McConnell Campbell R., Brue Stanley L., Barbiero Thomas P. Microeconomics. Ninth Edition
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terms and concepts
210 Part Two • Microeconomics of Product Markets
variable costs vary with output. The total cost
of any output is the sum of fixed and variable
costs at that output.
7. Average fixed costs, average variable costs,
and average total costs are fixed, variable,
and total costs per unit of output. Average
fixed cost declines continuously as output
increases because a fixed sum is being
spread over an increasing number of units of
production. A graph of average variable cost
is U-shaped, reflecting the law of diminish-
ing returns. Average total cost is the sum of
average fixed and average variable costs; its
graph is also U-shaped.
8. Marginal cost is the extra, or additional, cost
of producing one more unit of output. It is the
amount by which total cost and total variable
cost change when one more or one fewer
unit of output is produced. Graphically, the
marginal-cost curve intersects the ATC and
AVC curves at their minimum points.
9. Lower resource prices shift cost curves
downward, as does technological progress.
Higher input prices shift cost curves upward.
10. The long run is a period of time sufficiently
long for a firm to vary the amounts of all
resources used, including plant size. In the
long run all costs are variable. The long-run
ATC, or planning, curve is composed of seg-
ments of the short-run ATC curves, and it
represents the various plant sizes a firm can
construct in the long run.
11. The long-run ATC curve is generally U-
shaped. Economies of scale are first en-
countered as a small firm expands. Greater
specialization in the use of labour and man-
agement, the ability to use the most efficient
equipment, and the spreading of startup
costs among more units of output all con-
tribute to economies of scale. As the firm
continues to grow, it will encounter dis-
economies of scale stemming from the
managerial complexities that accompany
large-scale production. The output ranges
over which economies and diseconomies
of scale occur in an industry are often an
important determinant of the structure of
that industry.
plant, p. 181
firm, p. 181
industry, p. 181
sole proprietorship, p. 181
partnership, p. 181
corporation, p. 181
stocks, p. 183
bonds, p. 183
limited liability, p. 183
double taxation, p. 183
principle–agent problem,
p. 183
economic (opportunity) cost,
p. 184
explicit costs, p. 185
implicit costs, p. 185
normal profit, p. 185
economic profit, p. 186
short run, p. 187
long run, p. 187
total product (TP), p. 188
marginal product (MP), p. 188
average product (AP), p. 188
law of diminishing returns,
p. 188
fixed costs, p. 192
variable costs, p. 192
total cost, p. 192
average fixed cost (AFC),
p. 194
average variable cost (AVC),
p. 194
average total cost (ATC),
p. 195
marginal cost (MC), p. 195
economies of scale, p. 202
diseconomies of scale, p. 203
constant returns to scale,
p. 203
minimum efficient scale
(MES), p. 207
natural monopoly, p. 207
study questions
1. Distinguish between a plant, a firm, and an
industry. Why is an industry often difficult to
define?
2.
KEY QUESTION What are the major
legal forms of business organization? Briefly
state the advantages and disadvantages of
each. How do you account for the dominant
role of corporations in the Canadian economy?
3. “The legal form an enterprise takes is dic-
tated primarily by the financial requirements
of its particular line of production.” Do you
agree? Why or why not?
4.
KEY QUESTION Gomez runs a small
pottery firm. He hires one helper at $12,000
per year, pays annual rent of $5000 for his
shop, and spends $20,000 per year on
chapter eight • the organization and the costs of production 211
materials. He has $40,000 of his own funds
invested in equipment (pottery wheels, kilns,
and so forth) that could earn him $4000 per
year if alternatively invested. He has been
offered $15,000 per year to work as a pot-
ter for a competitor. He estimates his en-
trepreneurial talents are worth $3000 per
year. Total annual revenue from pottery
sales is $72,000. Calculate the accounting
profit and the economic profit for Gomez’s
pottery firm.
5. Which of the following are short-run and
which are long-run adjustments? (a) Wendy’s
builds a new restaurant. (b) Acme Steel Cor-
poration hires 200 more workers. (c) A
farmer increases the amount of fertilizer
used on his corn crop. (d) An Alcan alu-
minum plant adds a third shift of workers.
6.
KEY QUESTION Complete the fol-
lowing table by calculating marginal product
and average product from the data given.
Inputs of Total Marginal Average
lalbour product product product
00
1 15 ______ ______
2 34 ______ ______
3 51 ______ ______
4 65 ______ ______
5 74 ______ ______
6 80 ______ ______
7 83 ______ ______
8 82 ______ ______
Plot the total, marginal, and average prod-
ucts and explain in detail the relationship
between each pair of curves. Explain why
marginal product first rises, then declines,
and ultimately becomes negative. What
bearing does the law of diminishing returns
have on short-run costs? Be specific. “When
marginal product is rising, marginal cost is
falling. When marginal product is diminish-
ing, marginal cost is rising.” Illustrate and
explain graphically.
7. Why can the distinction between fixed costs
and variable costs be made in the short run?
Classify the following as fixed or variable
costs: advertising expenditures, fuel, interest
on company-issued bonds, shipping charges,
payments for raw materials, real estate taxes,
executive salaries, insurance premiums, wage
payments, depreciation and obsolescence
charges, sales taxes, and rental payments
on leased office machinery. “There are no
fixed costs in the long run; all costs are vari-
able.” Explain.
8. List several fixed and variable costs associ-
ated with owning and operating an automo-
bile. Suppose you are considering whether
to drive you car or fly 1000 kilometres for
spring break. Which costs—fixed, variable,
or both—would you take into account in
making your decision? Would any implicit
costs be relevant? Explain.
9.
KEY QUESTION A firm has $60 in
fixed costs and variable costs as indicated in
the table below. Complete the table; check
your calculations by referring to question 4
at the end of Chapter 9.
Total Total Average Average Average
Total fixed variable Total fixed variable total Marginal
product cost cost cost cost cost cost cost
0 $______ $ 0 $______ $______ $______ $______ $______
1 ______ 45 ______ ______ ______ ______ ______
2 ______ 85 ______ ______ ______ ______ ______
3 ______ 120 ______ ______ ______ ______ ______
4 ______ 150 ______ ______ ______ ______ ______
5 ______ 185 ______ ______ ______ ______ ______
6 ______ 225 ______ ______ ______ ______ ______
7 ______ 270 ______ ______ ______ ______ ______
8 ______ 325 ______ ______ ______ ______ ______
9 ______ 390 ______ ______ ______ ______ ______
10 ______ 465 ______ ______ ______ ______ ______
212 Part Two • Microeconomics of Product Markets
a. Graph total fixed cost, total variable cost,
and total cost. Explain how the law of
diminishing returns influences the shapes
of the variable-cost and total-cost curves.
b. Graph AFC, AVC, ATC, and MC. Explain
the derivation and shape of each of these
four curves and their relationships to one
another. Specifically, explain in nontech-
nical terms why the MC curve intersects
both the AVC and ATC curves at their
minimum points.
c. Explain how the location of each curve
graphed in question 7b would be altered
if (1) total fixed cost had been $100 rather
than $60, and (2) total variable cost had
been $10 less at each level of output.
10. Indicate how each of the following would
shift the (1) marginal-cost curve, (2) average-
variable-cost curve, (3) average-fixed-cost
curve, and (4) average-total-cost curve of a
manufacturing firm. In each case specify the
direction of the shift.
a. A reduction in business property taxes
b. An increase in the nominal wages of pro-
duction workers
c. A decrease in the price of electricity
d. An increase in insurance rates on plant
and equipment
e. An increase in transportation costs
11. Suppose a firm has only three possible
plant-size options, represented by the ATC
curves shown in the accompanying figure.
What plant size will the firm choose in pro-
ducing (a) 50, (b) 130, (c) 160 and (d) 250
units of output? Draw the firm’s long-run
average-cost curve on the diagram and
describe this curve.
12.
KEY QUESTION Use the concepts of
economies and diseconomies of scale to
explain the shape of a firm’s long-run ATC
curve. What is the concept of minimum effi-
cient scale? What bearing can the shape of
the long-run ATC curve have on the structure
of an industry?
13. (The Last Word) What is a sunk cost? Provide
an example of a sunk cost other than one
from the text. Why are such costs irrelevant
in making decisions about future actions?
internet application questions
1. Check out the National Post 500 list of
the largest Canadian firms at <www.
nationalpostbusiness.com/datamining/top500/
top500.htm>. From the top ten profit list, select
three firms from three different industries
and discuss the likely sources of economies
of scale that underlie their large size.
2. Use the Yahoo search engine at <www.
yahoo.ca> to locate a company’s homepage
of your choice. Find and review the com-
pany’s income statement in its annual report
and classify the nonrevenue items as either
fixed or variable costs. Are all costs clearly
identifiable as either fixed or variable? What
item would be considered as accounting
profit? Would economic profit be higher or
lower than this accounting profit?
ATC
ATC
3
ATC
2
ATC
1
0
80 150 240
Q
IN THIS CHAPTER
IN THIS CHAPTER
Y
Y
OU WILL LEARN:
OU WILL LEARN:
The four basic market
structures and how they
determine the degree of
competition among firms.
•
The four conditions required for
perfectly competitive markets.
•
The profit-maximizing output
in the short-run for a firm
in pure competition.
•
About the marginal cost and
the short-run supply curve.
•
About the firm’s profit
maximization in the long run.
•
That in competitive markets
firms attain both allocative and
productive efficiency.
Pure
Competition
I
n Chapter 7 we examined the relationship
between product demand and total rev-
enue, and in Chapter 8 we discussed costs
of production. Now we want to put revenues
and costs together to see how a business
decides what price to charge and how much
output to produce. A firm’s decisions con-
cerning price and production depend greatly
on the character of the industry in which it
is operating; there is no average or typical
industry. At one extreme is a single producer
that dominates the market; at the other
extreme are industries in which thousands of
firms each produce a minute fraction of mar-
ket supply. Between these extremes are many
other industries.
NINE
Since we cannot examine each industry individually, we will focus on several basic
models of market structure to help you understand how price and output are deter-
mined in the many product markets in the economy. The models will also help you
to assess the efficiency or inefficiency of those markets.
Economists group industries into four distinct market structures: pure competi-
tion, pure monopoly, monopolistic competition, and oligopoly. These four market
models differ in several respects: the number of firms in the industry, whether
those firms produce a standardized product or try to differentiate their products
from those of other firms, and how easy or how difficult it is for firms to enter the
industry.
Very briefly the four models are as follows:
● Pure competition is a market structure that requires a very large number of
firms producing a standardized product (that is, a product identical to that of
other producers, such as corn or cucumbers). New firms can enter the indus-
try very easily.
● Pure monopoly is a market structure in which one firm is the sole seller of a
product or service (for example, a local cable company). Since the entry of
additional firms is blocked, one firm constitutes the entire industry. Because
the monopolist produces a unique product, it makes no effort to differentiate
its product.
● Monopolistic competition is characterized by a relatively large number of
sellers producing differentiated products (clothing, furniture, books). There is
widespread nonprice competition, a selling strategy in which one firm tries to
distinguish its product or service from all competing products based on attrib-
utes like design and quality (an approach called product differentiation). Entry
to monopolistically competitive industries is quite easy.
● Oligopoly involves only a few sellers of an identical or similar product; con-
sequently each firm is affected by the decisions of its rivals and must take those
decisions into account when determining its own price and output.
Table 9-1 summarizes the characteristics of the four models for easy comparison. In
discussing these four market models, we will occasionally distinguish the charac-
teristics of a pure competition from those of the three other basic market structures,
which together we will designate as imperfect competition.
Let’s take a fuller look at pure competition, the focus of the remainder of this chapter.
● Very large numbers A basic feature of a purely competitive market is the pres-
ence of a large number of sellers acting independently, often offering their
products in large national or international markets. Examples include markets
for farm commodities, the stock market, and the foreign exchange market.
214 Part Two • Microeconomics of Product Markets
Pure Competition: Characteristics
and Occurrence
Four Market Models
pure
competition
A market structure
in which a very large
number of firms
produce a standard-
ized product.
pure
monopoly
A
market structure in
which one firm is
the sole seller of a
product or service.
monopolistic
competition
A market structure
in which a relatively
large number of
sellers produce
differentiated
products.
oligopoly A
market structure in
which a few large
firms produce homo-
geneous or differen-
tiated products.
imperfect
competition
The market models
of pure monopoly,
monopolistic com-
petition, and oligop-
oly considered as
a group.
● Standardized product Purely competitive firms produce a standardized (or
homogeneous) product. As long as the price is the same, consumers will be
indifferent about which seller to buy the product from. Buyers view the prod-
ucts of firms B, C, D, and E as perfect substitutes for the product of firm A.
Because purely competitive firms sell standardized products, they make no
attempt to differentiate their products and do not engage in other forms of
nonprice competition.
● Price-takers In purely competitive markets individual firms exert no signif-
icant control over product price. Each firm produces such a small fraction of
total output that increasing or decreasing its output will not perceptively
influence total supply or, therefore, product price. In short, the competitive
firm is a price-taker: it cannot change market price, it can only adjust to it. That
means that the individual competitive producer is at the mercy of the market.
Asking a price higher than the market price would be futile; consumers will
not buy from firm A at $2.05 when its 9999 competitors are selling an identical
product at $2 per unit. Conversely, because firm A can sell as much as it
chooses at $2 per unit, it has no reason to charge a lower price, say, $1.95, for
to do so would lower its profit.
● Free entry and exit New firms can freely enter, and existing firms can freely
leave, purely competitive industries. No significant legal, technological, finan-
cial, or other obstacles prohibit new firms from selling their output in any com-
petitive market.
chapter nine • pure competition 215
TABLE 9-1 CHARACTERISTICS OF THE FOUR BASIC
MARKET MODELS
MARKET MODEL
Monopolistic
Characteristic Pure competition competition Oligopoly Pure monopoly
Number of firms A very large Many Few One
number
Type of product Standardized Differentiated Standardized or Unique; no close
differentiated substitutes
Control over price None Some, but within Limited by mutual Considerable
rather narrow interdependence;
limits considerable with
collusion
Conditions of Very easy, no Relatively easy Significant Blocked
entry obstacles obstacles
Nonprice None Considerable Typically a great Mostly public
competition emphasis on deal, particularly relations
advertising, brand with product advertising
names, trademarks differentiation
Examples Agriculture Retail trade, Steel, automobiles, Local utilities
dresses, shoes farm implements,
many household
appliances
price-taker
A firm in a purely
competitive market
that cannot change
market price, only
adjust to it.
Relevance of Pure Competition
Although pure competition is relatively rare in the real world, this market model is
highly relevant. A few industries more closely approximate pure competition than
any other market structure. In particular, we can learn much about markets for agri-
cultural goods, fish products, foreign exchange, basic metals, and stock shares by
studying the pure competition model. Also, pure competition is a meaningful start-
ing point for any discussion of price and output determination. The operation of a
purely competitive economy provides a standard, or norm, for evaluating the effi-
ciency of the real-world economy.
To develop a tabular and graphical model of pure competition, we first examine
demand from a competitive seller’s viewpoint and see how it affects revenue. This
seller might be a wheat farmer, a strawberry grower, or a sheep rancher. Each purely
competitive firm offers only a negligible fraction of total market supply, therefore, it
must accept the price determined by the market; it is a price-taker, not a price-maker.
Perfectly Elastic Demand
The demand curve of the competitive firm, as represented by columns 1 and 2 in
Table 9-2, is perfectly elastic. As shown in the table, the market price is $131. The
firm represented cannot obtain a higher price by
restricting its output, nor does it need to lower
its price to increase its sales volume.
We are not saying that market demand is per-
fectly elastic in a competitive market. Market
demand graphs are the usual downsloping
curve, as a glance ahead at Figure 9-7(b) will
reveal. In fact, the total-demand curves for most
agricultural products are quite inelastic, even
though agriculture is the most competitive
industry in the Canadian economy. An entire
industry (all firms producing a particular
product) can affect price by changing industry
output. For example, all firms, acting inde-
pendently but simultaneously, can increase
price by reducing output, but the individual
firm cannot do that. So the demand schedule
faced by the individual firm in a purely compet-
itive industry is perfectly elastic at the market
price, as shown in Figure 9-1.
Average, Total, and Marginal Revenue
The firm’s demand schedule is also its revenue
schedule. The price per unit to the purchaser is
also revenue per unit, or average revenue, to
the seller. To say that all buyers must pay $131
per unit is to say that the revenue per unit, or
average revenue, received by the seller is $131.
216 Part Two • Microeconomics of Product Markets
<n103dept.matc.edu/
walshj/chrono/
Chrono%202/
purecomp3.htm>
A quick summary of
pure competition
Demand for a Purely Competitive Seller
TABLE 9-2 THE DEMAND
AND REVENUE
SCHEDULES
FOR A PURELY
COMPETITIVE FIRM
FIRM’S DEMAND FIRM’S
SCHEDULE REVENUE DATA
(1) (2) (3) (4)
Product Quantity Total Marginal
price, P demanded, revenue, revenue,
(average Q TR MR
revenue) (1) × (2)
$131 0 $ 0
131 1 131
$131
131 2 262
131
131 3 393
131
131 4 524
131
131 5 655
131
131 6 786
131
131 7 917
131
131 8 1,048
131
131 9 1,179
131
131 10 1,310
131
average
revenue
Total
revenue from the
sale of a product
divided by the
quantity of the
product sold.
The total revenue for each sales level is found by multiplying price by the corre-
sponding quantity the firm can sell. (Column 1 multiplied by column 2 in Table 9-2
yields column 3.) In this case, total revenue increases by a constant amount, $131,
for each additional unit of sales. Each unit sold adds exactly its constant price to
total revenue.
When a firm is pondering a change in its output, it will consider how its total rev-
enue will change as a result. What will be the additional revenue from selling
another unit of output? Marginal revenue is the change in total revenue, that is,
the extra revenue, that results from selling one more unit of output. In column 3,
Table 9-2, total revenue is zero when zero units are sold. The first unit of output
sold increases total revenue from zero to $131; marginal revenue for that unit is
$131. The second unit sold increases total revenue from $131 to $262, and marginal
revenue is again $131. Note in column 4 that, as is price, marginal revenue is a
constant $131. In pure competition, marginal revenue and price are equal. (Key
Question 3)
Graphical Portrayal
Figure 9-1 shows the purely competitive firm’s demand curve and total-revenue and
marginal-revenue curves. The demand curve (D) is horizontal, indicating perfect
price elasticity. The marginal-revenue curve (MR) coincides with the demand curve,
because the product price (and hence MR) is constant. Total revenue (TR) is a
straight line that slopes upward to the right. Its slope is constant because each extra
unit of sales increases TR by $131.
chapter nine • pure competition 217
total
revenue
The
total number of dol-
lars received by a
firm from the sale
of a product.
marginal
revenue
The
change in total rev-
enue that results
from selling one
more unit of a firm’s
product.
FIGURE 9-1 DEMAND, MARGINAL REVENUE, AND TOTAL
REVENUE OF A PURELY COMPETITIVE FIRM
TR
D
= MR
$1,179
1,048
917
786
655
524
393
262
131
0 24681012
Quantity demanded (sold)
Price and revenue
A purely competitive
firm can sell addi-
tional units of output
at the market price,
and thus its marginal-
revenue curve (MR)
coincides with its
perfectly elastic
demand curve (D).
The firm’s total-
revenue curve (TR)
is a straight upward-
sloping line.
Since the purely competitive firm is a price-taker, it can maximize its economic profit
(or minimize its loss) only by adjusting its output. In the short run, the firm has a
fixed plant. Thus, it can adjust its output only through changes in the amount of
variable resources (materials, labour) it uses. It adjusts its variable resources to
achieve the output level that maximizes its profit.
There are two ways to determine the level of output at which a competitive firm
will realize maximum profit or the minimum amount of loss. One method is to com-
pare total revenue and total cost; the other is to compare marginal revenue and mar-
ginal cost. Both approaches apply to all firms, whether they are pure competitors,
pure monopolists, monopolistic competitors, or oligopolists.
1
Total-Revenue–Total-Cost Approach: Profit-Maximization Case
With the market price of its product given by the market, the competitive producer
will ask: (1) Should we produce this product? (2) If so, in what amount? (3) What
economic profit (or loss) will we realize?
Let’s demonstrate how a firm in pure competition answers these questions, given
certain cost data and a specific market price. Our cost data are already familiar to
you because they are the fixed-cost, variable-cost, and total-cost data in Table 8-2,
repeated in columns 1 to 4 in Table 9-3. (Recall that these data reflect explicit and
implicit costs, including a normal profit.) Assuming that the market price is $131,
the total revenue for each output level is found by multiplying output (total prod-
uct) by price. Total revenue data are in column 5. Then in column 6 we find the profit
or loss at each output level by subtracting total cost, TC (column 4), from total rev-
enue, TR (column 5).
Should the firm produce? Definitely. It can realize a profit by doing so. How
much should it produce? Nine units. Column 6 tells us that this is the output at
which total economic profit is at a maximum. What economic profit (or loss) will the
firm realize? A $299 economic profit—the difference between total revenue ($1,179)
and total cost ($880).
Figure 9-2(a) compares total revenue and total cost graphically for this profit-
maximizing case. Observe again that the total revenue curve for a purely competitive
218 Part Two • Microeconomics of Product Markets
● In a purely competitive industry a large number
of firms produce a standardized product and no
significant barriers to entry exist.
● The demand of a competitive firm is perfectly
elastic—horizontal on a graph—at the market
price.
● Marginal revenue and average revenue for a
competitive firm coincide with the firm’s de-
mand curve; total revenue rises by the product
price for each additional unit sold.
Profit-Maximization in the Short Run
1
To make sure you understand these two approaches, we will apply them both to output deter-
mination under pure competition, but since we want to emphasize the marginal approach, we will
limit our graphical application of the total-revenue approach to a situation where the firm maxi-
mizes profits. We will then use the marginal approach to examine three cases: profit maximiza-
tion, loss minimization, and shutdown.
firm is a straight line (Figure 9-2). Total cost increases with output in that more pro-
duction requires more resources, but the rate of increase in total cost varies with the
relative efficiency of the firm. Specifically, the cost data reflect Chapter 8’s law of
diminishing marginal returns. From zero to four units of output, total cost increases
at a decreasing rate as the firm uses its fixed resources more efficiently. With addi-
tional output, total cost begins to rise by ever-increasing amounts because of the
diminishing returns accompanying more intensive use of the plant.
Total revenue and total cost are equal where the two curves in Figure 9-2(a) inter-
sect (at roughly two units of output). Total revenue covers all costs (including a nor-
mal profit, which is included in the cost curve) but there is no economic profit. For
this reason economists call this output a break-even point: an output at which a
firm makes a normal profit but not an economic profit. If we extended the data
beyond 10 units of output, another break-even point would occur where total cost
would catch up with total revenue somewhere between 13 and 14 units of output
in Figure 9-2(a). Any output between the two break-even points identified in the fig-
ure will produce an economic profit. The firm achieves maximum profit, how-
ever, where the vertical distance between the total-revenue and total-cost curves is
greatest. For our particular data, this is at nine units of output, where maximum
profit is $299.
The profit-maximizing output is easier to see in Figure 9-2(b), where total eco-
nomic profit is graphed for each level of output. Where the total-revenue and total-
cost curves intersect in Figure 9-2(a), economic profit is zero, as shown by the
total-profit line in Figure 9-2(b). Where the vertical distance between TR and TC is
greatest in the upper graph, economic profit is at its peak ($299), as shown in the
lower graph. This firm will choose to produce nine units, since that output maxi-
mizes its profit.
chapter nine • pure competition 219
TABLE 9-3 THE PROFIT-MAXIMIZING OUTPUT FOR A PURELY
COMPETITIVE FIRM: TOTAL-REVENUE–TOTAL-COST
APPROACH (PRICE $131)
PRICE: $131
(1) (2) (3) (4) (5) (6)
Total Total Total Total Total Profit (+)
product fixed cost, variable cost, cost, revenue, or loss (–)
(output), Q TFC TVC TC TR
0 $100 $ 0 $ 100 $ 0 $–100
1 100 90 190 131 – 59
2 100 170 270 262 – 8
3 100 240 340 393 + 53
4 100 300 400 524 +124
5 100 370 470 655 +185
6 100 450 550 786 +236
7 100 540 640 917 +277
8 100 650 750 1,048 +298
9 100 780 880 1,179 +299
10 100 930 1,030 1,310 +280
break-even
point
An output
at which a firm
makes a normal
profit but not an
economic profit.