CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 311
Thus, for these two reasons, the long-run supply curve in a market may be up-
ward sloping rather than horizontal, indicating that a higher price is necessary to
induce a larger quantity supplied. Nonetheless, the basic lesson about entry and
exit remains true. Because firms can enter and exit more easily in the long run than in the
short run, the long-run supply curve is typically more elastic than the short-run supply
curve.
QUICK QUIZ: In the long run with free entry and exit, is the price in a
market equal to marginal cost, average total cost, both, or neither? Explain
with a diagram.
CONCLUSION: BEHIND THE SUPPLY CURVE
We have been discussing the behavior of competitive profit-maximizing firms. You
may recall from Chapter 1 that one of the Ten PrinciplesofEconomics is that rational
people think at the margin. This chapter has applied this idea to the competitive
firm. Marginal analysis has given us a theory of the supply curve in a competitive
market and, as a result, a deeper understanding of market outcomes.
We have learned that when you buy a good from a firm in a competitive mar-
ket, you can be assured that the price you pay is close to the cost of producing that
good. In particular, if firms are competitive and profit-maximizing, the price of a
good equals the marginal cost of making that good. In addition, if firms can freely
enter and exit the market, the price also equals the lowest possible average total
cost of production.
Although we have assumed throughout this chapter that firms are price tak-
ers, many of the tools developed here are also useful for studying firms in less
competitive markets. In the next three chapters we will examine the behavior of
firms with market power. Marginal analysis will again be useful in analyzing these
firms, but it will have quite different implications.
◆ Because a competitive firm is a price taker, its revenue is
proportional to the amount of output it produces. The
price of the good equals both the firm’s average revenue
and its marginal revenue.
◆ To maximize profit, a firm chooses a quantity of output
such that marginal revenue equals marginal cost.
Because marginal revenue for a competitive firm equals
the market price, the firm chooses quantity so that price
equals marginal cost. Thus, the firm’s marginal cost
curve is its supply curve.
◆ In the short run when a firm cannot recover its fixed
costs, the firm will choose to shut down temporarily if
the price of the good is less than average variable cost.
In the long run when the firm can recover both fixed
and variable costs, it will choose to exit if the price is
less than average total cost.
◆ In a market with free entry and exit, profits are driven to
zero in the long run. In this long-run equilibrium, all
firms produce at the efficient scale, price equals the
minimum of average total cost, and the number of firms
adjusts to satisfy the quantity demanded at this price.
◆ Changes in demand have different effects over different
time horizons. In the short run, an increase in demand
raises prices and leads to profits, and a decrease in
Summary
312 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
demand lowers prices and leads to losses. But if firms
can freely enter and exit the market, then in the long run
the number of firms adjusts to drive the market back to
the zero-profit equilibrium.
competitive market, p. 292
average revenue, p. 294
marginal revenue, p. 294 sunk cost, p. 298
Key Concepts
1. What is meant by a competitive firm?
2. Draw the cost curves for a typical firm. For a given
price, explain how the firm chooses the level of output
that maximizes profit.
3. Under what conditions will a firm shut down
temporarily? Explain.
4. Under what conditions will a firm exit a market?
Explain.
5. Does a firm’s price equal marginal cost in the short run,
in the long run, or both? Explain.
6. Does a firm’s price equal the minimum of average total
cost in the short run, in the long run, or both? Explain.
7. Are market supply curves typically more elastic in the
short run or in the long run? Explain.
Questions for Review
1. What are the characteristics of a competitive market?
Which of the following drinks do you think is best
described by these characteristics? Why aren’t the
others?
a. tap water
b. bottled water
c. cola
d. beer
2. Your roommate’s long hours in Chem lab finally paid
off—she discovered a secret formula that lets people do
an hour’s worth of studying in 5 minutes. So far, she’s
sold 200 doses, and faces the following average-total-
cost schedule:
Q AVERAGE TOTAL COST
199 $199
200 200
201 201
If a new customer offers to pay your roommate $300 for
one dose, should she make one more? Explain.
3. The licorice industry is competitive. Each firm produces
2 million strings of licorice per year. The strings have an
average total cost of $0.20 each, and they sell for $0.30.
a. What is the marginal cost of a string?
b. Is this industry in long-run equilibrium? Why or
why not?
4. You go out to the best restaurant in town and order a
lobster dinner for $40. After eating half of the lobster,
you realize that you are quite full. Your date wants you
to finish your dinner, because you can’t take it home
and because “you’ve already paid for it.” What should
you do? Relate your answer to the material in this
chapter.
5. Bob’s lawn-mowing service is a profit-maximizing,
competitive firm. Bob mows lawns for $27 each. His
total cost each day is $280, of which $30 is a fixed cost.
He mows 10 lawns a day. What can you say about Bob’s
short-run decision regarding shut down and his long-
run decision regarding exit?
6. Consider total cost and total revenue given in the table
below:
QUANTITY
01 2 3 4 5 6 7
Total cost $8 $9 $10 $11 $13 $19 $27 $37
Total revenue 0 8 16 24 32 40 48 56
a. Calculate profit for each quantity. How much
should the firm produce to maximize profit?
Problems and Applications
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 313
b. Calculate marginal revenue and marginal cost for
each quantity. Graph them. (Hint: Put the points
between whole numbers. For example, the marginal
cost between 2 and 3 should be graphed at 2 1/2.)
At what quantity do these curves cross? How does
this relate to your answer to part (a)?
c. Can you tell whether this firm is in a competitive
industry? If so, can you tell whether the industry is
in a long-run equilibrium?
7. From The Wall Street Journal (July 23, 1991): “Since
peaking in 1976, per capita beef consumption in the
United States has fallen by 28.6 percent . . . [and] the size
of the U.S. cattle herd has shrunk to a 30-year low.”
a. Using firm and industry diagrams, show the short-
run effect of declining demand for beef. Label the
diagram carefully and write out in words all of the
changes you can identify.
b. On a new diagram, show the long-run effect of
declining demand for beef. Explain in words.
8. “High prices traditionally cause expansion in an
industry, eventually bringing an end to high prices and
manufacturers’ prosperity.” Explain, using appropriate
diagrams.
9. Suppose the book-printing industry is competitive and
begins in a long-run equilibrium.
a. Draw a diagram describing the typical firm in the
industry.
b. Hi-Tech Printing Company invents a new process
that sharply reduces the cost of printing books.
What happens to Hi-Tech’s profits and the price of
books in the short run when Hi-Tech’s patent
prevents other firms from using the new
technology?
c. What happens in the long run when the patent
expires and other firms are free to use the
technology?
10. Many small boats are made of fiberglass, which is
derived from crude oil. Suppose that the price of oil
rises.
a. Using diagrams, show what happens to the cost
curves of an individual boat-making firm and to the
market supply curve.
b. What happens to the profits of boat makers in the
short run? What happens to the number of boat
makers in the long run?
11. Suppose that the U.S. textile industry is competitive,
and there is no international trade in textiles. In long-
run equilibrium, the price per unit of cloth is $30.
a. Describe the equilibrium using graphs for the entire
market and for an individual producer.
Now suppose that textile producers in other countries
are willing to sell large quantities of cloth in the United
States for only $25 per unit.
b. Assuming that U.S. textile producers have large
fixed costs, what is the short-run effect of these
imports on the quantity produced by an individual
producer? What is the short-run effect on profits?
Illustrate your answer with a graph.
c. What is the long-run effect on the number of U.S.
firms in the industry?
12. Suppose there are 1,000 hot pretzel stands operating in
New York City. Each stand has the usual U-shaped
average-total-cost curve. The market demand curve for
pretzels slopes downward, and the market for pretzels
is in long-run competitive equilibrium.
a. Draw the current equilibrium, using graphs for the
entire market and for an individual pretzel stand.
b. Now the city decides to restrict the number of
pretzel-stand licenses, reducing the number of
stands to only 800. What effect will this action have
on the market and on an individual stand that is
still operating? Use graphs to illustrate your
answer.
c. Suppose that the city decides to charge a license fee
for the 800 licenses. How will this affect the number
of pretzels sold by an individual stand, and the
stand’s profit? The city wants to raise as much
revenue as possible and also wants to ensure that
800 pretzel stands remain in the city. By how much
should the city increase the license fee? Show the
answer on your graph.
13. Assume that the gold-mining industry is competitive.
a. Illustrate a long-run equilibrium using diagrams for
the gold market and for a representative gold mine.
b. Suppose that an increase in jewelry demand
induces a surge in the demand for gold. Using your
diagrams, show what happens in the short run to
the gold market and to each existing gold mine.
c. If the demand for gold remains high, what would
happen to the price over time? Specifically, would
the new long-run equilibrium price be above,
below, or equal to the short-run equilibrium price in
part (b)? Is it possible for the new long-run
equilibrium price to be above the original long-run
equilibrium price? Explain.
14. (This problem is challenging.) The New York Times
(July 1, 1994) reported on a Clinton administration
proposal to lift the ban on exporting oil from the
North Slope of Alaska. According to the article, the
administration said that “the chief effect of the ban has
314 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
been to provide California refiners with crude oil
cheaper than oil on the world market. . . . The ban
created a subsidy for California refiners that had not
been passed on to consumers.” Let’s use our analysis of
firm behavior to analyze these claims.
a. Draw the cost curves for a California refiner and for
a refiner in another partof the world. Assume that
the California refiners have access to inexpensive
Alaskan crude oil and that other refiners must buy
more expensive crude oil from the Middle East.
b. All of the refiners produce gasoline for the world
gasoline market, which has a single price. In the
long-run equilibrium, will this price depend on the
costs faced by California producers or the costs
faced by other producers? Explain. (Hint: California
cannot itself supply the entire world market.) Draw
new graphs that illustrate the profits earned by a
California refiner and another refiner.
c. In this model, is there a subsidy to California
refiners? Is it passed on to consumers?
315
IN THIS CHAPTER
YOU WILL . . .
See why monopolies
try to charge
different prices to
different customers
See how the
monopoly’s
decisions affect
economic well-being
Learn why some
markets have only
one seller
Analyze how a
monopoly
determines the
quantity to produce
and the price to
charge
Consider the
various public
policies aimed at
solving the problem
of monopoly
If you own a personal computer, it probably uses some version of Windows, the
operating system sold by the Microsoft Corporation. When Microsoft first de-
signed Windows many years ago, it applied for and received a copyright from the
government. The copyright gives Microsoft the exclusive right to make and sell
copies of the Windows operating system. So if a person wants to buy a copy of
Windows, he or she has little choice but to give Microsoft the approximately $50
that the firm has decided to charge for its product. Microsoft is said to have a mo-
nopoly in the market for Windows.
Microsoft’s business decisions are not well described by the model of firm
behavior we developed in Chapter 14. In that chapter, we analyzed competitive mar-
kets, in which there are many firms offering essentially identical products, so each
firm has little influence over the price it receives. By contrast, a monopoly such as
Microsoft has no close competitors and, therefore, can influence the market price of
its product. While a competitive firm is a price taker, a monopoly firm is a price maker.
MONOPOLY
316 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
In this chapter we examine the implications of this market power. We will see
that market power alters the relationship between a firm’s price and its costs. A
competitive firm takes the price of its output as given by the market and then
chooses the quantity it will supply so that price equals marginal cost. By contrast,
the price charged by a monopoly exceeds marginal cost. This result is clearly true
in the case of Microsoft’s Windows. The marginal cost of Windows—the extra cost
that Microsoft would incur by printing one more copy of the program onto some
floppy disks or a CD—is only a few dollars. The market price of Windows is many
times marginal cost.
It is perhaps not surprising that monopolies charge high prices for their prod-
ucts. Customers of monopolies might seem to have little choice but to pay what-
ever the monopoly charges. But, if so, why does a copy of Windows not cost $500?
Or $5,000? The reason, of course, is that if Microsoft set the price that high, fewer
people would buy the product. People would buy fewer computers, switch to
other operating systems, or make illegal copies. Monopolies cannot achieve any
level of profit they want, because high prices reduce the amount that their cus-
tomers buy. Although monopolies can control the prices of their goods, their prof-
its are not unlimited.
As we examine the production and pricing decisions of monopolies, we also
consider the implications of monopoly for society as a whole. Monopoly firms, like
competitive firms, aim to maximize profit. But this goal has very different ramifi-
cations for competitive and monopoly firms. As we first saw in Chapter 7, self-
interested buyers and sellers in competitive markets are unwittingly led by an
invisible hand to promote general economic well-being. By contrast, because
monopoly firms are unchecked by competition, the outcome in a market with a
monopoly is often not in the best interest of society.
One of the Ten PrinciplesofEconomics in Chapter 1 is that governments can
sometimes improve market outcomes. The analysis in this chapter will shed more
light on this principle. As we examine the problems that monopolies raise for so-
ciety, we will also discuss the various ways in which government policymakers
might respond to these problems. The U.S. government, for example, keeps a close
eye on Microsoft’s business decisions. In 1994, it prevented Microsoft from buying
Intuit, a software firm that sells the leading program for personal finance, on the
grounds that the combination of Microsoft and Intuit would concentrate too much
market power in one firm. Similarly, in 1998, the U.S. Justice Department objected
when Microsoft started integrating its Internet browser into its Windows operat-
ing system, claiming that this would impede competition from other companies,
such as Netscape. This concern led the Justice Department to file suit against
Microsoft, the final resolution of which was still unsettled as this book was going
to press.
WHY MONOPOLIES ARISE
A firm is a monopoly if it is the sole seller of its product and if its product does not
have close substitutes. The fundamental cause of monopoly is barriers to entry: Amo-
nopoly remains the only seller in its market because other firms cannot enter
the market and compete with it. Barriers to entry, in turn, have three main sources:
monopoly
a firm that is the sole seller of a
product without close substitutes
CHAPTER 15 MONOPOLY 317
CASE STUDY THE DEBEERS DIAMOND MONOPOLY
A classic example of a monopoly that arises from the ownership of a key re-
source is DeBeers, the South African diamond company. DeBeers controls about
80 percent of the world’s production of diamonds. Although the firm’s share of
the market is not 100 percent, it is large enough to exert substantial influence
over the market price of diamonds.
How much market power does DeBeers have? The answer depends in part
on whether there are close substitutes for its product. If people view emeralds,
rubies, and sapphires as good substitutes for diamonds, then DeBeers has rela-
tively little market power. In this case, any attempt by DeBeers to raise the price
of diamonds would cause people to switch to other gemstones. But if people
view these other stones as very different from diamonds, then DeBeers can ex-
ert substantial influence over the price of its product.
DeBeers pays for large amounts of advertising. At first, this decision might
seem surprising. If a monopoly is the sole seller of its product, why does it need
to advertise? One goal of the DeBeers ads is to differentiate diamonds from other
gems in the minds of consumers. When their slogan tells you that “a diamond
is forever,” you are meant to think that the same is not true of emeralds, rubies,
and sapphires. (And notice that the slogan is applied to all diamonds, not just
DeBeers diamonds—a sign of DeBeers’s monopoly position.) If the ads are
◆ A key resource is owned by a single firm.
◆ The government gives a single firm the exclusive right to produce some
good or service.
◆ The costs of production make a single producer more efficient than a large
number of producers.
Let’s briefly discuss each of these.
MONOPOLY RESOURCES
The simplest way for a monopoly to arise is for a single firm to own a key resource.
For example, consider the market for water in a small town in the Old West. If
dozens of town residents have working wells, the competitive model discussed in
Chapter 14 describes the behavior of sellers. As a result, the price of a gallon of wa-
ter is driven to equal the marginal cost of pumping an extra gallon. But if there is
only one well in town and it is impossible to get water from anywhere else, then
the owner of the well has a monopoly on water. Not surprisingly, the monopolist
has much greater market power than any single firm in a competitive market. In
the case of a necessity like water, the monopolist could command quite a high
price, even if the marginal cost is low.
Although exclusive ownership of a key resource is a potential cause of mo-
nopoly, in practice monopolies rarely arise for this reason. Actual economies are
large, and resources are owned by many people. Indeed, because many goods are
traded internationally, the natural scope of their markets is often worldwide. There
are, therefore, few examples of firms that own a resource for which there are no
close substitutes.
“Rather than a monopoly, we like
to consider ourselves ‘the only
game in town.’”
318 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
successful, consumers will view diamonds as unique, rather than as one among
many gemstones, and this perception will give DeBeers greater market power.
GOVERNMENT-CREATED MONOPOLIES
In many cases, monopolies arise because the government has given one person or
firm the exclusive right to sell some good or service. Sometimes the monopoly
arises from the sheer political clout of the would-be monopolist. Kings, for exam-
ple, once granted exclusive business licenses to their friends and allies. At other
times, the government grants a monopoly because doing so is viewed to be in the
public interest. For instance, the U.S. government has given a monopoly to a com-
pany called Network Solutions, Inc., which maintains the database of all .com,
.net, and .org Internet addresses, on the grounds that such data need to be central-
ized and comprehensive.
The patent and copyright laws are two important examples of how the gov-
ernment creates a monopoly to serve the public interest. When a pharmaceutical
company discovers a new drug, it can apply to the government for a patent. If the
government deems the drug to be truly original, it approves the patent, which
gives the company the exclusive right to manufacture and sell the drug for 20
years. Similarly, when a novelist finishes a book, she can copyright it. The copy-
right is a government guarantee that no one can print and sell the work without
the author’s permission. The copyright makes the novelist a monopolist in the sale
of her novel.
The effects of patent and copyright laws are easy to see. Because these laws
give one producer a monopoly, they lead to higher prices than would occur under
competition. But by allowing these monopoly producers to charge higher prices
and earn higher profits, the laws also encourage some desirable behavior. Drug
companies are allowed to be monopolists in the drugs they discover in order to en-
courage pharmaceutical research. Authors are allowed to be monopolists in the
sale of their books to encourage them to write more and better books.
Thus, the laws governing patents and copyrights have benefits and costs. The
benefits of the patent and copyright laws are the increased incentive for creative
activity. These benefits are offset, to some extent, by the costs of monopoly pricing,
which we examine fully later in this chapter.
NATURAL MONOPOLIES
An industry is a natural monopoly when a single firm can supply a good or ser-
vice to an entire market at a smaller cost than could two or more firms. A natural
monopoly arises when there are economies of scale over the relevant range of out-
put. Figure 15-1 shows the average total costs of a firm with economies of scale. In
this case, a single firm can produce any amount of output at least cost. That is, for
any given amount of output, a larger number of firms leads to less output per firm
and higher average total cost.
An example of a natural monopoly is the distribution of water. To provide wa-
ter to residents of a town, a firm must build a network of pipes throughout the
town. If two or more firms were to compete in the provision of this service, each
firm would have to pay the fixed cost of building a network. Thus, the average to-
tal cost of water is lowest if a single firm serves the entire market.
natural monopoly
a monopoly that arises because a
single firm can supply a good or
service to an entire market at a
smaller cost than could two or
more firms
CHAPTER 15 MONOPOLY 319
We saw other examples of natural monopolies when we discussed public
goods and common resources in Chapter 11. We noted in passing that some goods
in the economy are excludable but not rival. An example is a bridge used so infre-
quently that it is never congested. The bridge is excludable because a toll collector
can prevent someone from using it. The bridge is not rival because use of the
bridge by one person does not diminish the ability of others to use it. Because there
is a fixed cost of building the bridge and a negligible marginal cost of additional
users, the average total cost of a trip across the bridge (the total cost divided by the
number of trips) falls as the number of trips rises. Hence, the bridge is a natural
monopoly.
When a firm is a natural monopoly, it is less concerned about new entrants
eroding its monopoly power. Normally, a firm has trouble maintaining a monop-
oly position without ownership of a key resource or protection from the govern-
ment. The monopolist’s profit attracts entrants into the market, and these entrants
make the market more competitive. By contrast, entering a market in which an-
other firm has a natural monopoly is unattractive. Would-be entrants know that
they cannot achieve the same low costs that the monopolist enjoys because, after
entry, each firm would have a smaller piece of the market.
In some cases, the size of the market is one determinant of whether an indus-
try is a natural monopoly. Consider a bridge across a river. When the population is
small, the bridge may be a natural monopoly. A single bridge can satisfy the entire
demand for trips across the river at lowest cost. Yet as the population grows and
the bridge becomes congested, satisfying the entire demand may require two or
more bridges across the same river. Thus, as a market expands, a natural monop-
oly can evolve into a competitive market.
QUICK QUIZ: What are the three reasons that a market might have a
monopoly? ◆ Give two examples of monopolies, and explain the reason
for each.
Quantity of Output
Average
total
cost
0
Cost
Figure 15-1
ECONOMIES OF SCALE AS A
C
AUSE OF MONOPOLY. When a
firm’s average-total-cost curve
continually declines, the firm
has what is called a natural
monopoly. In this case, when
production is divided among
more firms, each firm produces
less, and average total cost rises.
As a result, a single firm can
produce any given amount at
the smallest cost.
320 PART FIVE FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY
HOW MONOPOLIES MAKE PRODUCTION
AND PRICING DECISIONS
Now that we know how monopolies arise, we can consider how a monopoly firm
decides how much of its product to make and what price to charge for it. The
analysis of monopoly behavior in this section is the starting point for evaluating
whether monopolies are desirable and what policies the government might pursue
in monopoly markets.
MONOPOLY VERSUS COMPETITION
The key difference between a competitive firm and a monopoly is the monopoly’s
ability to influence the price of its output. A competitive firm is small relative to the
market in which it operates and, therefore, takes the price of its output as given by
market conditions. By contrast, because a monopoly is the sole producer in its market,
it can alter the price of its good by adjusting the quantity it supplies to the market.
One way to view this difference between a competitive firm and a monopoly
is to consider the demand curve that each firm faces. When we analyzed profit
maximization by competitive firms in Chapter 14, we drew the market price as a
horizontal line. Because a competitive firm can sell as much or as little as it wants
at this price, the competitive firm faces a horizontal demand curve, as in panel (a)
of Figure 15-2. In effect, because the competitive firm sells a product with many
Quantity of Output
Demand
(a) A Competitive Firm’s Demand Curve (b) A Monopolist’s Demand Curve
0
Price
Quantity of Output0
Price
Demand
Figure 15-2
DEMAND CURVES FOR COMPETITIVE AND MONOPOLY FIRMS. Because competitive firms
are price takers, they in effect face horizontal demand curves, as in panel (a). Because a
monopoly firm is the sole producer in its market, it faces the downward-sloping market
demand curve, as in panel (b). As a result, the monopoly has to accept a lower price if it
wants to sell more output.
. discussing the behavior of competitive profit-maximizing firms. You
may recall from Chapter 1 that one of the Ten Principles of Economics is that rational
people. sharply reduces the cost of printing books.
What happens to Hi-Tech’s profits and the price of
books in the short run when Hi-Tech’s patent
prevents other firms