9.1
PERFECT COMPETITION
Although Perfect Competition does not really exist, we will examine it as a useful theoretical model
against which we can compare other forms of competition (or lack thereof). We will then move on to
Monopoly and Monopolistic Competition – both of which most certainly exist . After a couple of weeks
at looking at the basics – and some interesting aspects of Monopoly Pricing Practises, we will turn our
attention to possibly the most interesting form of market structure: that of Oligopoly.
As you will recall, Oligopoly was not really part of the 1st year syllabus, whereas the others were. These
notes, however, will assume a zero understanding of the first year material, and will start from scratch.
Those of you who understood last year can skim through the following pages very quickly. To those of
you who didn’t……. make sure that you understand the basics now!!!!!!
The necessary conditions for a perfectly competitive market to exist are.....

1. The Good Must Be Homogeneous
...... that is, the good must be standard, as far as the purchaser is concerned, regardless of
where or by whom it was produced.
...... the producer does not – or can not – try to differentiate his product in any way.
2. There Must Be a Vast Number of Buyers and Sellers

...... and thus no individual firm can influence the price of the good in the market by increasing
or decreasing the level of production.
...... and no individual buyer can influence the price of the good in the market by increasing or
decreasing the amount purchased.
...... each individual producer and consumer is therefore a "Price Taker".
3. There Are No Barriers to Either Entering or Leaving the Industry

...... any individual is at liberty to join the industry; any existing producer is at liberty to leave.
...... at the margin, each producer's output is so insignificant that their entry into or exit from
the industry has no effect on the market price of the good.
4. Entry and Exit Costs are Extremely Low

...... entrants do not have to incur huge costs to enter, and any learning curve that exists is swift
...... because sunk costs are not exorbitant, incumbents will not be reluctant to leave the
industry if they find themselves in a loss-making situation.
5. Perfect Information
...... we will assume away any problems of asymmetric information, and consider that all players
– buyers and sellers – have perfect information about costs, pricing and quality.
Microeconomics 303
A single farm producing a single crop is the typical, textbook example of a perfectly competitive firm.
In the real world, however, the three conditions set above are very rarely - if ever - satisfied. Perfect
competition does not exist, nor are there any markets even nearly approaching it.
Nevertheless, the model is worthwhile examining as it is useful in an academic way:
•• It provides a standard and framework by which results from real world situations - as well as
from other forms of theoretical market structures - can by analysed, compared and assessed.
•• It gives a clear idea about how a real world market might develop if such conditions as:
(a) easy entry and exit

(b) homogeneity of product and
(c) free access to new technology by each competitor
did all coincide with each other.
In perfect competition, the market price is set by the industry as a whole, with no individual firm
having any influence on it.
The market price is determined by the prevailing supply and demand conditions in the industry as a
whole, with this equilibrium price is then passed on to each individual firm in the industry.
Each firm is a price taker, and has to accept the industry's price.
Each firm is a price taker, and has to accept the industry's price.
The Industry A Representative Firm

P P
S
p0 p0 d
D
Q0 Q q
Thus firms in perfect competition face a perfectly price elastic demand curve.
For an individual firm: a tiny increase in the selling price (above the rest of the market) would lead to
the firm not selling any of its output, and a tiny decrease in price (below the rest of the market)
would theoretically generate an infinite increase in the amount of output that the firm could sell.
No firm has the incentive to charge a price in excess of p0. This is because, at any price above p0
sales volume – and hence revenue – would be zero (and hence heavy losses would be incurred). This
is because if every other firm in the industry is selling goods at price p0, consumers – with perfect
information – will never pay a price above p0 for the good.
304 Microeconomics
No firm has the incentive to charge a price which is below p0. This is because, at any price below p0
the entire output of the firm would be immediately purchased by a competitor and then resold at price
p0.
Given that the demand curve is perfectly elastic, this implies that marginal revenue is equal to
average revenue, as each marginal unit sold is sold for precisely the same price.

P P
S
p0 p0 d = AR = MR
D
Q0 Q q
Because the firm’s demand curve is perfectly elastic, it has a Total Revenue function which is linear.
A Representative Firm’s Its Corresponding Total

P Demand Curve $ Revenue Function
TR
p0 d = AR = MR
q q
TR P×Q
Average Revenue is , which, of course, is the same as which, of course, simply equals P.
Q Q
Marginal Revenue is the change in Total Revenue, given a change in output. It is, therefore, the
gradient of the Total Revenue function.
dTR
MR =
dQ
If the Total Revenue function is linear, then the Marginal Revenue must be constant (because the TR
has a constant slope). Moreover, it must be equal to the price. If every extra unit can be sold for a
constant price (average revenue) of $x, then Total revenue rises by the same $x every time an extra
unit is sold.
Microeconomics 305
More generally, allowing for a downward sloping demand curve, (i.e. to include the industry, as well as
the firm in perfect competition, or any demand curve in any form of market structure) we can derive
one of the most fundamental relationships within the theory of the firm.
Marginal revenue is the gradient of the TR, but the TR is itself derived directly from the demand curve.
We can thus define Marginal revenue in terms of the demand curve, too – by-passing the TR. As long
as we know the new price, the former quantity and the slope of the demand curve, Marginal revenue
can be calculated as:
dP
MR = P1 + Q0
dQ
… where dP/dQ is the slope of the demand curve.
Check it! Think back to when you derived a TR function last week. You didn’t do it? You’ve lost last
week’s notes? Okay – I’ll redraw it:
P 10
P Q TR MR
9
10 1 10 10
8 9 2 18 8
7 8 3 24 6
7 4 28 4
6
6 5 30 2
5 5 6 30 0
4 4 7 28 -2
3 8 24 -4
3 2 9 18 -6
2 1 10 10 -8
1
D
0 1 2 3 4 5 6 7 8 9 10 Q
Right: first work out MR the easy way: i.e. look at the CHANGE in TR in the above schedule.
Then, working out using the method on the previous page. I’ll do one for you here, but you must
practise a few others yourself.
Take the price $8. At this price, there are 3 units sold. What is the Marginal Revenue if the price falls
to $7?
dP
MR = P1 + Q0
dQ
∴ MR = 7 + 3[-1]
∴ MR = 4
Try it yourself!
Okay - on to that fundamental relationship that I was talking about…………….
We know that:
dP
MR = P1 + Q0
dQ
Modifying this slightly, we could say:
306 Microeconomics
dP
MR = P1 + Q0 x1
dQ
which we could re-write as:

dP P1
MR = P1 + Q0 x
dQ P1
This can be further modified to:

dP Q0
MR = P1 + P1 x x
dQ P1
which, of course, can be re-written as:

dP Q0
MR = P1 1 + x
dQ P1
The price elasticity of demand, η, you will remember, is defined as:
dQ P
η =− •
dP Q
… and thus, Marginal Revenue can be written as:
1 1
MR = P1 1 + or MR = P1 1 −
η η
All we are doing here is playing with a mathematical version of what you already learned a year ago: the relationship
between elasticity of demand and Marginal Revenue!
In the case of a perfectly competitive firm, η is approaching infinity, and thus:
1
MR = P1 1 −
∞
∴ MR = P1 1 − 0
∴ MR = P1
……….in other words, Marginal Revenue equals price, and given that price is the same as Average
Revenue, and Average Revenue is Demand; this means that for a perfectly competitive firm, its
Demand curve and MR function are one and the same.
Microeconomics 307
9.1.01 PERFECTLY COMPETITIVE BEHAVIOUR

The perfectly competitive firm will attempt to maximise its profit.
In order to do this, it will choose to produce a level of output which maximises the distance between its
total cost curve and the total revenue curve – i.e. it will equate MC to MR.
(The firm will set MC = MR as long as it is at least covering its variable costs. Please note: if the firm
is not even covering its variable costs, then setting MC equal to MR would maximised the firm's loss!)
$ TC
TR
An output of q0
maximises profit for
the firm, but an output
of q2 maximises loss.
Outputs of q1 and q3
represent the firm's
break-even points.
q2 q1 q0 q3 q
The profit function which relates to the above cost and revenue functions:
$
Profit is maximised at q0
where MC = MR; but losses
are maximised at q2 where
q1 q3
0
MC = MR too. The extent of
q2 q0 q profit may also be
determined with reference to
-F the Marginal Revenue and
π Marginal Cost curves.
Each firm in a competitive industry is a price taker:

P The Industry P A Representative Firm
S
MC
AC
p0 p0 d = AR = MR
D
Q0 Q q
308 Microeconomics
In order to maximise profit, the firm sets MC = MR, and produces an output of q0.
P The Industry S P A Representative Firm
MC
AC
p0 p0 d = AR = MR
D
Q0 Q q0 q
The extent of the firm's economic profit or supra-normal profit (or "supernormal profit", if you read silly
American textbooks) can be determined with reference to the firm's average cost of production at q0.
MC
AC
p0 p0 d = AR = MR
ac0
D
Q0 Q q0 q
Magnifying the firm's diagram:

$ MC AC As entry costs are
very low and as there
are no barriers to
p0 AR = MR joining the industry,
the fact that existing
π firms are making a
ac0
profit, this will entice
other firms to enter
the industry.
q0 q
This will increase the supply in the industry, thus lowering the market price of the good. Each individual
firm is a price-taker, and will have to accept the new, lower price.
P The Industry S0 P A Representative Firm
S1
p0 p0 d0 = AR0 = MR0
p1 p1 d1 = AR1 = MR1
D
Q0 Q1 Q q
Microeconomics 309
The firm will (have to) respond by adjusting its output in order to maximise its (now lower) profit.
TC
$
TR0
TR1
q1 q0 q
In terms of MC and MR:

$ MC AC
p0 AR0 = MR0
p1
π0
AR1 = MR1
ac0
ac1
π 1
q1 q0 q
As economic profit is still being made by firms in the industry - although at a lower level than formerly -
this profit will still be enough to induce other firms to enter the industry. The resultant increase in
supply in the industry will cause the equilibrium price to fall still further, reducing profits to an even
greater extent.
S0
S1
S2
p0 p0 d0 = AR0 = MR0
p1 p1 d1 = AR1 = MR1
p2 p2 d2 = AR2 = MR2
D
Q0 Q1 Q2 Q q
310 Microeconomics
The firm will respond by adjusting its output in order to maximise its (still lower) profit.
$ TC
TR0
TR1
TR2
q2 q0 q
q1
In terms of the MC and MR:

$
MC
AC
p0 AR0 = MR0
p1
AR1 = MR1
p2
AR2 = MR2
ac2
π2
q2 q1 q0 q
But profit is still being made, so more firms will be enticed into the industry …. and so on and so forth.

S0
S1
S2
S3
p0 p0 d0 = AR0 = MR0
p1 p1 d1 = AR1 = MR1
p2 p2 d2 = AR2 = MR2
P3 P3 d3 = AR3 = MR3
D
Q0 Q1 Q2 Q3 Q q
Microeconomics 311
If the price is pushed down below the lowest point of the average cost curve, the firm will move into a
loss making situation. It will need to consider whether or not to remain in the industry.
$ MC AC
(-π)
p0 AR0 = MR0
p1
AR1 = MR1
p2 AR2 = MR2
P3 LOSS (−π) AR3 = MR3
q3 q2 q1 q0 q
The firm will now be in a situation where it is trying to minimise its losses.
The firm will now be in a situation where it is trying to minimise its losses.
•• If producing an output helps to reduce the loss, it will produce. It will stay in the industry in the
short-run.
•• If, by producing, losses are even higher, the firm won't produce. It will leave the industry
straight away.
Its decision will be based on the critical factor of the extent of its variable costs. If it is covering its
variable costs, it will stay in the industry in the short run. If revenue is such that it can't even
cover its variable costs, it will leave the industry immediately.
The reason behind this is straight forward. If it leaves the industry immediately, it loses its fixed costs -
they are a sunk cost, already paid. If, by producing, it covers its variable costs, any excess revenue is
a contribution towards the fixed cost loss, thereby reducing the overall loss. If, by producing, it doesn't
cover its variable costs, this extra deficit adds daily to the fixed cost loss, thereby increasing the
overall loss.
$ TC TVC
TR > TVC
TR
The firm should
continue to produce
in the short run, even
though losses are
being made.
312 Microeconomics
$
TC
TVC
TR < TVC
The firm should

leave the industry
TR immediately in order
to minimise its
losses.
Looking at it another way, if AR exceeds AVC, the firm should remain in the industry in the short run.
$ MC
AR > AVCmin
AC
AVC
p AR = MR
q q
But if AR is less than AVC, the firm will should leave the industry immediately.
$ MC
AR < AVCmin
AC
AVC
AC
p AR = MR
Microeconomics 313
9.1.02 MC: THE FIRM’S SUPPLY CURVE

Whether it is making a profit or a loss, as long as the firm is producing (i.e. if can manage to cover its
variable costs) the firm sets the Marginal Revenue equal to Marginal Cost.
$ MC
AC
AVC
It therefore
p1 AR1 = MR1 adjusts its level of
p2 AR2 = MR2 output
accordingly, and
p3 AR3 = MR3 moves up and
p4 AR4 = MR4 down its Marginal
Cost function,
given changes in
the market price.
q4 q3 q2q1 q
Hence that portion of the firm's Marginal Cost curve which lies above the AVC is, effectively, the
firm's supply curve in the short run.
$ MC = SR SUPPLY AVC
q* q
And the portion of the firm’s Marginal Cost curve which lies above the AC is, effectively, the firm’s
long-run supply curve.
$ MC = LR SUPPLY
AC
AVC
q** q
[The industrial supply curve is the horizontal summation of the Marginal Cost curves of all the firms in
the industry.]
314 Microeconomics
9.1.03 THE PERFECTLY COMPETITIVE EQUILIBRIUM
Market conditions in a perfectly competitive industry will adjust to the situation where no individual
firm is making any economic profit.
If any such profits are being made, other firms will join the industry in search of them. Their entry
drives the market price downwards.

S1
AC
p0 p0 d0 = AR0 = MR0
p1 p1 d1 = AR1 = MR1
D
Q0 Q1 Q q
If losses are being made, firms will leave the industry to avoid them.

S3
S2
AC
p3 p3 d3 = AR3 = MR3
p2 p2 d2 = AR2 = MR2
D
Q3 Q2 Q q
Supply in the industry as a whole, therefore, will adjust to a level such that the equilibrium price in the
industry just covers the average cost of representative firms.
S
MC
AC
p* p* d* = AR* = MR*
D
Q* Q q* q
There is no incentive for any other firm to enter the industry – as no profits are being made. Nor is
there any incentive for existing firms to leave the industry – as no losses are being made. The
situation is “stable”. That is, the market structure is in equilibrium.
Microeconomics 315
9.1.04 PERFECT COMPETITION: A MATHEMATICAL EXAMPLE
Assume a Perfectly Competitive Industry where demand is given by P = 40 – 1/10,000Q. Each firm
in the industry has a cost function of the form: TCi= 200 + qi3 – 16qi2 + 70qi.
Determine:
a) a typical firm’s short-run cost function
b) a typical firm’s long-run cost function
c) the industrial equilibrium (i.e. equilibrium price, quantity, number of firms in the industry)
a) The firm’s short run supply curve.
The firm’s short-run supply curve is its Marginal cost function above the lowest point of the
Average variable cost.
So: the first thing we need to do is to find the

price at which the firm would leave the industry
immediately - i.e. the lowest point of the AVC. $ MC
If we look at Total cost, and take away the fixed

component ($200) this leaves us with the Total
Variable Cost. AVC
3 2
TVC = qi – 16qi + 70qi
2
So: AVC = qi – 16qi + 70
Minimising this:
dAVC
= 2qi – 16 = 0
dqi 8 q
∴ qi = 8
Getting an expression for Marginal cost: $ MC

3 2
TCi = 200 + qi – 16qi + 70qi
AVC
∴ dTC 2
MCi = = 3qi – 32qi + 70
dqi
Substituting for q = 8:
$6
∴ 2
MCi = 3[8] – 32[8] + 70 = $6.00
8 q
So the short-run supply curve is:

2
MCi = 3qi – 32qi + 70
subject to the equilibrium price in the industry being greater than or equal to $6.00.
316 Microeconomics
b) The firm’s long run supply curve.
We need a similar approach as in (a), except this time using the AC rather than the AVC. The firm’s
long-run supply curve is its Marginal cost function above the lowest point of the (Total) Average Cost
curve.
MC 3 2
$ TC = 200 + qi – 16qi + 70qi
AC
200 2
So: AC = + qi – 16qi + 70
qi
Minimising this:
dAC = – 200 + 2qi – 16 = 0

dqi 2
qi
∴ 2q 3 – 16q 2 – 200 = 0
i i
∴ 3 2
qi – 8qi – 100 = 0 $ MC
By Taylor’s approximation (knowning that q > 8) AC
3 2
If q = 10: qi – 8qi – 100 = 100
3 2
If q = 9: qi – 8qi – 100 = – 19
3 2
If q = 9.2: qi – 8qi – 100 = 1.568
3 2
If q = 9.19: qi – 8qi – 100 = 0.5027
…which is close enough.

9.19 q
[Precisely: q = 9.18526751399182]
We know from earlier that:

2
MCi = 3qi – 32qi + 70
$ MC Substituting for q = 9.19:

AC
∴ 2
MCi = 3[9.19] – 32[9.19] + 70
= $29.29
29.28
So the long-run supply curve is:
2
MCi = 3qi – 32qi + 70
subject to the equilibrium price of the

industry being greater than or equal to
9.19 q $29.29.
Microeconomics 317
c) The Industrial equilibrium
From part [b] we can see that the equilibrium price in the industry will settle at $29.29.
$ $ MC
AC
29.29 29.29 AR = MR
D
107,100 Q 9.19 q
Using the Industrial demand curve, we can see that 107,100 units will be demanded at such a price.
P = 40 – 1/10,000Q
∴ 29.29 = 40 – 1/10,000Q
1/
∴ 10,000Q = 40 – 29.29
∴ Q = 10,000(10.71)
∴ Q = 107,100
If total quantity demanded, industry wide, is 107,100, and each firm produces 9.19 units, then there
must be 11,654 firms in the industry.
107,100
n= = 11,653.97 = 11,654 firms
9.19
9.1.05 A CHANGE IN VARIABLE COSTS

$ TC1
TC0
If there is an increase in the variable costs of a
firm [i.e. the price of capital (r) or the price of
labour (w)], this would cause the Total Variable
Cost of production to increase.
Hence the TC function would pivot upwards:
318 Microeconomics
$ $
MC
AC
q q
Obviously, Average Cost will be higher given that Total Marginal Cost will be higher because MC is the
Cost is higher, remembering that the Average Cost is gradient of TC, and as can be seen in the TC diagram,
the Total Cost divided by output. (bottom of page 253) the gradient of TC1 is greater at
all levels of output than the gradient of TC0.
$ TC1
The exact nature of the change in
Average and Marginal Costs is
TC0 dependent upon the nature of the
change in Total Cost.
q1 q0 q
$ In a situation like this one illustrated
here, the Average Cost curve rises, but
MC1 AC1 is now minimised to the left hand side
of where it was minimised previously –
MC0 AC0 i.e. it is now minimised at q1 rather than
at q0.
And the Marginal Cost function rises,

but is now a completely different shape
to previously (i.e. it is steeper].
q1 q0 q
If there were a decline in variable costs the opposite would happen. It would just be the above diagram,
except in reverse: a downward pivot of the TC function, resulting in a lower Average Cost which is
minimised to the right-hand-side of where it was formerly, and a lower Marginal Cost which is flatter
than previously.
Microeconomics 319
9.1.06 A CHANGE IN FIXED COSTS

If the Fixed Costs of a company rise, this would could a vertical upward movement of the Total Cost
function.
$ If Total Cost is higher, obviously Average
At any level of output, costs are
Cost will be higher too.
now $[FC1 – FC0]
AC0
higher than they were previously.
$
TC1
TC0
q
But notice that there has been no change in the

gradient of the Total Cost function, at any level of output.
There has just been an upward shift. This means that,
at any level of output, Marginal Cost (which is the
gradient of Total Cost) remains exactly as it was before.
FC1 $
MC0
FC0
q
$ TC1
TC0
If Average Cost rises, but

Marginal Cost remains
unchanged, this means
that, inevitably, the Average
Cost is minimised to the
right-hand-side of where it
was minimised before.
q0 q1 q
$
MC0
The Average Cost
“slides up”
AC1
the Marginal Cost
AC0 curve.
q0 q1 q
If there were a fall in the firm’s Fixed Costs, the effects would imply be the opposite of the above. Once
again, MC would remain unchanged, but AC would fall, “sliding down” the unchanged AC, inevitably
being minimised to the left-hand-side of where it was minimised before.
320 Microeconomics
9.1.07 A PER-UNIT TAX

If a per-unit tax is imposed on a firm, this is like an extremely unique change in its variable costs. If the
government makes the firm pay, say $t per unit produced, then this adds $tq to the Total Cost. The
TC function pivots upwards, but in a very special manner: at q=1 costs rise by $t; at q=2 costs rise by
$2t; at q=3 costs rise by $3t, etc., etc., etc.
This causes the TC to pivot upwards – and of course it causes AC and MC to rise – but AC will be
minimised at exactly the same level of output as before. Moreover, both the MC and AC rise by
precisely $t – the per-unit tax being the per-unit rise in costs.
$ TC1
TC0
q0 q
$
MC1 AC1
MC0 AC0
q0 q
Microeconomics 321
9.1.08 A PER-UNIT SUBSIDY

A per-unit subsidy is simply the opposite of a per-unit tax. If $s per unit is granted to producers, the TC
function pivots downwards, resulting in a vertical drop of both AC and MC.
$
MC0 AC0
MC1 AC1
q0 q
9.1.09 A LUMP SUM TAX

A Lump-Sum Tax is like an addition to the Fixed Costs of a firm. It is not connected to the level of
output of the firm, and hence causes an upward vertical shift of the Total Cost function by $T, without
changing its gradient at any level of output. This causes MC to remain unchanged, although AC will, of
course, be higher (and now minimised to the right-hand-side of where it was previously minimised).
$
TC1
TC0
F+T
q0 q1 q
$
MC0
AC1
AC0
q0 q1 q
322 Microeconomics
9.1.10 A LUMP SUM SUBSIDY

A Lump-Sum Subsidy works in the opposite way to a Lump-Sum Tax. The TC function will shift vertically
downwards by $S as the subsidy acts as a reduction in fixed costs. This causes MC to remain
unchanged, and AC to “slide down” MC, now being minimised to the left of where it was before.
MC0
AC0
AC1
q1 q0 q
9.1.11 TAXES AND SUBSIDIES DONE MATHEMATICALLY

It makes it much easier to understand all of these taxes’ and subsidies’ effects on the cost functions if
you deal with it mathematically. Even if you don’t like maths, try and force yourself through the
following.
It will make everything much clearer, I promise; and help you to understand rather than simply learn
the last few pages.
Imagine a firm with a Total Cost function as follows:
TC = a + bq + cqQ2
where “a” is not related to q – it’s a constant – i.e. the Fixed Cost;
and “bq + cq2“ is obviously related to q – i.e. the Variable Cost.
In the absence of any form of tax (or subsidy), let’s see what the AC and MC would look like, and at
what level of output AC would be minimised.
The Average Cost
Average Cost is Total Cost divided by Quantity: $

AC = TC a
AC = + b + cq
q q
a
Therefore: AC = + b + cq
q
q
Microeconomics 323
The Average Cost’s Minimum Point
We can find the level of output at which AC is minimised by differentiating AC with respect to q,
and equating the result to zero:
dAC a
= − 2 +c = 0
dq q
$
a a
∴ c = 2 AC = + b + cq
q q
2 a
∴ q =
c
½ q
a ( a/c)
∴ q=
c
The Marginal Cost
Marginal Cost is the first derivative of Total Cost:

$
dTC MC = b + 2cq
dq a
MC =
AC = + b + cq
q
So, in this case: MC = b + 2cq

q
Let’s now see mathematically how the TC, the MC, the AC and the AC’s minimum point vary if taxes
are imposed, or subsidies granted.
324 Microeconomics
A PER-UNIT TAXATION [9.1.07 DONE MATHEMATICALLY]
If a per unit tax of, say, $t per unit (t x q) is imposed, this will affect the firm’s TC as follows:
TC = a + bq + cq2 + tq
The New AC
Average Cost is still Total Cost divided by Quantity:
AC = TC
q
a
So this time it’s: AC =
q
+ b + cq + t
The New AC’s Minimum

The level of output at which AC is minimised: a
AC’ = + b + cq + t
$ q
dAC a a
dq = − 2 +c = 0 AC = + b + cq
q q
a
∴ c = 2
q
½ q
2
a ( a/c)
∴ q =c
a
∴ q= ………which is exactly the same as without the Per-Unit tax.
c
This means that if a Per-Unit tax is imposed, AC is
higher (at every level of q), by precisely $t, but is
minimised at the same level of q.
The New MC
Marginal Cost:
$ MC’ = b + 2cq + t
dTC
MC = dq
MC = b + 2cq
So, in this case: MC = b + 2cq + t

………………which means that if a Per-Unit tax is imposed, ½ q
MC is also higher (at every level of q) by ( a/c)
precisely $t – i.e. a vertical upward shift.
Microeconomics 325
LUMP SUM TAXATION [9.1.09 DONE MATHEMATICALLY]

If a lump sum tax of, say, $T is imposed, this will affect the firm’s TC as follows:
TC = a + bq + cq2 + T
The New AC
AC = TC
q
a T
q
+ b + cq +
q
The New AC’s Minimum Point

The level of output at which AC is minimised: a T
AC’ = + b + cq +
$ q q
dAC a
= − 2 + c − T2 = 0
dq q q a
AC = + b + cq
a +T q
∴ c = 2
q
½ Q
2 a+T ( a/c)
∴ q = c ½
((a+T)/c)
∴ q= a+T
c
Given that if T > 0 then [a +T] > 0, this means that

½ ½
((a+T)/c) > ( a/c)
i.e. AC is minimised at a higher level of output than before.
The “New” MC
Marginal Cost: a T
MC = b + 2cq AC’ = q + b + cq + q
dTC $
MC =
dq
a
AC = + b + cq
So, in this case: MC = b + 2cq (i.e. no change!) q
………………which means that if a Lump-Sum tax is imposed,

MC does not change (because the gradient of ½ q
the TC is unaffected. ( a/c)
½
((a+T)/c)
326 Microeconomics
A PER-UNIT SUBSIDY [9.1.08 DONE MATHEMATICALLY]
If a per unit subsidy of, say, $s per unit (s x q) is granted, this will affect the firm’s TC as follows:
TC = a + bq + cq2 − sQq
The New AC
Average Cost is still the Total Cost divided by the Quantity:
AC = TC
q
a
q
+ b + cq - s

AC = + b + cq
$ q
dAC a a
= − 2 +c = 0
dq q AC’ = + b + cq - s
q
a
∴ c = 2
q
a ½ q
2 ( a/c)
∴ q =
c
∴ q= a ……………which is exactly the same as without the Per-Unit subsidy.

c
This means that if a Per-Unit subsidy is given, AC is lower
(at every level of q by precisely $s, but is still minimised
at the same level of q.
The New MC
Marginal Cost:
$ MC = b + 2cq
dTC
MC = dq
MC’ = b + 2cq - s
So, in this case: MC = b + 2cq - s

…………which means that if a Per-Unit subsidy is ½ q
granted, MC is also lower (at every level ( a/c)
of q) by precisely $s – i.e. a vertical
downward shift.
Microeconomics 327
LUMP SUM SUBSIDISATION [9.1.10 DONE MATHEMATICALLY]

If a lump sum subsidy of, say, $S is granted, this will affect the firm’s TC as follows:
TC = a + bq + cq2 – S
The New AC
AC = TC
q
a S
q
+ b + cq -
q

AC = + b + cq
$ q
dAC a
= − 2 + c + S2 = 0
dq q q a S
AC’ = + b + cQ -
a-S q q
∴ c = 2
q
½ q
2 a-S ( a/c)
∴ q = c ½
((a-S)/c)
∴ q= a-S
c
Given that if S > 0 then [a - S] < 0, this means that
½ ½
( (a - S)/c) < ( a/c)
i.e. AC is minimised at a lower level of output than
before.
The “New” MC
Marginal Cost:
MC = b + 2cq
dTC $
MC =
dq
So, in this case: MC = b + 2cq (i.e. no change!)
………………which means that if a Lump-Sum subsidy is granted,

MC does not change (because the gradient of q
the TC is unaffected.
328 Microeconomics
9.1.12 A PER UNIT TAX IMPOSED ON A PERFECTLY COMPETITIVE INDUSTRY

Assume a Perfectly Competitive industry which is in equilibrium ex ante.
Price The Industry Price A Representative Firm
S0
MC0
AC0
P0 P0 AR0 = MR0
D0
Q0 Industry q0 The Firm’s
Output Output
If a Per-Unit tax is imposed upon firms in a perfectly competitive industry, this causes their Average
Cost and Marginal Costs curves to rise vertically (by the extent of the tax):
MC1
AC1
S0 MC0
AC0
P0 P0 AR0 = MR0
D0
Output Output
Firms will immediately react by cutting their output – trying to adjust to where the new MC1 is equal to
the unchanged MRo in order to minimise losses. They will aim to reduce output to q* (although they
won’t actually have to cut-back so drastically, as we will shortly see. O[Firms which can not now even
cover their variable costs will start leaving the industry].
MC1
AC1
S0 MC0
AC0
P0 P0 AR0 = MR0
D0
Q0 Industry q* q0 The Firm’s
Output Output
Microeconomics 329
With thousands and thousands of firms all cutting back on their output, this causes industrial supply to
reduce:

S1 MC1
AC1
S0 MC0
AC0
P0 P0 AR0 = MR0
D0
Q* Q0 Q q* q0 q
The way to show the industrial supply moving to the “correct” place is to make sure that it rises
vertically, at Q0, by precisely the same amount that MC has risen vertically at q0:

S1 MC1
AC1
S0 P0 MC0
AC0
P0 AR0 = MR0
D0
Q* Q0 Q q* q0 q
This, of course, generates a higher equilibrium price……………

S1 MC1
AC1
S0 MC0
AC0
P1
P0 P0 AR0 = MR0
D0
Q* Q1 Q0 Q q* q0 q
…….which, as price-takers, all firms in the industry are subjected to.
330 Microeconomics
All firms take the higher price, P1.

S1 MC1
AC1
S0 MC0
AC0
P1 P1 AR1 = MR1
P0 P0 AR0 = MR0
D0
Q1 Q0 Q q0 q
To minimise their losses, firms that choose to remain in the industry in the short-run adjust their
output to q1. Other firms, which are not covering their variable costs, will continue to leave the
industry.

S1 MC1
AC1
S0 MC0
AC0
P1 P1 AR1 = MR1
P0 P0 AR0 = MR0
D0
Q1 Q0 Q q1 q0 q
But firms are still making losses, a situation which is not sustainable in the long run. Firms will
gradually leave the industry, causing a further decline in industrial supply.

S1 MC1
S2 AC1
S0 MC0
AC0
P1 P1 AR1 = MR1
P0 P0 AR0 = MR0
D0
Q1 Q0 Q q1 q0 q
And then the normal rules of Perfect Competition take over. If losses are being made, firms will leave.
If so many firms leave that the price is pushed up such that incumbent firms make an economic profit,
other firms will enter.
Microeconomics 331
The industry can only be back in equilibrium when supply has adjusted to a point where the price
generated by the industry just covers the lowest point of the new Average Cost curve of representative
firms within the industry.

S1 MC1
S2 AC1
S0 MC0
P2 P2 AR2 = MR2
AC0
P1 P1 AR1 = MR1
P0 P0 AR0 = MR0
D0
Q2 Q1 Q0 Q q1 q0 q
The industry returns to equilibrium at price P2 and industrial output Q2, with those firms which have
remained in the industry are back to producing q0.
9.1.13 A LUMP SUM TAX IMPOSED ON A PERFECTLY COMPETITIVE INDUSTRY
Once again, assume a Perfectly Competitive industry which is in equilibrium ex ante.

S0
MC0
AC0
P0 P0 AR0 = MR0
D0
Output Output
If the government imposes a Lump-Sum Tax on all firms in the industry, this raises their Average Cost
(but not their Marginal Cost).

AC1
S0
MC0
AC0
P0 P0 AR0 = MR0
D0
Q0 Q q0 q
332 Microeconomics
Firms will not adjust their output, as MC still equals MR at q0. The only thing is that, whereas
previously they were breaking even, they will now be suffering economic losses. Firms which cannot
cover their variable costs will begin to leave the industry immediately. Others will remain in the short
run. As firms leave, industrial supply begins to decrease.

AC1
S0
MC0
AC0
P0 P0 AR0 = MR0
D0
Q0 Q q0 q
Then the normal rules of Perfect Competition take over. If losses are being made, firms will leave. If so
many firms leave that the price is pushed up such that incumbent firms make an economic profit,
other firms will enter. The industry can only be back in equilibrium when supply has adjusted to a point
where the price generated by the industry just covers the lowest point of the new Average Cost curve
of representative firms within the industry.

S1
AC1
S0
MC0
P1 P1 AR = MR1
AC0 1
P0 P0 AR0 = MR0
D0
Q1 Q0 Q q0 q1 q
The industry returns to equilibrium at the higher price P1 with industrial output having declined to Q1.
There are now far fewer firms in the industry than there used to be, but those which do remain now
make the higher level of output q1, where their unchanged MC equals MR1.
Microeconomics 333
9.1.14 A PER UNIT SUBSIDY GRANTED TO FIRMS

IN A PERFECTLY COMPETITIVE INDUSTRY
Once again, assume an industry in equilibrium to begin with.

S0 MC0
AC0
P0 P0 AR0 = MR0
D0

Output Output
If a Per-Unit subsidy is given to all firms, this will cause their Average Cost and Marginal Cost functions
to fall vertically (by precisely the extent of the per-unit subsidy).

S0 MC0
AC0
MC1
P0 P0 AR = MR0
AC1 0
D0
Q0 Q q0 q
To maximise profits, firms will immediately begin to increase their output to where MR equals the new
MC1:

S0 MC0
AC0
MC1
P0 P0 AR = MR0
AC1 0
D0
Q0 Q q0 q* q
This increased output has an immediate impact upon the industrial supply curve.
334 Microeconomics
This increased output has an immediate impact upon the industrial supply curve:

S0 MC0
S1 AC0
MC1
P0 P0 AR = MR0
AC1 0
D0
Q0 Q q0 q* q
The way to show the industrial supply moving to the “correct” place is to make sure that it drops
vertically, at Q0, by precisely the same amount that MC has fallen vertically at q0.

S0 MC0
S1 AC0
MC1
P0 P0 AR = MR0
AC1 0
D0
Q0 Q q0 q* q
This lowers the industrial price – which of course is passed on to all firms in the industry. They will
adjust their output accordingly.

S0 MC0
S1 AC0
MC1
P0 P0 AR = MR0
AC1 0
P1 P1 AR1 = MR1
D0
Q0 Q1 Q q0 q1 q
Firms are now making a healthy economic profit. This will induce other firms into the industry.
Industrial supply will increase still further as more firms enter.
Microeconomics 335

S0 MC0
S1 AC0
S2 MC1
P0 P0 AR = MR0
AC1 0
P1 P1 AR1 = MR1
D0
Q0 Q1 Q q0 q1q* q
The usual principles of Perfect Competition then apply. If profits are being made, firms will join. If so
many firms join that the price is pushed so far down that incumbent firms make economic losses,
firms will commence leaving the industry.
The industry can only be back in equilibrium when supply has adjusted to a point where the price
generated by the industry just covers the lowest point of the new Average Cost curve of representative
firms within the industry.

S0 MC0
S1 AC0
S2 MC1
P0 P0 AR = MR0
AC1 0
P1 P1 AR1 = MR1
P2 P2 AR2 = MR2
D0
Q0 Q1 Q2 Q q0 q1 q
The industry returns to equilibrium at price P2 and industrial output Q2, with all firms in the industry
producing q0 (the former level of output of the original incumbents).
9.1.15 A LUMP SUM SUBSIDY GRANTED TO FIRMS IN A

PERFECTLY COMPETITIVE INDUSTRY
Once again, assume a Perfectly Competitive industry which is in equilibrium ex ante.

S0
AC0
MC0
P0 P0 AR0 = MR0
D0
Output Output
336 Microeconomics
A Lump-Sum Subsidy will cause firms’ Average Cost functions to fall, but will leave their MC functions
intact.

S0
AC0
MC0
P0 P0 AR0 = MR0
AC1
D0
Q0 Q q0 q
Firms will continue to produce outputs of q0 (where MC=MR) but will now make a lot of economic
profit. This profit will entice other firms into the industry. Industrial supply will increase.

S0
AC0
MC0
P0 P0 AR0 = MR0
AC1
D0
Q0 Q q0 q
The usual principles of Perfect Competition apply. If profits are being made, firms will join. If so many
firms join that the price is pushed so far down that incumbent firms make economic losses, firms will
commence leaving the industry. The industry can only be back in equilibrium when supply has adjusted
to a point where the price generated by the industry just covers the lowest point of the new Average
Cost curve of representative firms within the industry.

S0
AC0
S1
MC0
P0 P0 AR = MR0
AC1 0
P1 P1 AR1 = MR1
D0
Q0 Q1 Q q1 q0 q
The industry returns to equilibrium at the lower price P1 with industrial output having increased to Q1.
There are now far more firms in the industry than there used to be, but each of these now make the
lower level of output q1, where their unchanged MC equals MR1.
Microeconomics 337
9.1.16 PERFECT COMPETITION: LONG-RUN EQUILIBRIA

Earlier we examined equilibrium within a perfectly competitive framework, and saw that supply in the
industry would always adjust to a level where the equilibrium price generated by the industry-as-a-whole
just covers the lowest part of the average cost function of representative firms in that industry. This
eliminates any economic profit or any economic loss, thereby eradicating any incentive for any other
firms to either enter or leave the industry. The situation is thus “stable”: - i.e. an equilibrium.
Even given a change in demand conditions – something we did not examine earlier – supply will also
adjust to a level such that the price equates to the minimum value of the average cost curve of any
firm in the industry. It is in situations where there is a change in demand that we need to analyse
different outcomes which might occur given different types of competitive industries. The emphasis of
the analysis (as far as your examiner is concerned, at any rate) is on the nature of the resultant long-
run industry supply curve.
There are three types of industries that we should consider, those with:
• constant costs
• rising costs
• falling costs
The “costs” here are costs which accrue to any and all firms in the industry, and which are subject to
economies or diseconomies of scale which accrue to the industry as a whole (rather than simply to an
individual firm’s production function).
Constant Cost Industries [Perhaps the least realistic of the three……….]
A “Constant Cost” industry is one where no external economies or diseconomies of scale accrue to
the industry as a whole - that is to say, there are no changes in the cost conditions of firms as a
result of the entry and exit of other firms. If this occurs, the long run supply curve of the industry will
be perfectly elastic.
Starting with a perfectly competitive industry which has achieved short-run equilibrium….

S0
MC0
AC0
p0 p0 AR0=MR0
D0
Q0 Q q0 q
…. consider the effects of an increase in demand for the good or service.
An increase in demand – from D0 to D1 (next page) - generates a higher equilibrium price of p1 in the
industry. This higher equilibrium price is passed on to each firm in the industry.
338 Microeconomics
An increase in demand – from D0 to D1 (below) - generates a higher equilibrium price of p1 in the

industry. This higher equilibrium price is passed on to each firm in the industry.
P P
S0
MC0
AC0
p1 p1 AR1=MR1
p0 p0 AR0=MR0
D1
D0
Q0 Q1 Q q0 q
Existing firms adjust their output to where marginal cost is equal to the new marginal revenue, and
commence to make super-normal profit.
S0
MC0
AC0
p1 p1 AR1=MR1
p0 p0
π
AR0=MR0
D1
D0
Q0 Q1 Q q0 q1 q
This profit will entice other firms into the industry. As a result, the price begins to fall. Firms will
continue to enter as long as profits are being made; thus the price will continue to fall until all
economic profit is eliminated.
S0
MC0
S1 AC0
p1 p1 AR1=MR1
p0 p0 AR0=MR0
D1
D0
Q0 Q1 Q2 Q q0 q1 q
The industry returns to equilibrium at price p0 with industrial output now being Q2 (which is [q0 x n’]
where n’ is the new, larger number of firms in the industry.
Microeconomics 339
The implication is that, no matter what the level of industrial output, in the long-run the price returns to
the initial p0. In other words, the Long Run Supply Curve of the industry is therefore perfectly elastic at
price p0.

S1
p1 p1
p0 p0
• • SLR
D1
D0
Q0 Q1 Q2 Q q0 q1
Had there been a decrease in demand, the reverse would have happened, but the long-run supply
function of the industry would also be horizontal at the price p0.
A decrease in demand – from D0 to D2 below – would generate a lower equilibrium price of p2 in the
industry as a whole. This lower equilibrium price is passed on to each and every firm in the industry.
P The Industry P A Rep. Firm MC0 AC0

S0
p0 p0 AR0=MR0
p2 p2 AR2=MR2
D2 D0
Q2 Q0 Q q0 q
Firms will now making losses. Some will leave the industry immediately (if they are not covering their
variable costs). Others will stay in the short run – adjusting their output to where their MC equals the
new MR in order to minimise losses.
P The Industry P A Rep. Firm MC0 AC0
S0
p0 p0 AR0=MR0
p2 p2
−π
AR2=MR2
D2 D0
Q2 Q0 Q q2 q0 q
340 Microeconomics
Even firms which stayed in the short-run will commence to leave the industry, and eventually supply will
adjust to a point where the equilibrium price generated by the industry just covers the lowest point of
the average cost functions of representative firms remaining in the industry.

S2 S0
MC0
AC0
p0 p0 AR0=MR0
p2 p2 AR2=MR2
D2 D0
Q3 Q2 Q0 Q q2 q0 q
Once again, there is no incentive for any firms to enter the industry, as no profits are being made; nor
is there any incentive for more firms to leave the industry, as losses are no longer being made. The
industry is once again in equilibrium. If we join the initial equilibrium point to the new equilibrium point,
we can see that – as when there was an increase on demand – the Long Run Supply Curve of the
industry is perfectly elastic at the price p0.

2 S0
MC
p0 p0
SLR
p2 p2
D2 D0
Q3 Q2 Q0 Q q2 q0
Changing Cost Industries
Although individual firms are price takers, and cannot attempt to influence the price of the good in the
market, exogenous factors may affect all firms in the industry, with a resultant impact upon their costs
- and ultimately the market price.
Pecuniary Influences
......result from changes in the prices of factor inputs, raw materials or power which will affect all firms.
Prices could rise - given a general rise in demand for these factors inputs, raw materials, etc. -
external pecuniary diseconomies of scale.
Prices could fall : given a general increase in the size of the industry, external pecuniary economies of
scale may well accrue.
Microeconomics 341
Non Pecuniary or Technological Influences

......result from changes in technology which affect the methods of production (i.e. the efficient
expansion path) and hence effect all firms which wish to remain competitive.
Technological influences also may convey economies or diseconomies upon the entire industry.
With changing cost industries, average costs may rise or fall. The point at which they are minimised is
dependent upon whether the external economies or diseconomies affect the firms fixed costs or
variable costs – or both.
From the previous chapter, you will recall that if If, on the other hand, variable costs rise, the
fixed costs rise but variable costs remain whole MC function shifts upwards as the TC
unchanged, the MC (which is the slope of the TC pivots to the left, and the AC is minimised to
remains unchanged, and thus the AC “slides up” the left hand side of where it was formerly
the MC - i.e. it will be minimised to the right-hand minimised.
side of where it was minimised previously.
$ A rise in variable costs
$ A rise in fixed costs MC1
MC AC1
AC1
MC0
AC0 AC0
q1 q0 q
q0 q1 q
If there is an increase in both fixed costs and variable costs simultaneously, the new AC may be
minimised to either the left or right hand side of its former minimum point, depending upon which
effect outweighs the other.
$ AC1
In the analysis which follows over the next few

pages, for simplicity I will assume that the effects
counterbalance each other precisely – i.e. the AC0
new AC will be minimised at precisely the same
level of output as the former one.
q0 q
Beware: this is an over-simplification.
Next May, your examiner will expect you to show the new AC minimised either to the left or to the right
of q0 depending upon the way he phrases his question. For example, if he states that labour costs
increase, he will expect you to show q1 to the left-hand-side of q0 (as wages are a variable cost);
whereas if he states that rents rise (and rents are fixed costs) he will expect you to show q1 to the
right-hand-side of q0.
The reason for my over-simplification here is to try and enable you to concentrate – for the moment –
on the major issue relating to changing cost industries – the Long Run Supply Curve.
[It’s no good being unable to see the forest because the trees are in the way!]
342 Microeconomics
Rising Cost Industries
A rising cost industry is one where, given an increase in supply, average costs will rise. The “increase
in supply” means more firms entering the industry. This means there will be an increase in the
demand for labour (which must accompany such an expansion of output} which will increase the price
of labour (the going wage rate) facing all firms in the industry. There will be an increase in demand for
raw materials, for power, for factory space, etc., as new firms enter, leading to a rise in their cost too.
Starting with an increase in demand in the industry, the equilibrium price rises:
MC0
AC0
p1 p1 AR1=MR1
p0 p0 AR0=MR0
D0 D1
Q0 Q1 Q q0 q
Existing firms adjust their output, and commence to make economic profit.

S0 MC0
AC0
p1 p1 AR1=MR1
π
p0 p0 AR0=MR0
D0 D1
Q0 Q1 Q q0 q1 q
Seeing these profits, other firms will be enticed into the industry.

S0
MC0
AC0
p1 p1 AR1=MR1
π
p0 p0 AR0=MR0
D0 D1
Q0 Q1 Q q0 q1 q
Microeconomics 343
But such an increase in supply will generate rising costs.

S0
AC1
S1
AC0
Q q
As supply in the industry increases, costs rise. Equilibrium will be achieved at price p2 (below) where
the new supply in the industry (S1) generates a price which just covers the lowest point of the new
(higher) average cost function of a representative firm (AC1).

S1 MC1
MC0 AC1
AC0
p1 p1 AR1=MR1
p2 p2
AR2=MR2
p0 p0
AR0=MR0
D0 D1
Q0 Q1 Q2 Q q0 q1 q
Thus an industry in which average costs rise as the industry's output level rises will, in the long run, not
have a perfectly elastic supply curve (as with constant cost industries), but will have one which is
positively sloped.

S1 MC1
MC0
p1 p1
SLR
p2 p2
•
p0 p0
•
D0 D1
Q0 Q1 Q2 Q q0 q1
344 Microeconomics
Falling Cost Industries
There are some industries where, given an increase in supply occurs, average costs fall. This could be
for pecuniary reasons - economies of scale accruing to the industry as a whole, or technological
reasons - scientific breakthroughs which benefit the entire industry.
An increase in demand in the industry generates a rise in the equilibrium price:
MC0
AC0
p1 p1 AR1=MR1
p0 p0
AR0=MR0
D0 D1
Q0 Q1 Q q0 q
Existing firms adjust their output, and commence to make economic profit.
MC0
AC0
p1 p1 AR1=MR1
π
p0 p0 AR0=MR0
D0 D1
Q0 Q1 Q q0 q1 q
Seeing these profits, other firms will be enticed into the industry.
MC0
AC0
p1 p1 AR1=MR1
π
p0 p0
AR0=MR0
D0 D1
Q0 Q1 Q q0 q1 q
Microeconomics 345
But such an increase in supply causes an industry-wide fall in costs.

S0
AC2
S1
AC1
Q q
As supply in the industry increases, costs fall. Equilibrium will be achieved at price p2 (below) where
the new supply curve in the industry (S1) generates a price which just covers the lowest point of the
new (lower) average cost function of representative firms (AC1).
MC0
MC1 AC0
p1 p1 AR1=MR1
S1 AC1
p0 p0 AR0=MR0
p2 p2 AR2=MR2
D0 D1
Q0 Q1 Q2 Q q0 q1 q
Thus an industry in which average costs fall as the industry's output level rises will have (in the long
run) a downward sloping supply curve.

S0
MC0
MC
p1 p1
S1
p0 p0
•
p2 p2
•
D1
SLR
D0
Q0 Q1 Q2 Q q0 q1
346 Microeconomics
Changing cost industries have a few strange anomalies, and of course, it is these anomalies which are
likely to be examined.
In a constant cost industry, a per-unit tax will result in the price of the good rising, and the magnitude of
the price rise will be precisely equal to the tax.

Price Price
MC1
S2 S1 AC1
S0 MC0
P2 P2 AR2 = MR2
AC0
P P1 P1 t AR1 = MR1
P0 P0 AR0 = MR0
D0
Q2 Q1 Q0 Q q1 q0 q
(Look back to pages 317 – 319 if you need to see all the mechanics, short-run and long run, in detail, if
you need to.)
This will not be the case with a changing-cost industry, however.
In a rising cost industry, a per-unit tax will generate a price rise which is less than the size of the tax;
and in a falling cost industry it will generate a price rise which is greater than the size of the tax.
A PER-UNIT TAX IMPOSED UPON FIRMS IN A RISING COST INDUSTRY
The short-run scenario is the same as that of a constant cost industry. Firms adjust their output to
minimize losses, and the price rises to P1.

Price Price
MC1
S1 AC1
S0 MC0
AC0
P1 P1 AR1 = MR1
P0 P0 AR0 = MR0
D0
Q1 Q0 Q q1 q0 q
But firms are making losses, so they will begin to leave the industry.
In a rising cost industry, as more firms enter the industry, costs rise . . . . . but of course if firms leave
the industry, costs fall. This leads to the price settling at P3, (which is lower than the price P2 in
constant cost industries). The final change in price is smaller than the magnitude of the tax.
Microeconomics 347
The final change in price is smaller than the tax.

Price Price
S3 MC1
AC1
S1
MC2 AC2
S0
MC0
P3 P3 AC0
AR3 = MR3
P P1 P1 t AR1 = MR1
P0 P0 AR0 = MR0
D0
Q3 Q1 Q0 Q q1 q0 q3 q
A PER-UNIT TAX IMPOSED UPON FIRMS IN A FALLING COST INDUSTRY
As with rising-cost industries, the short-run scenario is the same as that of a constant cost industry.
Firms adjust their output to minimize losses, and the price rises to P1.

MC1
S1 AC1
S0 MC0
AC0
P1 P1 AR1 = MR1
P0 P0 AR0 = MR0
D0
Q1 Q0 Q q1 q0 q
But firms are making losses, so they will begin to leave the industry.
In a falling cost industry, as more firms enter the industry, costs fall . . . . . but of course the reverse is
true: if firms leave the industry, costs will rise. This leads to the price settling at P4 (which is higher
than price P2 in constant cost industries). The final change in price is greater than the magnitude of
the tax.
MC3
Price Price MC1 AC
S3 3
AC1
S1 MC0
P4 S0 P4 AR4 = MR4
AC0
P
P1 P1 t AR1 = MR1
P0 P0 AR0 = MR0
D0
Q4 Q1 Q0 Q q1 q4 q0 q
348 Microeconomics
9.1.17 MARGINAL FIRMS

We have seen how the long-run supply curve in a constant-cost industry will be perfectly elastic, and
how it will be positively sloped in a rising cost industry, and negatively sloped in a constant cost
industry.
However, even in a constant cost industry, there are instances where the long-run supply curve could
be positively sloped. And the examiner, of course, likes to set questions about such cases (“a perfectly
competitive industry with constant costs must have a perfectly elastic long-run supply curve., true or
false?”)
Imagine an industry where firms face different costs – perhaps based on their location. A firm based
in Orchard Road, for example, will have higher costs than a firm based in Tuas or Woodlands. With
unchanged demand for the product, the firms with higher costs will be forced to leave the industry
(which is why there is no manufacturing done in the Orchard area now, whereas there was in the
1960s).
P The Industry P A typical Tuas firm P A typical Orchard firm

MCO
S
MCT
ACO
ACT
P0 P0 P0 AR0=MR0
D
Q0 Q qT0 qT qO
Now suppose that there is an increase in demand for the good that the industry produces, and that
Tuas is capacity constrained (that is to say: Tuas is full – there are no factory sites available for rent.)

MCO
S
MCT
ACO
P1 P1 P1 AR1=MR1
ACT
P0 P0 P0 AR0=MR0
D1
D0
Q0 Q qT0 qT qO
The increase in demand will drive the price up to P1, inducing existing firms in Tuas to increase their
output, and also enticing firms in the Orchard area to enter the industry.
Microeconomics 349
MCO
S
MCT
ACO
P1 P1 P1 AR1=MR1
ACT
P0 P0 P0 AR0=MR0
D1
D0
Q0 Q1 Q qT0qT1 qT qO0 qO
Firms will continue to enter in the Orchard area, until the price is driven down to P2, where they just
break even (firms in Tuas, given their lower costs, make positive economic profits, even in the long run).

MCO
S0
S1 MCT
ACO
P1 P1 P1 AR1=MR1
ACT
P2 P2 P2 AR2=MR2
P0 P0 P0 AR0=MR0
D1
D0
Q0 Q1Q2 Q qT0qT1 qT qO1qO0 qO
qT2
Both Tuas and Orchard firms have experienced no exogenous effects on their costs (i.e. it’s a constant
cost industry, and yet the long run supply curve is positively sloped:

MCO
S0
S1 MCT
ACO
P1 P1 P1 AR1=MR1
ACT
P2 P2 P2 AR2=MR2
P0 P0 P0 AR0=MR0
LRS
D1
D0
Q0 Q1Q2 Q qT0qT1 qT qO1qO0 qO
qT2
350 Microeconomics
9.2
MONOPOLY
A monopoly is the other extreme to Perfect Competition. As far as economics textbooks are
concerned, a monopolist is the only producer and/or vendor of a particular good or service.
In reality, statutory law may define a company which has more than x% of the market share of an
industry as "a Monopoly". In the United Kingdom, the Monopolies and Mergers Commission (MMC) –
which is a statutory body which investigates mergers and acquisitions – defines a Monopoly as a
situation has more than 25% of the total market share of the industry. [The figure was 40% before
1979 when Mrs. Thatcher came to power. She reduced it to 33% that year – as it still is in the United
States – and then again to 25% in 1982.)
Any large merger or take-over plan in the UK is referred to the MMC. After careful analysis – which
may take months or even years – the MMC has the power to block any merger or acquisition if it
believes that the resulting company or group of companies will attain 25% or more of the market
share of the industry.
As far as this course is concerned, however, just as in year one, we will assume that a monopoly is the
sole producer in an industry.
The necessary conditions for a Monopoly to exist are:
1. There Is Only One Producer
The monopolist is the only producer/vendor of a particular good.
All consumers are thus "price takers", whereas the monopolist is not: he has the power to
set his own price by simply varying the volume of output he produces. He is not a price taker
but a price maker.
2. Zero Substitution
There are no perfect substitutes for the monopolist's good or service, nor are there even any
close substitutes. There will be few - if any - slight substitutes.
[Thus we are not discussing goods like green apples as in perfect competition; but services like
telephone calls (where British Telecom had a complete monopoly in the UK until 1984, and
Singapore Telecom had here in Singapore until April 1997).]
3. Extreme Barriers Of Entry
Entry into the industry is impossible - or is virtually impossible. There may be legislation
forbidding entry, and in any event, the costs of entering will be prohibitive.
Once again, there are no laws to stop you setting up a stall at a wet market selling apples, and
the costs of doing so are very low; but there are laws to prevent you from forming a company
to produce nuclear weapons.
Microeconomics 351
9.2.01 THE SOURCES OF MONOPOLY POWER

There are six main reasons to explain the existence of a monopoly - i.e. the rationale behind why there
may be only one firm in a particular industry or market.
1. Resource Based Monopoly Power

A firm may control something essential to the input process that no other firm can acquire.
This may be because it owns the only known reserves of a particular raw material (De Beers and
diamonds in South Africa).
It may be because is possesses a non-patented secret about the ingredient mix (Coca-Cola in the
United States).
2. Legal Monopoly Power

It may, on occasions, be illegal for more than one firm to produce a good or service.
This may be because the government has granted a franchise to an individual firm or person, giving
that company or person the exclusive rights to produce a particular good or service.
The franchise may be granted for reasons of National Security – i.e. the production of weapons and
munition – but history is littered with instances of less rational legal monopolies.
3. Patent Monopoly
Musicians, writers and other artists have a copyright over their output for a certain period of time,
giving them a monopoly on the profits which accrue to their music or books.
So too do companies which patent new inventions. [Patents, and thus “monopoly rights” vary from
nation to nation.] Such patents ensure that the inventors of a particular good or production process
have exclusive rights to their own inventions.
4. Collusive Monopoly (Not Oligopoly)

If a number of firms in oligopolistic competition collude – i.e. they act together to maximise the
industry’s profits rather than any individual firm’s – a collusive monopoly is formed. For a time during
the 1970s the oil cartel OPEC was a collusive oligopoly/collusive monopoly.
Such a situation is common in the event of war. With the Germans about to invade, the British
government wanted all armaments and aircraft producers in the country concentrating on defeating
Hitler rather than competing with each other, and thus allowed monopoly profits to accrue as the
major firms in the industry co-ordinated their output.
5. Natural Monopoly
Occasionally circumstances exist where economies of scale are so important that one company can
produce the total output of an industry at a lower cost than if two or more firms competing with each
other could. Such is a Natural Monopoly.
There are certain instances where the first firm in an industry becomes a natural monopoly, virtually by
default. This could be due to the massive up-front sunk costs involved (telecommunications, etc).
There are certain instances where, with a few firms competing, the one which becomes marginally
larger automatically becomes much larger, and thus becomes a Natural Monopoly. [Think of
something like the Singapore Sweep. If there were two or three competing sweeps, which would you
buy tickets for? The one with the biggest prize, obviously. But the more people who buy tickets for that
company, the greater the prize which it will be able to offer, and hence the more people will buy tickets
from it. The other companies will vanish soon!]
352 Microeconomics
Imagine a town where there were two or more dating agencies. The one which gains a reputation for
having most people on its books will attract more custom. But as it attracts more custom, it will
inevitably get more people on its books – which will attract more custom – which will get more people
on its books …… etc. Inevitably in an industry like this, the player which becomes the biggest will, by
default, become even bigger and become a Natural Monopoly.
6. Monopoly by Good Management
This should really be classified as Oligopoly.
If a firm can remain a monopoly by the strategic behaviour and manoeuvres of its management,
managing to deter entry by others into the industry, it is said to by a Monopoly by Good Management.
The type of strategic behaviour firms like this might adopt will be examined in detail when we look at
the game theoretic approach to Oligopolistic Competition next term.
9.2.02 Monopoly: Short-Run and Long-Run Equilibrium

Because the firm is not in a competitive market, the demand for the monopolist's output will be
downward sloping: AR ≠ MR
P
The Industry = The Firm
The monopolist is not a price

taker - it is a price maker.
The industry's demand curve
is the firm's demand curve.
MR q
MC
pm
In order to maximise profit, AC
the monopolist produces
where: MC = MR
thereby restricting output and
charging a high price.
D
qm q
MR
Microeconomics 353
Its rewards are “supra-normal” or "economic" profits, which can be determined with respect to his
average cost at level of output qm.
MC
pm
AC
π
D
qm q
MR
The monopolist could produce a higher output, and sell at a lower price. He would still be making a
profit until q' (below) selling at price p', where: AC = AR.
MC
pm
AC
p'
D
qm q' q
MR
But because there is no competition, the monopolist maximises his profit by producing where MC =
MR thereby restricting his output to qm, and hence pushing the market price up to pm.
It is because monopolists restrict their output in this manner - in order to raise price so as to
maximise profits - that economists (and Governments!) are not fond of them.
Monopolists waste resources in order to maximise super-normal profits, resulting in a welfare loss
to society at large.
This can be seen by the deadweight efficiency loss of a monopolist (also known as Harberger's
Triangle after an American Economist who did much research into it Monopoly-induced welfare losses
during the 1930s).
354 Microeconomics
If the industry was competitive, supply would be

Equal to demand, and the following surplus would
accrue (some of it being consumer’s surplus,
of it being producer’s surplus): But with a Monopoly, surplus is cut off at qm:
P
P
MC = S MC = S
pm pm
AC AC
D
D
qm q qm q
MR
MR
P The Deadweight Efficiency Loss

of a Monopolist
Harberger's Triangle is the surplus

(consumer’s and producer’s) which MC = S
fails to accrue because an industry p
m
is controlled by a Monopolist rather
AC
than being competitive. It is thus a
useful measure of the (welfare) cost
of a monopolist to society as a
whole.
D
qm Q
MR
9.2.03 REGULATORY RESPONSES

It is because of the welfare loss associated with the monopolist's restricted output that monopolists
are often the target for regulation by government.
The aim of the government will (in most cases) be to encourage the monopolist to increase his output.
A punitive tax régime will not aid this endeavour. A per-unit tax will have the effect of causing the
monopolist to decrease output - the opposite of what is required.......
Microeconomics 355
9.2.04 A PER-UNIT TAX IMPOSED UPON A MONOPOLY

A per-unit tax imposed upon a Monopolist will not reduce the welfare loss (i.e. the Dead-weight
Efficiency Loss] but will in fact increase it.
P
MC1
A Per-Unit tax will cause the MC and AC

to rise vertically. This will cause the MC0
pt AC1
Monopolist to reduce its output, now
setting MC1 equal to his MR. pm
AC0
The Monopolist will now produce an
output of qt. This is the opposite of what
the government would desire, given that
the initial output of qm was insufficient in
the first place. D
qt qm q
MR
9.2.05 A LUMP SUM TAX IMPOSED ON A MONOPOLY

The imposition of a Lump-Sum tax will not alter the Monopolist’s level of output at all. A Lump-Sum tax,
as we have now seen several times, will cause the AC to rise, but will leave MC unchanged (as a Lump-
Sum Tax does not affect the gradient of the TC curve).
As MC = MR at the same level of output, the monopolist has no incentive to change the quantity it
produces.
P Profit before tax P Profit after tax
MC MC
pm pm AC1
AC
AC0
D
D
qm q qm q
MR MR
The profit maximising Monopolist will continue to produce an output of qm, and is merely relieved of
some of his economic profit.
356 Microeconomics
9.2.026 A PER-UNIT SUBSIDY GRANTED TO A MONOPOLY

A Per-Unit Subsidy, if granted to a Monopolist, would increase its output. This should be obvious,
because his MC and AC functions would shift vertically downwards, and it would now equate the new
MC1 with his MR, thus producing a higher level of output.
P
P
MC0 MC0
MC1
pm AC0 pm AC0
ps
AC1
D D
qm q qm qs q
MR MR
However, granting any form of a subsidy to a Monopolist (which is already making a vast amount of
profit) would be political suicide for any government!!!!!
[The only solution might be to grant a Per-Unit Subsidy and a Lump-Sum Tax simultaneously. Think
about it!]
9.2.07 A LUMP SUM SUBSIDY GRANTED TO A MONOPOLY

No government in their right mind would give a Monopolist a Lump-Sum Subsidy. This would merely
cause the magnitude of his economic profit to increase, without causing the slightest effect on his level
of output.
P Profit before P Profit after

the subsidy the subsidy
MC MC
pm AC0 pm AC0
AC1
D D
qm q qm q
MR MR
Granting a lump-sum subsidy to a monopolist which is already making a huge profit would be
tantamount to political suicide.
Microeconomics 357
9.2.08 REGULATORY RESPONSES (continued)

In practise, the method and measure of regulatory response will depend upon the source of monopoly
power itself. If the government creates a monopoly, for example, for reasons of national defence and
security, it will inevitably regulate it in a different manner to a private monopoly.
The left-wing political argument in the years immediately following the 2nd World War was that
nationalisation was the answer. The idea was that, if all monopolies came under government control,
these firms could be forced to produce at the price/output level as if they were in a competitive
market.
This was hardly a success, and the nationalisation of the 1940s to the 1970s has been reversed by
the Thatcher government and its successors.
All the big British monopolies that were nationalised between 1945 and 1979 have now been de-
nationalised (i.e. privatised)
British Airways privatised in 1985

British Coal partially privatised in 1999
British Gas privatised in 1987
British Rail partially privatised in 1997
British Steel privatised in 1986
British Telecom privatised in 1984
London Transport privatised gradually from 1984 through 1987
The Electricity Board privatised in 1991
The Water Board privatised in 1990
Royal Mail partially privatised in 1999
In many cases, these firms have been split into different private firms which can compete against each
other.
This was not the case with British Airways and British Telecom; but with both the “system” was
completely de-regulated, with the two being forced by governments to give potential rivals access to
their facilities.
This has worked effectively with British Telecom (Mercury, NTL, etc) – but not as well with British
Airways.
Regulation of Resource Based Monopolies

Governments can regulate to force the monopolist to sell off some of its natural resources – at a
government imposed price – to a (government selected) potential competitor, thus forming a
competitive market. This has been done – with a reasonable degree of effectiveness – with the water
and electricity industries in the UK.
Regulation of Patent and Copyright Monopolies

Governments are less likely to regulate here, as it can be demonstrated that the welfare losses
associated with such monopolies are more than outweighed by their benefits to society. The benefits
which accrue to society as a whole are new inventions, new works of literature, new music, etc. –
which, in the absence of some sort of copyright or patent system, might not be produced at all.
Even so, time-limits are put on patents. In the UK a patent lasts 25 years; in the USA it’s 17 years.
Regulation of Legal Monopolies

Given that these are government sanctioned, probably by political considerations rather than by any
form of economic rationale or logic, there is likely to be little regulation that the government can – or
would want to – instrument. Concurrently, the same political forces might argue that welfare gains to
society accruing from having the industry as a monopoly would outweigh any lost surplus.
358 Microeconomics
Regulation of Collusive Monopolies

Once again, given that these are government sanctioned, there is unlikely to be much regulated
instrumented. As argued, however, the benefits of having an armaments industry working in
collaboration in times of war may be seen to outstrip any welfare losses associated with Harberger’s
triangle.
Of course, if a group of companies collude without government permission, then they will open
themselves up to the full force of Anti-Trust Regulation (which we’ll look at in next term’s Oligopolistic
Competition).
Regulation of Natural Monopolies

A Natural Monopoly is one where economies of scale are so important that one firm can produce the
total output of an industry at a lower cost than the combined output of two or more firms competing
with each other. A typical example is a telecommunications company.
A natural monopoly is the most susceptible to regulation by government.
However, if the natural monopolist is relatively young, the government may be loathed to intervene in
the short run. Unlike firms in competition (or indeed other forms of monopoly) natural monopolies
have marginal cost functions which are downward sloping over large range of output.
MC
AC
D = AR
q
MR
In competitive markets – and other types of monopoly – an increase in demand will lead to an
increase in price.
P S
p1
p0
D1
D0
q0 q1 Q
Microeconomics 359
But this won't necessarily be the case with a natural monopolist!
Initially:
P
P0 MC
D0 = AR0
q0 Q
MR0
… and then, as the market grows (new technology like cell phones or DVDs “taking off”) there’s an
increase in demand:
P0 MC
P1
D1 = AR1
D0 = AR0
q0 q1 Q
MR0 MR1
…and as a result the price actually falls.
In the short-run, therefore, a government might be reluctant to intervene with a natural monopolist,
rather waiting for prices to decline and output to increase. In the long run, however, once an industry
is well established, the government will certainly want to intervene.
[This is why the United States government was so reluctant to intervene with Microsoft in the 1980s
and 1990s – it saw it as a Natural Monopolist which was still growing. It was only when the industry
was deemed to be established that the US government did start intervening. You may recall, just a few
years ago, that Microsoft very narrowly avoided being broken up into different companies by the US
government.)
Intervention – whether in a natural monopoly or any other type of monopoly – is a tricky issue, as we
have seen than normal forms of taxation fail to address the matter of the deadweight efficiency loss –
Harberger’s triangle. The only options left to government are direct price controls. These may take
the form of:
• average cost pricing or • marginal cost pricing
360 Microeconomics
9.2.09 AVERAGE COST PRICING
This is a form of regulation which forces the monopolist to produce where AC = AR. The firm will still
produce an output which is less than that which is Pareto efficient (i.e. like a competitive market where
MC = AR), but forcing it to produce a greater quantity would force it to go out of business.
ACP is a "second-best" pricing policy for a natural monopoly. (Why it is 2nd best will be seen shortly)
Average Cost Pricing

P
MC
AC
pac
D = AR
qac Q
MR
9.2.10 MARGINAL COST PRICING
MCP is a regulation which forces the firm to produce an output which would be produced if the market
were competitive: that is where the marginal cost equals average revenue.
Marginal Cost Pricing – Case 1
MC
AC
pmc
D = AR
qmc Q
MR
However, although Marginal Cost Pricing (above) would work, it would not work if the average cost
curve was significantly higher than shown above.
Microeconomics 361
If the firm’s average cost is high – as shown below – then Marginal Cost Pricing would push the firm
into a loss-making situation.
Marginal Cost Pricing – Case 2

P
MC
AC
pmc
D = AR
qmc Q
MR
The government will have to pay for this loss by means of a lump sum subsidy – or else the firm would
be forced to go out of business.
Subsidizing a monopolist would be a complete waste of taxpayers’ money, and however “bad” for
society the monopolist is, society is still better off with the monopoly existing than closing down
altogether. [Think how different the world would be, today, if something had forced Bill Gates to shut
down Microsoft 20 years ago.]
Hence – Average Cost Pricing is more often used than Marginal Cost Pricing. It is “Second Best”
because it does not force the monopolist to produce the efficient level of output (i.e. to where MC = AR
– that is: to where supply equals demand as would be the case in a competitive market, which would
be the “Best” solution), but it at least forces the monopolist to produce more and sell at a lower price,
thereby reducing (although not eliminating) the deadweight efficiency loss.
362 Microeconomics
9.2.11 PRICE DISCRIMINATION

A Monopolist operates at an inefficient level, given that it restricts output to a point where consumers
are willing to pay more for an extra unit than it would cost to produce it,
i.e. AR = MV and MV > MC.
The monopolist doesn't want to produce that extra unit, because it would mean forcing down the price
at which he has to sell all his output.
However, if the monopolist could sell different units of output at different prices, it would be a
different story. Such a price/output régime is known as Price Discrimination.
Economists generally consider there to be three types of price discrimination:
•• First - Degree Price Discrimination
First - degree price discrimination means that the monopolist sells different units of output for
different prices, and these prices differ from person to person.
This is sometimes known as Perfect Price Discrimination.
•• •• Second - Degree Price Discrimination
Second - degree price discrimination means that the monopolist sells different units of
output for different prices, but every individual who buys the same amount of goods
pays the same price. Thus, prices differ across the units of the good, but not across
people.
The most common example of this is bulk discounts.
•• •• •• Third - Degree Price Discrimination
Third - degree price discrimination means that the monopolist sells different
units of output for different prices, but every unit of output sold to a given
person sells for the same price.
This is the most common form of price discrimination, examples of which

include student discounts, senior citizens' discounts, different prices for 1st
class vs. 2nd class tickets on trains, 1st class vs. “economy” tickets for flights,
etc.
The Necessary Conditions for Discrimination:
Which ever kind of discrimination is in question, there are four conditions for it to exist:
1. The firm must be a monopolist - that is, a price maker.
2. The firm must have the ability to identify opportunities to discriminate.
3. There must be no risk of arbitrage.
4. The benefits derived from discriminating should outweigh the costs.
Microeconomics 363
9.2.12 FIRST - DEGREE PRICE DISCRIMINATION

Under Perfect Price Discrimination, each unit is sold to the individual who values it most highly - at the
highest price he is willing to pay. No consumers' surplus is generated: it all goes to the producer.
The surprising thing is that this achieves a Pareto efficient level of output . . . .
The perfect price discriminator must produce an output where price equals marginal cost. If AR > MC,
this would mean that there was someone willing to pay more than it costs to produce an extra unit of
output - so why not produce it and sell it to that person?
Thus, first degree price discrimination leads to a level of output where AR = MC : Pareto efficient. The
summation of consumers' and producer's surplus is maximised - it's just that the producer ends
up getting all of it!
As the word "perfect" suggests, this is a theoretical idealised concept. It does not exist in reality, but it
is interesting in that it gives an example of resource allocation other than perfect competition which
achieves Pareto efficiency.
The closest example to perfect discrimination would be that of a small town doctor who charges each
of his patients different prices, based on their ability to pay.
OG
Assuming the customer has money income
M, and that he can spend his income on the M0
Doctor's services [D] or Other Goods [OG], POG •α
then he would be indifferent between being
at point α where he buys no doctor's
services, and any other point on his
indifference curve.
Assume the doctor provides n units of his services:
The maximum that the consumer

would be willing to pay for these
OG services can be determined with
OG
reference to his indifference curve.
M0
POG •α
M0
POG •α
M0 − PD •β
n D POG
n D
364 Microeconomics
9.2.13 SECOND - DEGREE PRICE DISCRIMINATION

This is also known as non-linear pricing or multi-part pricing. It is "non-linear" because the price per
unit of output is not constant: it depends how many units you buy. Such discrimination is commonly
used by public utilities -for example, the price per unit of electricity depends on how much of it is
bought.
In other industries, bulk discounts for large purchases are occasionally available. Such discrimination
allows the firm to extract more of the purchaser's consumer's surplus than if a single price was
charged to all buyers, but obviously less than if the firm was able to practice perfect discrimination.
Two-Part Tariffs
A special form of second degree differentiation is known as a two-part tariff. Such a system is
practiced by utilities, and to a certain degree by Singapore Telecom for local calls.
The customers is allowed to buy any amount of, say, gas, at a given (low) price. In order to qualify,
however, he has to pay a "standing charge" or a "rental fee".
If he knew the precise nature of demand of the customer, the monopolist could equate the price per
unit to his marginal cost, and extract the entire consumer's surplus from the rental fee. This, like
perfect discrimination, would result in a Pareto efficient outcome - i.e. the last unit is sold at a price
which equals marginal cost.
Of course, the vendor will never know the precise nature of demand: he will thus attempt to extract
some of the consumer's surplus from the standing charge or rental fee, and then charge a per-unit
fee higher than marginal cost. All of you have had experience of the above. Every time you've been to a
disco or anywhere else with a "cover charge", this is what they are attempting to do!
OG
We can look at two part pricing
through the individual's indifference M0
curve, as we did with perfect POG •α
discrimination.
Assuming the customer has money

income M, he would be indifferent
between being at point α where he
buys none of the monopolist's goods
[MG], and any other point on his
indifference curve.
MG
Once again assume the monopolist provides n units of his good or service, but this time charges an up-
front fee of $F and then a per unit price of $p*, i.e. a two-part tariff rather than simply a one-off price.
Microeconomics 365
OG
The monopolist can choose where he
wants to be on the individual's indifference M0 α
function by selecting the appropriate POG •
combination of up-front fee $F and per
unit price $p*.
M0 − F
The up-front fee $F determines the POG
intercept of the consumer's budget
constraint, and the per unit price $p*
determines its gradient. OG0
n M0 − F MG
P*
In this manner, a 2nd degree price discriminator can extract a large lump-sum of the consumers’
surplus with its up-front fee.
It’s almost like a monopolist setting an output …. and then extracting a large part of the
where AR (almost) equals MC…….. consumers’ surplus as his up-front fee:
P P
MC MC
F
P2D P2D
D D
Q2D Q2D
MR MR
Of course, if the monopolist had perfect information about consumers’ marginal valuations, he would
charge a price which was equal to his marginal cost, and then extract the entire consumers’ surplus
as his up-front fee:
P
Of course, if the monopolist had MC

perfect information about
consumers’ marginal valuations, F = CS
he would charge a price which P2D*
was equal to his marginal cost,
and then extract the entire
consumers’ surplus as his up-
front fee:
D
Q2D*
MR
This would generate the same Pareto efficient as a perfect (1st degree) discriminator!
366 Microeconomics
Second-Degree Price Discrimination: A Numerical Example
A monopolist faces the following demand curve:
P(Q) = 212 – ½Q
and has a cost structure given by:

2
TC(Q) = 2,100 + 2Q + 1 /10 Q .
Determine her optimal two-tier pricing structure.
In the absence of any form of discriminatory practice, the monopolist will set MC = MR in the usual
manner:
MC = MR So: P = 212 – ½Q = 212 - ½(175) = $ 124.50

∴ 2 + 0.2Q = 212 – Q
2
∴ 1.2Q = 210 π = TR – TC = PQ – (2,100 + 2Q + 0.1Q )
2
∴ Q = 175 ∴ π = [124½ x175) – (2,100 + 2[175] + 0.1[175] )
∴ π = $16,450
If she engages a 2-part pricing system, she can sell each unit where AR = MC.
MC = AR So: P = 212 – ½Q = 212 - ½(300) = $ 62.0

∴ 2 + 0.1Q = 212 – 0.5Q
2
∴ 0.7Q = 210 ∴ π = [62 x300) – (2,100 + 2[300] + 0.1(300] )
∴ Q = 300 ∴ π = $6,900
So: she sells 300 units at a price of $62 – but that is the second part of the tariff. In order to
consume even the first unit, customers have to pay an up-front fee.
How much? Price

S = MC
[$]
The monopolist will try

to extract the entire
consumers’ surplus [212 – 62] x 300
with the first part of the CS =
2
tariff. $62
= $22,500
P = 212 – ½Q
300 Quantity
[units]
So: the monopolist will charge an “entrance fee” or “subscription charge” or “rental fee” of $22,500,
and sell each unit thereafter at $62.
In this way she makes profit of: $22,500 + $6,900 = $29,400 (almost 80% more than if she doesn’t
discriminate!)
Microeconomics 367
9.2.14 THIRD - DEGREE PRICE DISCRIMINATION

If the monopolist can identify two (or more) groups of people to whom it can sell the same
product at different prices, without risk of arbitrage, it will do so. These groups of people will
have a different price elasticity of demand for the good in question. This is why we see:
• First, Business and Economy Class on airlines
• First and Second Class on railways
• different grades of rooms in hotels
• lower prices for students who produce a student card
• discounts for senior citizens
• lower fares for children on buses and the MRT
The discrimination could also be geographical. MacDonalds sells an identical product (the Big Mac) at
completely different prices in Switzerland, China, Singapore and a hundred other countries.
Given that different demand conditions (i.e. different price elasticities of demand) existing in the
various different markets, if the monopolist were to seek to maximise profit in one or more market
segment, it would be unable to do so in the other segments.
The price discriminating monopolist will thus seek to maximise its over-all profits in the industry,
rather than in the individual market segments. It will do this by equating marginal revenue across all
markets.
Imagine two different market segments for the same good – i.e. the demand for Swatch watches in
Singapore (Market Segment 1) and the demand for Swatch watches in Malaysia (Market Segment 2).
The markets are significantly different.
P Singapore
Singapore has a small population, but that population is

significantly richer, on average, than the population
elsewhere in South East Asia. This means that the
demand for Swatch watches in Singapore has a high
choke price (the intercept of the demand curve on the
vertical axis) but because of the small population, the
market is relatively small (the demand curve hits the
horizontal axis at a fairly low level of output).
DS
qS
MRS
P Malaysia
Malaysia, on the other hand, will have a lower choke

price as the population is not as rich, on average.
This means that the demand curve intercepts the
vertical axis at a lower point than in Singapore.
But because of the larger population in Malaysia,

overall demand is greater than in Singapore – hence
the demand curve intercepts the horizontal axis at a
DM higher level of output
qM
MRM
368 Microeconomics
Horizontally summing up the two demand curves and the two Marginal Revenue curves:
Singapore Malaysia The Combined Market

P P P
DS DM ΣD
qS qM Q
MRS MRM ΣMR
we get a demand curve that is kinked, and a Marginal Revenue curve that is discontinuous.
To maximise profit, the monopolist will equate Marginal Cost to the horizontally summed Marginal
Revenue:

P P P
MC
DS DM ΣD
qS qM Q* Q
MRS MRM ΣMR
This determines the overall optimal level of output, Q*.
The firm will then equate Marginal Revenue across both markets:

P P P
MC
DS DM ΣD
qS qM Q* Q
MRS MRM ΣMR
Microeconomics 369
This determines the optimal amount of produce to sell in each market segment.

P P P
MC
DS DM ΣD
qS* qS qM* qM Q* Q
MRS MRM ΣMR
The monopolist will maximise profit by selling qS* units in Singapore, and qM* units in Malaysia, where
qS* + qM* = Q*.
The price charged in each market is determined by the demand in each market.

P P P
MC
PS
PM
DS DM ΣD
qS* qS qM* qM Q* Q
MRS MRM ΣMR
So, the monopolist will sell a small quantity for a high price in Singapore, and a higher quantity at a
lower price in Malaysia.
Imagine the situation occurred where the MC crosses ΣMR twice (due to the latter’s discontinuity)

P P P
MC
DS DM ΣD
qS qM Q
MRS MRM ΣMR
370 Microeconomics
The monopolist now has a dilemma: should it produce Q* or Q**?

P P P
MC
DS DM ΣD
qS qM Q*Q** Q
MRS MRM ΣMR
If it produces Q*, it will sell in Singapore alone (as the resultant price would be above Malaysia’s choke
price). If it makes Q**, it will sell in both markets.
It will select the option which maximises profit. With the above case, that would be Q**, but that need
not always be the case.
Why Q**? This can best be shown mathematically but it can also be seen graphically by a very careful
analysis of the difference between MR and MC.

P P P
MC
DS DM ΣD
qS qM Q*Q** Q
MRS MRM ΣMR
Magnifying the tiny area of the above diagram, circled above, we get:
Q* Q**
Microeconomics 371
As output increases from Q* to Q’, we are But as output increases beyond Q’, we are
no longer maximising profit, and the decline once again moving towards a profit maximum,
in profit can be measured by looking at the and gain in profit can be measured by looking
difference between MC and MR: at the difference between MC and MR:
Q*Q’ Q** Q*Q’ Q**
This area is bigger, so the profit maximising firm will make Q**, and sell in both countries.
The Efficiency of 3rd-Degree Price Discrimination
In terms of Pareto efficiency, the result of 3rd Degree Price Discrimination is ambiguous.
The final result is obviously not efficient, but the question is: is it nearer to being efficient than if
discrimination had not occurred?
g
g If Q* is less than what would have been produced, then total surplus has decreased: so no.
g
g If Q* exceeds what would have been produced, then maybe! It depends on the exact situation.
Consumers in market segment 1 are paying a higher price than previously - obviously some surplus
transfer - and sales in that segment are lower - obviously a welfare loss.
Consumers in market segment 2 are paying a lower price than previously - obviously another surplus
transfer - and sales in that segment are greater than before - obviously a welfare gain.
Whether the gain exceeds the loss will vary from case to case.
With linear cases (such as the ones I have shown) there will definitely be a welfare loss. If demand
functions are non-linear, then it is theoretically possible that there will be a welfare gain.
372 Microeconomics
Third-Degree Price Discrimination: A Numerical Example
A monopolist faces two market segments in which the demand functions are given as:
Market 1: p1 = 160 - 4q1
Market 2: p2 = 100 - 0.8q2
where p1 and p2 are the prices in the relevant markets, q1 and q2 are the quantities (in thousands of
units) in the relevant markets, and a Total Cost function given as:
TC = 2,000 + 12Q + ½Q2
where Q is output (in thousands of units).
Determine the profit maximising price/output combination between the two segments.
Step 1: Get each market’s MR function, then flick it around to get it in terms of q.
P Market Segment 1
Segment 1:
p1 = 160 – 4q1
∴ MR1 = 160 – 8q1
∴ 8q1 = 160 – MR1
∴ q1 = 20 – 0.125MR1
D1
q1
MR1
P Market Segment 2
Segment 2:
p2 = 100 – 0.8q2
∴ MR2 = 100 – 1.6q2
∴ 1.6q2 = 100 – MR2
∴ q2 = 62.5 – 0.625MR2
D2
Q
MR2
We now have the functions in a format which are very easy to horizontally sum.
Microeconomics 373
Step 2: Sum the two MR curves, then flick the equation back in terms of money.
P
The Combined Market
q1 = 20 − 0.125MR1
q2 = 62.5 – 0.625MR2
q* = 82.5 – 0.75MR*
∴ 0.75MR* = 82.5 – q*
∴ MR* = 110 – 1.333’q*
ΣD
Q
ΣMR or MR*
Step 3: Equate the combined MR to MC, solving for total output.
TC = 2,000 + 12Q + ½ Q2
∴ MC = 12 + 1Q
Setting MC = MR: 12 + 1Q = 110 – 1.333’q* where q* = Q
∴ 2.333’Q = 98
∴ Q = 42
So: total output is 42,000 units:
Segment 1 Segment 2 The Combined Market

P P P
MC
D1 D2 ΣD
q1 Q2 42,000 Q
MRS MRM ΣMR
How will this be split across the two market segments?
By equating Marginal Revenue in both, so the next thing we need to do is to compute what MR is when
Q = 42,000.
374 Microeconomics
Step 4: Solve for MR (or MC) at the profit maximising level of output.
MC = 12 + 1Q ∴ MC = 12 + 1[42] ∴ MC = 54 [= MR*]
Segment 1 Segment 2 The Combined Market

P P P
MC
54
D1 D2 ΣD
q1 Q2 42,000 Q
MRS MRM ΣMR
Step 5: Equate MR across both market segments. Solve for prices and output.
Segment 1: Segment 2:
q1 = 20 – 0.125MR1 q2 = 62.5 – 0.625MR2

∴ q1 = 20 – 0.125[54] ∴ q2 = 62.5 – 0.625[54]
∴ q1 = 20 – 6.75 ∴ q2 = 62.5 – 33.75
∴ q1 = 13.75 ∴ q2 = 28.75
p1 = 160 – 4q1 p2 = 100 – 0.8q2

∴ p1 = 160 – 4[13.75] ∴ p2 = 100 – 0.8[28.75]
∴ p1 = 160 – 55 ∴ p2 = 100 – 23
∴ p1 = 105 ∴ p2 = 77
So – the firm should sell:
13,750 units in … and 28,750 units in

Segment 1 at a Segment 2 at a price of
price of $105.00 $77.00 each.
P Segment 1 P Segment 2 P The Combined Market
MC
105
77
54
D1 D2 ΣD
13,750 q1 28,750 Q2 42,000 Q
MRS MRM ΣMR
Microeconomics 375
The firm’s profit:
π = TR1 + TR2 − TC
∴ π = p1. q1 + p2. q2 – 2,000 – 12Q – ½ Q2
∴ π = (105)(13.75) + (77)(28.25) – 2,000 – 12(42) – ½ (42)2

∴ π = 1,443.75 + 2,175.25 – 2,000 – 504 – 882
∴ π = $1,997
So: profit is $1,997 million
9.2.15 THIRD - DEGREE PRICE DISCRIMINATION (continued)

Another way of showing 3rd-degree Price Discrimination - which some students will find intuitively
appealing, others will find extremely complex (if you belong to the latter group: IGNORE IT ) - is to show
Market 2, laterally inverted, mapped on top of Market 1.
In this manner, one can graphically equate Marginal Revenue in both market segments in a very easy
manner.
[n.b. this analysis starts with the premise that the overall quantity, q*, is pre-determined - i.e. as in the
case as of a plane to Hong Kong: total seat availability is given; it is the split between 1st Class,
Business and Economy which is the profit maximiser's problem]
Start by drawing both market segments:
P SEGMENT 1 P SEGMENT 2
D1 D2
Q Q
MR1 MR2
…….. and then laterally invert Market 2.
376 Microeconomics
Laterally inverting Market 2:
SEGMENT 2 P
D2
Q
MR2
Map Market 2 on top of Market 1:
P P
SEGM EN T 1 SEGM ENT 2
D2 D1
Q Q
M R2 M R1
Equating MR1 to MR2 gives the profit maximising solution, showing the total quantity split between
market segments, and the relevant prices in different segments.
P P
SEGMENT 1 SEGMENT 2
P1
P2
D2 D1
Q q1 q2 Q
MR 2 MR 1
Microeconomics 377
9.2.16 INTER-TEMPORAL PRICE DISCRIMINATION

A monopolist may find it profitable to discriminate in price between periods – what is known as inter-
temporal price discrimination. This can be analysed in the same manner as third degree price
discrimination, with:
"Market 0" being the market now,
"Market 1" being the market later.
In order to maximise profits the Monopolist will attempt to equate discounted marginal revenues in
each period.
i.e. MR1 = (1 + r)MR0
where r is the market rate of interest.
[A perfectly competitive industry would seek to equate discounted prices in each period.]
Assume a demand curve, with corresponding MR, which is identical in nominal terms over two periods,
this year and next year:
Pt0 2007 Pt1 2008
Dt0 Dt1
Qt0 Qt1
MRt0 MRt1
In Real Terms however, moneys received a year from now are less worth than moneys received now,
thus we need to discount the second period’s D and MR by the market rate of interest.
Pt0 2007 Pt1 2008
Dt0 Ddt1 Dt1

Qt0 Qt1
MRt0 MRt1 MRd t1
Now the two time periods can be treated as two “market segments”, and the problem can be
approached in an identical manner as 3rd degree price discrimination.
378 Microeconomics
9.2.17 SKIMMING
If potential customers fail to anticipate a lower price in a future time periods, the monopolist may
"skim" the market.
Assuming customers are myopic (i.e. blind to the fact that the price will fall in later time periods) the
monopolist can charge a very high price initially, and continue to do so until demand dries up.
He can then lower the price marginally, and repeat the process.
P
Pt0
Pt1
Pt2
Pt3
qt0 qt1 qt2 qt3 Q
In time period t0, the monopolist charges pt0 and sells a resultant qt0.
Having done so, he reduces the price to pt1 in the next time period, and sells a resultant qt1.
When he has sold all that he can at this price, he further reduces his price to pt2 in the next time
period, and sells qt2, etc.
In this way, he manages to extract the maximum consumers' surplus.
If potential customers are not myopic, but form the rational expectation that the price will drop in
future time periods, only the very impatient will buy in early time periods. Taken to the extreme: faced
with rational consumers, the monopolist loses his monopoly power.
This is the essence of the Coase Conjecture.
9.2.18 THE COASE CONJECTURE
If potential customers are rational, and prices can change instantaneously, all customers will form the
expectation that the price will eventually fall to marginal cost. No customer will buy the product until
the price has fallen to marginal cost. In equilibrium, the monopolist will have to reduce his price to
marginal cost very quickly, thereby losing his monopoly power.
It is therefore in the interest of the monopolist not to discriminate inter-temporally. If he can make a
(credible) commitment that he will not lower his price, a certain number of customers will purchase his
product in the first period.
He has to then avoid the temptation of lowering the price in the second period, or else his price
commitments will never be perceived as credible again.
Microeconomics 379
9.3
MONOPOLISTIC COMPETITION [1]
Monopolistic Competition is "Monopolistic " - because each firm has a degree of local monopoly
power over its own products - and hence each individual firm faces its own, unique downward sloping
demand curve.
It is "Competition " - because their monopoly power is restricted by the presence of similar products
sold by competing firms, and entry costs are low.
Market Conditions
1. There are a large number of firms (as in perfect competition)
2. There are few barriers to entry and exit (as in perfect competition)
3. The goods are non-homogeneous (unlike perfect competition)

i.e. differentiated products (similar to Monopoly)
The major difference between monopolistic and perfect competition lies in this product differentiation.
In perfect competition firms sell a good that is homogeneous, meaning that buyers cannot physically
distinguish between products sold by different firms in the industry. They regard the goods as perfect
substitutes for one another.
In monopolistic competition firms sell a differentiated product. These are goods which are similar
enough to be classified as "one product", but are dissimilar enough so that buyers can distinguish
between products sold by different firms in the industry.
Because consumers regard the products as close (but not perfect) substitutes for each other, each
producer has a certain degree of monopoly power over his own price/output combination.
9.2.19 MONOPOLISTIC COMPETITION – The Short Run

P
In the short-run, given that the firm
possesses a certain degree of
monopoly power (and hence a
downward-sloping demand curve), it
will equate marginal revenue to MC
marginal cost in order to maximise pm
profit. AC
π
D
qm q
MR
In other words, we start off with the basis monopoly diagram.
380 Microeconomics
But unlike a monopoly, this is not a stable equilibrium. Seeing economic profit being made, other firms
will be enticed into the industry.
As these new firms enter, all existing firms receive a smaller and smaller market share. [The “pie” is
being spread amongst more and more players.]
Monopolistic Competition: Long Run Equilibrium
In the long-run, supranormal profit will be eliminated, as new firms enter the industry. Firms will
enter, enticed by the prospect of profit. The resultant effect is that the demand curve facing individual
firm is pushed down to a point tangential to their average cost curve - AC = AR.
Enticed by profit, other firms enter the industry.

To start with: Demand facing existing firms declines:
P P
MC MC
pm pm
AC AC
π
D D1 D0
qm q qm q
MR
MR0
This decrease in demand will be associated with The incumbent firms adjust their output to
a corresponding change in MR: where MC = MR1:
P
P
MC
MC
pm
pm
p1 AC
AC
D0 D1 D0
D1
qm q q1 qm q
MR0 MR0
MR1 MR1
Less economic profit is now being made.
Microeconomics 381
MC
pm Less economic profit is now being made.
p1 AC
D1 D0
q1 qm q
MR1 MR0
P
MC
But as some economic profit is still being pm
made........ other firms will still be attracted p1 AC
into the industry. Demand facing each
incumbent firm will continue to decline ……
D1 D0
D2
q1 qm q
MR1 MR0
P
MC
AC Firms will continue to enter the industry

until all economic profits have been
p* eliminated.
The long-run equilibrium is where the

demand curve is tangential to the average
cost curve, with the firms making zero
economic profit (i.e. they break even]
D = AR
q* q
MR
Since AC=AR, no economic profit is being made. There is now no incentive for any other firm to enter
the industry; but as no losses are being made there is not any immediate incentive for any firm to leave
the industry. We have an equilibrium.
[More about Monopolistic Competition early next year, when we’ve discovered a bit about game theory and Oligopolistic
Competition.]
382 Microeconomics

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9.01 CONCENTRATION RATIOS

CR10 = 23%: Competitive

9.02 THE HERFINDAHL-HIRSCHMANN INDEX

= 0.81 + 9(0.0001) = 0.8109

9.03 THE LERNER MONOPOLY INDEX

[Price – Marginal Cost]

The necessary conditions for a perfectly competitive market to exist are.....

2. There Must Be a Vast Number of Buyers and Sellers

...... each individual producer and consumer is therefore a "Price Taker".

3. There Are No Barriers to Either Entering or Leaving the Industry

4. Entry and Exit Costs are Extremely Low

Nevertheless, the model is worthwhile examining as it is useful in an academic way:

(a) easy entry and exit

did all coincide with each other.

The Industry A Representative Firm

The Industry A Representative Firm

A Representative Firm’s Its Corresponding Total

Okay - on to that fundamental relationship that I was talking about…………….

which we could re-write as:

This can be further modified to:

which, of course, can be re-written as:

The price elasticity of demand, η, you will remember, is defined as:

… and thus, Marginal Revenue can be written as:

In the case of a perfectly competitive firm, η is approaching infinity, and thus:

9.1.01 PERFECTLY COMPETITIVE BEHAVIOUR

Each firm in a competitive industry is a price taker:

Magnifying the firm's diagram:

In terms of MC and MR:

In terms of the MC and MR:

P The Industry P A Representative Firm

P3 LOSS (−π) AR3 = MR3

The firm should

9.1.02 MC: THE FIRM’S SUPPLY CURVE

9.1.03 THE PERFECTLY COMPETITIVE EQUILIBRIUM

P The Industry S0 P A Representative Firm

P The Industry P A Representative Firm

9.1.04 PERFECT COMPETITION: A MATHEMATICAL EXAMPLE

a) The firm’s short run supply curve.

So: the first thing we need to do is to find the

If we look at Total cost, and take away the fixed

Getting an expression for Marginal cost: $ MC

So the short-run supply curve is:

b) The firm’s long run supply curve.

dAC = – 200 + 2qi – 16 = 0

…which is close enough.

We know from earlier that:

$ MC Substituting for q = 9.19:

subject to the equilibrium price of the

c) The Industrial equilibrium

9.1.05 A CHANGE IN VARIABLE COSTS

Hence the TC function would pivot upwards:

And the Marginal Cost function rises,

9.1.06 A CHANGE IN FIXED COSTS

But notice that there has been no change in the

If Average Cost rises, but

9.1.07 A PER-UNIT TAX

9.1.08 A PER-UNIT SUBSIDY

9.1.09 A LUMP SUM TAX

9.1.10 A LUMP SUM SUBSIDY

9.1.11 TAXES AND SUBSIDIES DONE MATHEMATICALLY

Imagine a firm with a Total Cost function as follows:

and “bq + cq2“ is obviously related to q – i.e. the Variable Cost.

The Average Cost