1. If an industry is to be classed as one
of pure (or perfect) competition, there are said to be two basic
requirements.It is argued that when these two conditions are satisfied, the
result is, for the individual firm, a demand curve that is virtually horizontal—i.e.,
perfectly or almost perfectly elastic with respect to price. The firm is free
to sell as much or as little as it pleases at a market price over which it has
Very few real-life firms find themselves in
this position. This is because (so the present chapter argues) of failure to
satisfy one or both of the two basic requirements for perfect competition. In
real life, that is, the number of firms may be too (large/small) for perfect
competition. In addition, the products sold by the various firms may be
(identical among all firms/differentiated from one firm to the next).
(i) many small firms, (ii) all selling
small: differentiated from one firm to the
2. These two characteristics—a too-small
number of sellers and/or the differentiation of the competing products—are said
to have "monopolistic" consequences.
Notice that this word
"monopolistic" does not mean that the firms involved are monopolies.
The conventional definition of a monopoly situation is this: (i) only one firm
in the industry, and (ii) no close substitutes available for the product of
that one-firm industry.
Except in a few special areas such as
public utilities, cases approximating genuine monopoly are almost as difficult
to find as are cases of perfect competition. Monopoly is a kind of extreme
instance of competitive imperfection. Economist Edward H. Chamberlin, who did
much to develop the ideas set out in the first part of this chapter, argued
that the typical real-life situation is one of "monopolistic competition."
Each firm finds that it must reckon with the competition of close substitute
products (so that it is not a monopoly); and yet its situation is not that of
pure or perfect competition.
The word "monopolistic" is used
because it is argued that there is one monopoly-like characteristic to be found
in all such cases of monopolistic or imperfect competition. less than perfectly elastic with respect to
price—i.e., it is "tilted" rather than horizontal.
3. If the number of selling firms is small,
the name given to the resulting situation is
If the number of selling firms is large,
but competition is not perfect, this must be (in the language of the text) a
situation of oligopoly: many differentiated sellers.
In its opening sections, this text chapter
describes the circumstances of imperfect or monopolistic competition. But it
does not attempt to explore these situations in any real detail. Instead, after
its introductory outline, the chapter turns to an examination of the
profit-maximizing behavior of a monopoly firm. Analytically, this monopoly case
is decidedly easier than the so-called "intermediate" cases—those not
perfectly competitive, and yet not completely monopolistic. It would be unwise
to tackle these more intricate cases before having mastered the elementary
ideas of monopoly pricing.
Even the terms and diagrams involved in a
description of monopoly pricing may seem complicated at first. Yet the basic
idea involved is simple. The monopoly firm is assumed to behave so as to
"maximize its profit"—which is exactly what the firm in pure (or
perfect) competition was assumed .The monopoly firm simply operates in rather
To review the basic ideas of "profit
1. "Maximizing profit" means
making as much money as supply conditions will permit.
2. To "maximize profit," there
must be something the firm can do that will influence its profit. There must be
some variable which changes profit, and which the firm can control.
3. This chapter assumes that the monopoly
firm can control the quantity it sells, just as the firm in pure (or perfect)
competition can do. (In real life, this control is at best indirect and
incomplete; there are other and more complex decisions to be made. But this
chapter tackles a simple case.) So the variable which the monopoly firm can
control is its sales quantity: it looks for the particular sales quantity that
will maximize its profit.
4. The monopoly firm is assumed to have
control over its sales quantity because it knows the demand schedule for its
product—i.e., it knows the sales quantity that goes with each and any price it
5. From this demand schedule, it is easy to
develop a revenue schedule (Total Revenue being quantity sold multiplied by
price per unit)—i.e., a schedule showing revenue associated with each possible
6. The firm must know also the Total Cost
of each and any output quantity. By bringing together the revenue and cost
schedules, it can then identify that output quantity at which the excess of
revenue over cost (profit) is greatest. (And it can tell the price to charge
for this Maximum-profit output just by consulting the demand schedule once
To repeat, the essential thing to grasp
about this sequence of ideas is that it is simple. It is only when the monopoly
firm's profit-maximizing "equilibrium position" (with respect to
sales output and price) is outlined in marginal terms that it may seem
complicated. But these marginal terms are essential analytic tools when one
moves on to more complex situations. Hence the emphasis on Marginal Revenue and
Marginal Cost in the text chapter and in the review questions which follow.
4. Columns (1) and (2) of Study Guide Table
1 represent a demand schedule. This schedule has been computed or estimated by
a firm as indicating the quantities it can sell daily at various prices.
This firm must operate under conditions of
(perfect/imperfect) competition, since as the output to be sold increases,
price (remains constant/must be reduced).
5. We treat the first two columns of Table
1 as representing a monopoly firm's demand schedule. Our task is to determine
what price the monopolist will charge, and what output it will produce and
sell—if its objective is Maximum-profit.
o. Column (3) of Table 1 shows Total
Revenue—price times quantity. Complete the four blanks in this column.
Then use Columns (2) and (3) figures to
illustrate Total Revenue on Study Guide Fig. 1—i.e., show Total Revenue
associated with various output quantities. Join the points with a smooth curve.
Disregard momentarily the TC curve already drawn on Fig. 1.
с. Notice that this demand schedule becomes
price-inelastic , when price is sufficiently lowered—specifically, when price
The graph of Columns (1) and (2) of Table 2
is already drawn on Fig.1 as a Total Cost curve (TC). (Mark the curve you drew
in question 5 as TR, to distinguish it from the cost curve.)
It is now possible to see at once why the
profit-maximizing process outlined here is a simple one. The firm is doing
nothing more than to search for the output at which the vertical distance
between TR and TC is greatest. This distance, for any output, is (fixed
cost/price/profit or loss). (If TR is above TC, it is profit; if TC is above,
it is loss.' So it is preferable to look for "greatest vertical
distance" with ГД above TC. The greatest distance with ГС on top marks the
maximum-possible loss, which is somewhat less desirable as an operating
6. Figure 1 is too small to indicate
quickly the precise Maximum-profit position. But even a glance is sufficient to
indicate that this best-possible position is approximately i.45/65/85) units of
The firm can be thought of as gradually
increasing its output and sales, pausing at each increase to see if its profit
position is improved. Each extra unit of output brings in
a little more revenue (provided demand has
not vet moved to the price-inelastic range); and each extra unit incurs a
little more cost. The firm's profit position is improved if this small amount
of extra revenue (exceeds/is equal to/is less than) the small amount of extra
More elegantly put, output should be
increased, for it will yield an increase in profit, if Marginal Revenue (MR)
(exceeds/is equal to/is less than) Marginal Cost (MC). The firm should cut back
its output and sales if it finds that MR (exceeds/is equal to/is less than) MC.
And so the "in-balance" position
is where MR is (less than/equal to/greater than) MC.
7. A more careful development of the
Marginal Revenue idea is needed. Column (4) in Table 1 shows the extra number
of units sold if price is reduced. Column (5) shows extra revenue (positive or
negative) accruing from that price reduction. Complete the blanks in these two
columns to familiarize yourself with the meanings involved.
8. The general profit-maximizing rule is:
Expand your output until you reach the output level at which MR = MC—and stop
at that point.
The profit-maximizing rule for the firm in
pure (or perfect) competition: P = MC. This is nothing but a particular
instance of the MR = MC rule. It is assumed in pure (or perfect) competition
that the demand curve facing the individual firm is perfectly horizontal, or
perfectly price- (elastic/inelastic}. That is, if market price is $2, the firm
receives (less than $2 /exactly $2/more than $2) for each extra unit that it
sells. In this special case, MR (extra revenue per unit) is (greater than/the
same thing as/less than) price per unit (which could be called Average Revenue,
or revenue per unit). So in pure (or perfect) competition, P == MC and MR = MC
are two ways of saying the same thing.
9. In imperfect competition, the firm's
demand curve is—and things are different. From inspection of the figures in
Table 1 [compare Columns (1) and (6)], it is evident that with such a demand
curve, MR at any particular output is (greater than/the same thing as/less
than) price for that output.
Why is this so? Suppose, at price $7, you
can sell 4 units; at price $6, 5 units. Revenues associated with these two
prices are respectively $28 and $30. Marginal Revenue from selling the fifth
unit is accordingly $(2/5/6/7/28/30). It is the difference in revenue obtained
as a result of selling the one extra unit. Why only $2—when the price at which
that fifth unit sold was 86? Because to sell that fifth unit, price had to be
reduced. And that lowered price applies to all 5 units. The first 4, which
formerly sold at $7, now bring only $6. On this account, revenue takes a
beating of $4. You must subtract tins $4 from the $6 which the fifth unit
brings in. This leaves a net gain in revenue of $2—Marginal Revenue.
10. To return to the fortunes of the firm
in Tables 1 and 2: The tables do not provide sufficient unit-by-unit detail to
show the exact Maximum-profit output level. But Table 1 indicates that between
sales outputs of 63 and 71, MR is $1.63. The MR figures fall as sales are
expanded, so that the $1.63 would apply near the midpoint of this range, say at
output 67. It would be somewhat higher between 63 and 66; somewhat lower
between 68 and 71.
Similarly, MC (Table 2) would be SI.60 at
output of about 67 units. So the Maximum-profit position would fall very close
to 67 units produced and sold per period.
To sell this output, the firm would charge
a price (see Table 1) of about 8(7 '5.75/4/1.60). Its Total Revenue [look for
nearby figures in Column (3)] would be roughly $(380/580/780). Its Total Cost
(Table 2) would be roughly ^(310/510/710), leaving profit per period of about
$5.75; $380; $310.
The text notes that in geometric terms
Marginal Revenue can be depicted as the slope of the Total Revenue curve.
Tills can be illustrated by looking more
carefully at the Total Revenue curve you have drawn in Study Guide Fig. 1.
Study Guide Fig. 2 shows an enlargement of a small segment of that curve: that
part of the curve between output quantities of 25 and 31. If 25 units are sold,
the price is 810 and Total Revenue is $250. This is point A on Fig. 2. If price
is reduced to $9, that increases sales by 6 units, from 25 units to 31 units.
Thus Total Revenue becomes $279 (31 multiplied by $9). So, if the firm reduces
price from $10 to $9, in effect it moves from point A to point B.
Figure 2's heavier, curved line is the
smooth curve used to join points A and B. It is an approximation of the points
that would be obtained if we had quantity and revenue information on prices
such as '59.90, S9.SO, and so on.
There is also a straight line (the thin
line) joining A and B. It is close to the probable true Total Revenue curve
although it is not likely to be the exact curve.
Instead of dropping from price $10 all the
way to $9, suppose we had moved only to (say) $9.60. That would have produced
(roughly) a 2-unit increase in quantity demanded. In this way, we would move
closer to the true MR figure than our previous 6-unit approximation supplied.
In Fig. 2 terms, we would be moving from A only to
D, not from A to B. Notice carefully that
the straight line (the thin line) joining A to D becomes a (better/poorer)
approximation of the presumed true Total Revenue curve than was the case when
the points involved were A and B.
In sum, the closer we move point B to point
A (for example, if we make it D rather than B), the closer the slope figure
comes to being a measure of the true MR figure. Strictly speaking, we have true
MR (the rate of change in revenue as measured in terms of 1-unit output
changes) only when the line whose slope is being measured and used to indicate
MR is actually tangent to the Total Revenue curve.
In its near-closing section Bygones and
Margins, the text chapter emphasizes that if a firm is setting its price and
output according to MR = MC principles, it will disregard Fixed Cost.
QUIZ: Multiple Choice
1. If a firm's Marginal Revenue exceeds its
Marginal Cost, Maximum-profit rules require that firm to (1) increase its
output in both perfect and imperfect competition; (2) increase its output in
perfect but not necessarily in imperfect competition; (3) increase its output
in imperfect but not necessarily in perfect competition; (4) decrease its
output in both perfect and imperfect competition; (5) increase price, not
output, in both perfect and imperfect competition.
2. Whenever a firm's demand curve is
horizontal or "perfectly elastic," then (1) the firm cannot be
operating under conditions of perfect competition; (2) the profit-maximizing
rule of MR-equal-to-MC does not apply; (3) price and Marginal Revenue-must be
one and the same; (4) price and Marginal Cost must be one and the same; (5)
none of the above is necessarily correct.
3. A basic difference between the firm in
perfect (or pure) competition and the monopoly firm, according to economic
analysis, is this: (1) The perfect competitor can sell as much as he wishes at
some given price, whereas the monopolist must lower his price whenever he
wishes to increase the amount of his sales by any significant amount;
(2) the monopolist can always charge a
price that brings him a substantial profit, whereas the perfect competitor can
never earn such a profit; (3) the elasticity of demand facing the monopolist is
a higher figure than the elasticity of demand facing the perfect competitor;
(4) the monopolist seeks to maximize profit, whereas the perfect competitor's
rule is to equate price and Average Cost; (5) none of the above.
4. "Oligopoly" means (1) the same
thing as imperfect competition; (2) a situation in which the number of
competing firms is large but the products differ slightly; (3) a situation in
which the number of competing firms is small;
(4) that particular condition of imperfect
competition which is just removed from monopoly, regardless of the number of
firms or type of product: (5) none of these.
5. When a monopoly firm seeking to maximize
its profits has reached its "equilibrium position," then (1) price
must be less than Marginal Cost; (2) price must be equal to Marginal Cost; (3)
price must he greater than Marginal Cost; (4) price may be equal to or below
Marginal Cost, but not above it; (5) none of the above is necessarily correct
since equilibrium does not require any particular relation between price and
6. To explain why imperfect competition is
far more prevalent than perfect competition, the text lays considerable
emphasis upon the following: (1) the fact that Marginal Revenue is less than
price; (2) the tendency of Marginal Cost to continue to fall over substantial
levels of output produced; (() the disposition of firms to try to maximize the
profit they can gain from sales; (4) the tendency of Marginal Cost to rise
after some particular level of output produced has been reached; (5) the fact
that large firms now typically produce many different products, thus squeezing
smaller firms out of their markets.
7. Among the five statements below, one
must be false with respect to any firm operating under conditions of imperfect
competition. Which one? (1) The number of competing sellers offering similar
(although differentiated) products can be large. (2) Other firms may sell
which are identical or almost identical
with this firm's product. (3) The number of competing sellers offering similar
(although differentiated) products can be small. (4) The firm's Marginal
Revenue will be less than the price it obtains. (5) The demand curve facing the
firm can be perfectly horizontal.
8. A level of output for a firm at which
Marginal Cost had risen to equality with price would (1) be a profit-maximizing
output level in both pure (or perfect) competition and imperfect competition;
(2) be a profit-maximizing output level in pure (or perfect) competition but
not in imperfect competition; (3) not be a profit-maximizing output level
either in perfect or in imperfect competition; (4) be a profit-maximizing
output level in imperfect competition but not in pure (or perfect) competition;
(5) definitely be a profit-maximizing output level in imperfect competition,
but might or might not be in pure (or perfect) competition.
9. A firm in conditions of imperfect
competition which finds itself at an output level where Marginal Cost has risen
to equality with price, and which wants to maximize its profit, ought to (1)
increase its output; (2) change (either increase or decrease) its price but not
its output; (3) maintain both price and output at their present levels; (4)
increase its price; (5) perhaps do any of the above—information furnished is
insufficient to tell.
10. The essence of the general rule for
maximizing profits given in the text chapter is that a firm should set its
price, or its output, as follows: set its (1) price at a level where the excess
over the minimum-possible level of Average Cost is at its maximum; (2) output
at a level where the extra production cost resulting from the last unit
produced just equals the extra revenue brought in by that last unit; (3) price
at the highest level which the traffic will bear; (4) price at a level just
equal to Marginal Cost (assuming that Marginal Cost would rise with any
increase in output); (5) output at a level where Average Cost is at a minimum.
11. A firm would be designated as a
monopoly, according to the definition conventionally used by economists, in any
situation where (1) the firm's Marginal Revenue exceeds the price it charges at
all levels of output (other than the first unit sold); (2) the firm's Marginal
Revenue is less than the price it charges at all levels of output (other than
the first unit sold); (3) the firm has at least some degree of control over the
price that it can charge; (4) the profit earned by the .firm significantly
exceeds the competitive rate of return, after proper allowance has been made
for risk undertaken; (5) there is no other firm selling a close substitute for
the product of this firm.
12. The Marginal Revenue (MR) associated
with any given point on a firm's demand curve will be related to the elasticity
of demand at that point (with respect to price) as follows:
(1) When demand is inelastic, MR will be
negative in value;
(2) when demand is elastic, MR will be
negative in value;
(3) when demand is inelastic, MR will be
zero in value; (4)
when demand is elastic, MR will be zero in
value; (5) .VR of monopoly or imperfect competition. The AR line is Aver-is
always positive in value (although below price) regardless age Revenue—in other
words, it is price obtainable per unit. of elasticity, except at the point or
region of unit elasticity.
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