Managing in Competitive, Monopolistic, and Monopolistically

Competitive Markets
Chapter 8

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 Learning Objective
• Identify the conditions under which firm operates as perfectly
competitve, monopolistically competitive or a monopoly
• Apply marginal principle to determine the profit-maximazing
price and output
• Decide whether a firm making short-run loseses should continue
or shutdown

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 Introduction

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 Four types of Market Structure

Economists who study industrial organization divide markets into four types—
monopoly, oligopoly, monopolistic competition, and perfect competition.
Resources : Principles of Economic, George Mankiw
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What is a Competitive Market?
The Meaning of Competition
A competitve market, sometimes called perfectly competitve
market, has two characteristic
• There are many buyers and many seller in the markets.
• The goods offered by the various seller are largely the same.

As a result of these conditions, the actions of any single buyer or

seller in the market have a neglible impact on the market price.
Buyer and seller takes the market price as given.

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 Competitive Market
Characteristics

Perfectly competitive markets are characterized

by:
• The interaction between many buyers and sellers that are “small” relative
to the market.
• Each firm in the market produces a homogeneous (identical) product.
• Buyers and sellers have perfect information.
• No transaction costs.
• Free entry into and exit from the market.
• The implications of these conditions are:
a single market price is determined by the interaction of demand and supply
firms earn zero economic profits in the long run.

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Example of a perfectly competitive market

Exampe 1 : As an example, consider the market of milk. No single consumer of

milk can influence the price of milk because each buys a small amount relative
to the size of market. Similiarly dairy farmers has limited control over the price
because many sellers are offering milk that is essentially identical.

Example 2 : One classic example of a perfectly competitive market is

agriculture. There are many farmers and ranchers, and each is so small relative
to the market that he or she has no perceptible impact on the prices of corn,
wheat, pork, or beef. Agricultural products tend to be homogeneous; there is
little difference between corn produced by farmer Jones and corn produced by
farmer Smith.

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Demand at the Market and Firm Levels Under firm demand curve
The demand curve for an
Perfect Competition (Figure 8-1) individual firm’s product;
in a perfectly competitive
market, it is simply the
market price.
Price Price
Firm
Supply

𝑃𝑒
𝐷 𝑓 = 𝑃𝑒

Demand

0 Market Firm’s
output output
The left-hand panel depicts the market, where the equilibrium price, Pe is determined by the intersection of the market
supply and demand curves. From the individual firm’s point of view, the firm can sell as much as it wishes at a price of
Pe; thus, the demand curve facing an individual perfectly competitive firm is given by the horizontal line in the right-
hand panel, labeled © 2022 by McGraw-Hill Education. All Rights Reserved. -8
 Short-Run Output Decisions
The short run is a period of time over which some factors of production are
fixed.

To maximize short-run profits, managers must take as given the fixed inputs (and
fixed costs) and determine how much output to produce by changing the
variable inputs.

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 Maximizing Profit
Under perfect competition, the demand for an individual firm’s product is the market price of
output, which we denote P. If we let Q represent the output of the firm, the total revenue to the
firm of producing Q units is R = PQ. Since each unit of output can be sold at the market price
of P, each unit adds exactly P dollars to revenues.

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 Revenue, Costs, and Profits for a Perfectly
Competitive Firm (Figure 8-2) Costs
$ 𝐶 𝑄

Revenue
𝑅 =𝑃×𝑄
B
Maximum
profits
Marginal revenue
is the change in revenue Slope of 𝐶 𝑄 = 𝑀𝐶
Slope of 𝑅 = 𝑀𝑅 = 𝑃
attributable to the last
unit of output. A

Profit –
maximizing
output

0 𝑄∗ Firm’s output

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 Competitve Firm’s Demand
The demand curve for a competitive firm’s product is a horizontal line at the
market price. This price is the competitive firm’s marginal revenue.
𝐷 𝑓 = 𝑃 = 𝑀𝑅 PRINCIPLE

A CALCULUS ALTERNATIVE
Marginal revenue is the derivative of the revenue function. For a perfectly competitive
firm, revenue is
𝑅 = PQ

where P is the market equilibrium price. Thus,

𝑑𝑅
MR = =𝑃
𝑑𝑄
The profits of a perfectly competitive firm are simply the difference between revenues
and costs:
𝜋 = 𝑃𝑄 − 𝐶 (𝑄)

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 Profit Maximization under Perfect
Competition (Figure 8-3)
$
𝐴𝑇𝐶
𝑀𝐶

𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅
𝑃𝑒
Profits
𝐴𝑇𝐶 𝑄 ∗

0 𝑄∗ Firm’s output

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 Profit Maximization under Perfect
Competition (Figure 8-3)
An alternative way to express the competitive output rule is depicted in Figure 8–3, where
standard average and marginal cost curves have been drawn.

The shaded rectangle in Figure 8–3 represents the maximum profits of the firm. To
see this, note that the area of the shaded rectangle is given by its base (Q*) times the
𝐶 𝑄∗
height 𝑃𝑒 − 𝐴𝑇𝐶(𝑄∗ ) Recall that 𝐴𝑇𝐶 𝑄 ∗ = ; that is, average total cost is total
𝑄∗
cost divided by output. The area of the shaded rectangle is

𝐶(𝑄∗ )
𝑄∗ 𝑃𝑒 − = 𝑃 𝑒 𝑄 8 − 𝐶(𝑄 ∗ )
𝑄∗
which is the definition of profits.

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 Competitive Output Rule
To maximize profits, a perfectly competitive firm produces the output at which price
equals marginal cost in the range over which marginal cost is increasing.
𝑃 = 𝑀𝐶 𝑄
PRINCIPLE
A Calculus Alternative
The profits of a perfectly competitive firm are
𝜋 = 𝑃𝑄 − 𝐶 𝑄
The first-order condition for maximizing profits requires that the marginal profits be
zero:

𝑑𝜋 𝑑𝐶 𝑄
=𝑃− =0
𝑑𝑄 𝑑𝑄
Thus, we obtain the profit-maximizing rule for a firm in perfect competition:
𝑑𝐶
𝑃=
𝑑𝑄
or

P= 𝑀𝐶
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 Competitive Output Rule

PROBLEM

The cost function for a firm is 𝐶 𝑄 = 5 + 𝑄 2 .

If the firm sells output in a perfectly competitive market and other firms in the
industry sell output at a price of $20, what price should the manager of this firm
charge?

What level of output should be produced to maximize profits? How much profit
will be earned?

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Competitive Output Rule

ANSWER

Since the firm competes in a perfectly competitive market, it must charge the same
price other firms charge; thus, the manager should price the product at $20. To find
the profit-maximizing output, we must equate price with marginal cost. This firm’s
marginal costs are MC = 2Q.

Equating this with price yields 20 = 2Q

so the profit-maximizing level of output is 10 units. The maximum profits are thus
𝜋 = 20 10 − 5 + 102 = 200 − 5 − 100 = $95

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 Short-Run Loss Minimization (Figure 8-4)
$ 𝐴𝑇𝐶
𝑀𝐶
𝐴𝑉𝐶

𝐴𝑇𝐶 𝑄 ∗
𝑒
Loss 𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅
𝑃

0 𝑄∗ Firm’s output
Consider first a situation where there are some fixed costs of production. Suppose the market price, Pe, lies below the average total
cost curve but above the average variable cost curve, as in Figure 8–4. In this instance, if the firm produces the
output Q*, where Pe = MC, a loss of the shaded area will result.
18
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 The Shut Down Case
𝑀𝐶 𝐴𝑇𝐶
$ 𝐴𝑉𝐶

Loss if shut down

𝐴𝑇𝐶 𝑄 ∗
∗
Fixed Cost
𝐴𝑉𝐶 𝑄
𝑃𝑒 𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅
Loss if produce

0 𝑄∗ Firm’s output
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Short- Run Output Decision Under Perfect Competition Methods of Procuring Inputs

In some circumstances, however, the firm will decide to shutdown and not
produce anything at all.
• A shut down refers to a short run decision not to produce anything during
spesific period of the time because of current market condition.
• The firm shut down if the revenue that it would be earn from producing is less
than its variable costs of production.

A bit of mathematics can make this shut down rule more useful. If TR is total revenue and
VC stands for variable cost, then the firm’s decision can be written as
Shut down if TR < VC
The firms shuts down if TR < VC. By dividing both sides of the inequality by the quantity (Q),
we can write as Shut down if TR/Q < VC/Q

We can restated as

Shut down if P < AVC

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 Short-Run Firm Supply Curve for a
Competitive Firm (Figure 8-6)
𝑀𝐶
$
Short-run supply
curve for individual firm
𝐴𝑉𝐶
𝑃1

𝑃0

0 𝑄0 𝑄1 Firm’s output
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The Short-Run Firm and Industry Supply Curves

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 The Short-Run Firm and Industry
Supply Curves
The short-run supply curve for a perfectly competitive firm is its marginal cost curve
above the minimum point on the 𝐴𝑉𝐶 curve, as illustrated in Figure 8-6
PRINCIPLE

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 The Market Supply Curve 8-7
Individual firm’s
supply curve
𝑀𝐶𝑖 Market supply
curve
S

$12

$10

0 1 500 Market output

Notice that the industry supply curve is flatter than the supply curve of an individual firm and that the more firms
in the industry, the farther to the right is the market supply curve.

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 Entry and Exit : The Market and Firm’s
Demand
Market Firm
Price 𝑆2 Price

𝑆0
𝑆1
𝐸𝑥𝑖𝑡 𝐸𝑛𝑡𝑟𝑦
𝑃2 𝐷 𝑓 = 𝑃2 = 𝑀𝑅2
Exit
𝑃0 𝐷 𝑓 = 𝑃0 = 𝑀𝑅0
Entry
𝑃1 𝐷 𝑓 = 𝑃1 = 𝑀𝑅1

D
0 Market 0 Firm’s
output output
One important assumption underlying the theory of perfect competition is that of free entry and exit. If firms earn short-run economic profits,
in the long run additional firms will enter the industry in an attempt to reap some of those profits. As more firms enter the industry, the
industry supply curve shifts to the right. © 2022 by McGraw-Hill Education. All Rights Reserved. 25
 Long-Run Competitive Equilibirum ( Figure 8-9)
$ 𝑀𝐶

𝐴𝐶
Long-run competitive
equilibrium

𝑃𝑒 𝐷 𝑓 = 𝑃𝑒 = 𝑀𝑅

0 𝑄∗ Firm’s output

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 Long-Run Competitive Equilibrium

In the long run, perfectly competitive firms produce a level of output such that
1. 𝑃 = 𝑀𝐶
2. 𝑃 = 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝐴𝐶 PRINCIPLE

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Monopoly and Monopoly Power

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 Transaction Costs
Monopoly and Monopoly Power
Monopoly: A market structure in which a single firm serves an entire market for a
good that has no close substitutes.

The fundamental cause of monopoly is barriers to entry : A monopoly remains the

only seller in its market beceause others firms cannot enter the market and compete
with it.

Barriers to entry, in turn, have two main sources :

• Monopoly sources : A Key resources required for production is owned by a single
firm
• Goverement regulation : The Goverement gives a single firm the exclusive right to
produce some good or services

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 Monopoly Power
Being the sole seller of a good in a market gives that
firm greater market power than if it competed against
other firms.

Implication:
market demand curve is the monopolist’s demand
curve.
However, a monopolist does not have unlimited
market power.
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The Monopolist’s Demand Figure 8-10 Monopoly

Monopolist’s power is constrained

Price by the demand curve.

A
𝑃0

𝑃1 B

𝐷 𝑓 = 𝐷𝑀

0 𝑄0 𝑄1 Output

Figure 8–10 depicts the demand curve for a monopolist.

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Sources of Monopoly Power

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Sources od Monopoly Power Monopoly

Economics of Scale : exist whenever long-run average costs decline as output

increases.
– Diseconomies of scale: exist whenever long-run average costs increase
as output increases.

Economies of scope: exist when the total cost of producing two products
within the same firm is lower than when the products are produced by
separate firms.

Cost complementarity: exist when the marginal cost of producing one output
is reduced when the output of another product is increased.
Patents and other legal barriers

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 Elasticity of Demand and Total
Revenues (Figure 8-12)
Price Revenue
Maximum revenues
Elastic 𝑃0 × 𝑄0

Unitary Total Revenue

Unitary 𝑅0 R(Q)
𝑃0

Inelastic

Demand

0 𝑄0 Q 0 𝑄0 Firm’s
MR output
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 Marginal Revenue and Elasticity
Formula : Monopolist’s Marginal Revenue
The monopolist’s marginal revenue function is
1+𝐸
𝑀𝑅 = 𝑃
𝐸
where 𝐸 is the elasticity of demand for the monopolist’s
product and 𝑃 is the price charged.

– For 𝑃 > 0
• 𝑀𝑅 > 0 when 𝐸 < −1.
• 𝑀𝑅 = 0 when 𝐸 = −1.
• 𝑀𝑅 < 0 when −1 < 𝐸 < 0.
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 Marginal Revenue and Linear
Demand
Given a linear inverse demand function

𝑃 𝑄 = 𝑎 + 𝑏𝑄
where 𝑎 > 0 𝑎𝑛𝑑 𝑏 < 0, the associated marginal revenue is

𝑀𝑅 𝑄 = 𝑎 + 2𝑏𝑄

In addition to the general formula for marginal revenue that is valid for all demand
functions, it is useful to have the following formula for marginal revenue, which is
valid for the special case of a linear inverse demand function.

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Marginal Revenue in Action

PROBLEM

Suppose the inverse demand function for a monopolist’s product is given by

𝑃 = 10 − 2𝑄.
What is the maximum price per unit a monopolist can charge to be able to sell 3
units? What is marginal revenue when 𝑄 = 3?

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Marginal Revenue in Action

ANSWER
First, we set Q = 3 in the inverse demand function (here a = 10 and b = −2) to get
𝑃 = 10 − 2 3 = $4.
Thus, the maximum price per unit the monopolist can charge to be able to sell 3 units is $4.
To find marginal revenue when Q = 3, we set Q = 3 in the marginal revenue formula for
linear inverse demand to get
𝑀𝑅 = 10 − 2 2 3 = −$2

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 Monopoly Output Rule
A profit-maximizing monopolist should produce the output, 𝑄𝑀 , such that marginal
revenue equals marginal cost:
PRINCIPLE
𝑀𝑅 𝑄𝑀 = 𝑀𝐶 𝑄𝑀
A CALCULUS ALTERNATIVE

The profits for a monopolist are

𝜋 = 𝑅 𝑄 − 𝐶(𝑄)
where R(Q) is total revenue. To maximize profits, marginal profits must
be zero:

𝑑𝜋 𝑑𝑅(𝑄) 𝑑𝐶 𝑄
= − =0
𝑑𝑄 𝑑𝑄 𝑑𝑄
or
𝑀𝑅 = 𝑀𝐶

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Cost, revenues, and Profits Under
Monopoly 𝐶 𝑄
Cost function
( Figure 8-13)

$
Slope of
𝑅 = 𝑀𝑅

Slope of
𝐶 𝑄 = 𝑀𝐶

0 𝑄𝑀 Output

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Costs, Revenues, and
Profits Under Monopoly
(Figure 8-13) with Profit
Curve

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Profit Maximization Under Monopoly
( Figure 8-14)

MC
Price 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 =
𝑃𝑀 − 𝐴𝑇𝐶 𝑄𝑀 × 𝑄𝑀 ATC

𝑃𝑀
Profits
𝐴𝑇𝐶(𝑄𝑀 )

Demand
𝑄𝑀 Quantity
MR

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 Monopoly Pricing Rule
Given the level of output, 𝑄𝑀 , that maximizes profits, the monopoly price is the price
on the demand curve corresponding to the 𝑄𝑀 units produced:
𝑃𝑀 = 𝑃 𝑄𝑀 PRINCIPLE

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 Monopoly in Action
PROBLEM

Suppose the inverse demand function for a monopolist’s product is given by

𝑃 = 100 − 2𝑄
and the cost function is 𝐶 𝑄 = 10 + 2𝑄.
Determine the profit-maximizing price, quantity and maximum profits.

Answer:
Profit-maximizing output is found by solving: 100 − 4𝑄 =
2 ⟹ 𝑄𝑀 = 24.5.
The profit-maximizing price is: 𝑃𝑀 = 100 − 2 24.5 =
$51.
Maximum profits are: 𝜋 = $51 × 24.5 − (10 + 2 ×
24.5) = $1,190.50.

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 Monopoly

The Absence of a Supply Curve

• Recall, firms operating in perfectly competitive markets
determine how much output to produce based on
price (𝑃 = 𝑀𝐶).
– Thus, a supply curve exists in perfectly competitive
markets.

A monopolist’s market power implies 𝑃 > 𝑀𝑅 = 𝑀𝐶.

A monopolist determines how much to produce based on marginal
revenue which is less than price; a change in quantity will change market
price.
Thus, there is no supply curve for a monopolist, or in markets served by
firms with market power.

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 Multiplant Decision
Often a monopolist produces output in different locations.
– Implications: manager must determine how much output to
produce at each plant.

Consider a monopolist producing output at two plants:

– The cost of producing 𝑄1 units at plant 1 is 𝐶 𝑄1 , and the
cost of producing 𝑄2 at plant 2 is 𝐶 𝑄2 .
– When the monopolist produces identical products at two
plants, the per-unit price consumers are willing to pay for the
total output produced at the two plants is 𝑃 𝑄 , where 𝑄 =
𝑄1 + 𝑄2 .

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Multiplant Output Rule Monopoly

Profit Maximization Rule for a two-plant monopolist: Produce output in each plant such
that MC of producing in each plant = MR of total output

Multiplant Output Rule

Let 𝑀𝑅 𝑄 be the marginal revenue of producing a total of 𝑄 = 𝑄1 + 𝑄2 units of

output. Suppose the marginal cost of producing 𝑄1 units of output in plant 1 is 𝑀𝐶1 𝑄1
and that of producing 𝑄2 units in plant 2 is 𝑀𝐶2 𝑄2 . The profit-maximizing rule for the
two-plant monopolist is to allocate output among the two plants such that:
𝑀𝑅 𝑄 = 𝑀𝐶1 𝑄1
𝑀𝑅 𝑄 = 𝑀𝐶2 𝑄2

PRINCIPLE

6-47
 Implications of Entry Barriers
A monopolist may earn positive economic profits,
which in the presence of barriers to entry
prevents other firms from entering the market to
reap a portion of those profits.
– Implication: monopoly profits will continue over
time provided the monopoly maintains its market
power.

• Monopoly power, however, does not guarantee

positive profits.
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 A Monopolist Earning Zero Profit
(Figure 8-15)
Price MC
ATC

𝑃𝑀 = 𝐴𝑇𝐶(𝑄 𝑀 )

Demand

𝑄𝑀 Quantity
MR

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 Deadweight Loss of Monopoly
The consumer and producer surplus that is lost
due to the monopolist charging a price in excess
of marginal cost.

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 Deadweight Loss of Monopoly
(Figure 8-16)
Price

MC
𝑀
𝑃

Deadweight loss
𝑃𝐶

𝑄𝑀 𝑄𝐶 Quantity
The shaded area in Figure 8–16 represents the deadweight loss of monopoly, that is, the
welfare loss to society due to the monopolist producing output below the competitive
level.
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Monopolistic Competition

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 Monopolistic Competition
Conditions for Monopolistic An industry is monopolistically competitive if
Competition

There are many buyers and sellers.

Monopolistic Each firm in the industry produces a

Competition differentiated product

There is free entry into and exit from the

industry.

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Key difference between monopolistically competitive and Monopolistic
perfectly competitive market

Is that each firm produces a slightly differentiated product.

Implication: products are close, but not perfect, substitutes; therefore, firm’s
demand curve is downward sloping under monopolistic competition

For example, other things being equal, some consumers prefer McDonald’s hamburgers,
whereas others prefer to eat at Wendy’s, Burger King, or one of the many other restaurants
that serve hamburgers. As the price of a McDonald’s hamburger increases, some consumers

will substitute toward hamburgers produced by another firm. But some consumers may con-
tinue to eat at McDonald’s even if the price is higher than at other restaurants.

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 Profit-Maximization under
Monopolistic Competition (Figure 8-17)
Price MC
𝑃𝑟𝑜𝑓𝑖𝑡𝑠 =
𝑃∗ − 𝐴𝑇𝐶 𝑄 ∗ × 𝑄∗
ATC

𝑃∗
Profits
𝐴𝑇𝐶(𝑄∗ )

Demand

𝑄∗ MR Quantity

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 Profit-Maximization Rule for
Monopolistic Competition

To maximize profits, a monopolistically competitive firm produces where its marginal

revenue equals marginal cost. The profit-maximizing price is the maximum price per
unit that consumers are willing to pay for the profit-maximizing level of output. In
other words, the profit-maximizing output, Q*, is such that
𝑀𝑅 𝑄∗ = 𝑀𝐶 𝑄∗

and the profit-maximizing price is

𝑃∗ = 𝑃 𝑄∗ .

PRINCIPLE

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 Long- Run Equilibrium
If firms in monopolistically competitive markets
earn:

– short-run profits, additional firms will enter in the

long run to capture some of those profits.

– short-run losses, some firms will exit the industry in

the long run.

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 Effect of Entry on a Monopolistically Competitive
Firm’s Demand (Figure 8-18)
To make this notion more precise, suppose a
monopolistically competitive firm that sells brand
Price MC X faces an initial demand curve of D0 in Figure 8–
18. Since this demand curve lies above the ATC
curve, the firm is earning positive economic
profits. This, of course,
ATC lures more firms into the industry. As additional
firms enter, the demand for this firm’s
product will decrease because some consumers
will substitute toward the new products
offered by the entering firms.
𝑃∗
Due to entry of new
firms selling other brands

Demand1 Demand0
𝑄∗ Quantity of Brand X
MR1 MR0
Entry continues until the demand curve decreases to D1, where it is just tangential to the firm’s average cost curve.
At this point, firms in the industry are earning zero economic profits, and there is no incentive for additional firms
to enter the industry.
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Long-Run Equilibrium under Monopolistic Competition (Figure
8-19)

Price MC
Long-run monopolistically
competitive equilibrium
ATC

𝑃∗

Demand1
MR1 Quantity of Brand X
𝑄∗

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 The Long-Run and Monopolistic
Competition
In the long run, monopolistically competitive firms produce a level of output such that:

1. 𝑃 > 𝑀𝐶
2. 𝑃 = 𝐴𝑇𝐶 > 𝑚𝑖𝑛𝑖𝑚𝑢𝑚 𝑜𝑓 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡𝑠 PRINCIPLE

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 Implications of Product
Differentiation
The differentiated nature of products in monopolistically
competitive markets implies that firms in these industries must
continually convince consumers that their products are better than
their competitors.

© 2022 by McGraw-Hill Education. All Rights Reserved. 61

 Implications of Product
Differentiation
• Two strategies monopolistically competitive firms use to persuade
consumers:
– Comparative advertising: form of advertising where a firm attempts to
increase the demand for its brand by differentiating its product from
competing brands
• Brand equity is the additional value added to a product because of its brand

– Niche marketing: a marketing strategy where goods and services are

tailored to meet the needs of a particular segment of the market.
• Green marketing targets consumers who are concerned about environmental
issues

• Successful differentiation and branding strategies can make managers

brand myopic, resting on the brand’s past laurels instead of focusing on
industry trends and changing consumer preferences.

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 Optimal Advertising Decisions
How much should a firm spend on advertising to maximize
profits?
– Depends, in part, on the nature of the industry.
– The optimal amount of advertising balances the marginal
benefits and marginal costs.

Profit-maximizing advertising-to-sales ratio is:

𝐴 𝐸𝑄,𝐴
=
𝑅 −𝐸𝑄,𝑃
• The more elastic the demand for a firm’s product, the lower the optimal advertising-
to-sales ratio
• The greater the advertising elasticity, the greater the optimal advertising-to-sales ratio

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 Thank You

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