Financial Decision Making _ Project 1

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Supply, Demand, and Equilibrium 

The concepts of supply and demand frequently crop up in news stories, particularly in relation to prices of consumer goods. We've all come to recognize that supply and demand influence pricing, but in what other ways do they affect the economy? 

Supply (the producer side of the economy) and demand (the consumer side) are inextricably linked, as a change in one affects the other. Producers are willing to supply a specific amount of goods and services, and that amount varies by price point. Similarly, consumer demand varies according to price. Equilibrium is the price at which the amount suppliers provide equals the amount consumers demand. 

Supply, demand, and equilibrium are complex concepts that interact in many ways—some readily apparent, others a bit more subtle. The resources provided here define the concepts, explain in detail their roles in the economy, and offer examples of how the three factors relate. 

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Supply, Demand, and Equilibrium 

The concepts of supply and demand frequently crop up in news stories, particularly in relation to prices of consumer goods. We've all come to recognize that supply and demand influence pricing, but in what other ways do they affect the economy? 

Supply (the producer side of the economy) and demand (the consumer side) are inextricably linked, as a change in one affects the other. Producers are willing to supply a specific amount of goods and services, and that amount varies by price point. Similarly, consumer demand varies according to price. Equilibrium is the price at which the amount suppliers provide equals the amount consumers demand. 

Supply, demand, and equilibrium are complex concepts that interact in many ways—some readily apparent, others a bit more subtle. The resources provided here define the concepts, explain in detail their roles in the economy, and offer examples of how the three factors relate. 

Perfect competition is defined as an economic model predicting that, at a long-run equilibrium, production takes place at the lowest possible cost per unit and that all economic profits and losses are eliminated. Perfect competition expresses several main characteristics:

· The central characteristic of the model of perfect competition is the fact that price is determined by the interaction of demand and supply; buyers and sellers are price takers.

· The model assumes the presence of a large number of firms producing identical (homogeneous) goods or services, a large number of buyers and sellers, easy entry and exit in the industry, and complete information about prices in the market.

· The model of perfect competition underlies the model of demand and supply.

Compare this model with a monopolistic economic model, as shown in the table below

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Monopoly Production and Pricing Decisions

A monopoly occurs when only one company provides goods or services to a specific market.

Efficiency, Equity, and Concentration of Power

A monopoly firm determines its output by setting marginal cost equal to marginal revenue. It then charges the price at which it can sell that output, a price determined by the demand curve. That price exceeds marginal revenue; it therefore exceeds marginal cost as well. That contrasts with the case of perfect competition, in which price and marginal cost are equal. The higher price charged by a monopoly firm may allow it a profit—in large part at the expense of consumers, whose reduced options may give them little say in the matter. The monopoly solution thus raises problems of efficiency, equity, and the concentration of power.

Monopoly and Efficiency

The fact that price in monopoly exceeds marginal cost suggests that the monopoly solution violates the basic condition for economic efficiency, that the price system must confront decision makers with all of the costs and all of the benefits of their choices. Efficiency requires that consumers confront prices that equal marginal costs. Because a monopoly firm charges a price greater than marginal cost, consumers will consume less of the monopoly’s good or service than is economically efficient.

To contrast the efficiency of the perfectly competitive outcome with the inefficiency of the monopoly outcome, imagine a perfectly competitive industry whose solution is depicted in the following figure, Perfect Competition, Monopoly, and Efficiency. The short-run industry supply curve is the summation of individual marginal cost curves; it may be regarded as the marginal cost curve for the industry. A perfectly competitive industry achieves equilibrium at point C, at price Pc and quantity Qc.

Now, suppose that all the firms in the industry merge and a government restriction prohibits entry by any new firms. Our perfectly competitive industry is now a monopoly. Assume the monopoly continues to have the same marginal cost and demand curves that the competitive industry did. The monopoly firm faces the same market demand curve, from which it derives its marginal revenue curve. It maximizes profit at output Qm and charges price Pm. Output is lower and price higher than in the competitive solution.

Perfect Competition, Monopoly, and Efficiency

Given market demand and marginal revenue, we can compare the behavior of a monopoly to that of a perfectly competitive industry. The marginal cost curve may be thought of as the supply curve of a perfectly competitive industry. The perfectly competitive industry produces quantity Qc and sells the output at price Pc. The monopolist restricts output to Qm and raises the price to Pm.

Reorganizing a perfectly competitive industry as a monopoly results in a deadweight loss to society given by the shaded area GRC. It also transfers a portion of the consumer surplus earned in the competitive case to the monopoly firm.

Society would gain by moving from the monopoly solution at Qm to the competitive solution at Qc. The benefit to consumers would be given by the area under the demand curve between Qm and Qc; it is the area QmRCQc. An increase in output, of course, has a cost. Because the marginal cost curve measures the cost of each additional unit, we can think of the area under the marginal cost curve over some range of output as measuring the total cost of that output. Thus, the total cost of increasing output from Qm to Qc is the area under the marginal cost curve over that range—the area QmGCQc. Subtracting this cost from the benefit gives us the net gain of moving from the monopoly to the competitive solution; it is the shaded area GRC. That is the potential gain from moving to the efficient solution. The area GRC is a deadweight loss.

Monopoly and Equity

The monopoly solution raises issues not just of efficiency but also of equity. The figure above shows that the monopolist charges price Pm rather than the competitive price Pc; the higher price charged by the monopoly firm reduces consumer surplus. Consumer surplus is the difference between what consumers are willing to pay for a good and what they actually pay. It is measured by the area under the demand curve and above the price of the good over the range of output produced.

If the industry were competitive, consumer surplus would be the area below the demand curve and above PcC. With a monopoly, consumer surplus would be the area below the demand curve and above PmR. Part of the reduction in consumer surplus is the area under the demand curve between Qc and Qm; it is contained in the deadweight loss area GRC. But consumers also lose the area of the rectangle bounded by the competitive and monopoly prices and by the monopoly output; this lost consumer surplus is transferred to the monopolist.

The fact that society suffers a deadweight loss due to a monopoly is an efficiency problem. But the transfer of a portion of consumer surplus to the monopolist is an equity issue. Is such a transfer legitimate? After all, the monopoly firm enjoys a privileged position, protected by barriers to entry from competition. Should it be allowed to extract these gains from consumers? Public policy suggests that the answer is no. Regulatory efforts imposed in monopoly cases often seek to reduce the degree to which monopoly firms extract consumer surplus from consumers by reducing the prices these firms charge.

Monopoly and the Concentration of Power

The objections to monopolies run much deeper than worries over economic efficiency and high prices. Because the monopoly enjoys barriers that block potential rivals, a monopoly firm wields considerable market power. For many people, that concentration of power is objectionable. A decentralized, competitive market constantly tests the ability of firms to satisfy consumers, pushes them to find new products and new and better production methods, and whittles away economic profits. Firms that operate in the shelter of monopoly may be largely immune to such pressures. Consumers are likely to be left with fewer choices, higher costs, and lower quality.

Perhaps more important in the view of many economists is the fact that the existence of economic profits provides both an incentive and the means for monopolists to aggressively protect their position and extend it if possible. These economists point out that monopolists may be willing to spend their economic profits in attempts to influence political leaders and public authorities (including regulatory authorities) who can help them maintain or enhance their monopoly position. Graft and corruption may be the result, claim these critics. Indeed, Microsoft has been accused by its rivals of bullying computer manufacturers into installing its web browser, Internet Explorer, exclusively, on their computers.

Demand Curves Perceived by a Perfectly Competitive Firm and by a Monopoly

A perfectly competitive firm acts as a price taker, so its calculation of total revenue is made by taking the given market price and multiplying it by the quantity of output that the firm chooses. The demand curve as it is perceived by a perfectly competitive firm appears in graph (a) in the figure below. The flat perceived demand curve means that, from the viewpoint of the perfectly competitive firm, it could sell either a relatively low quantity like Ql or a relatively high quantity like Qh at the market price P.

The Perceived Demand Curve for a Perfect Competitor and a Monopolist

(a) A perfectly competitive firm perceives the demand curve that it faces to be flat. The flat shape means that the firm can sell either a low quantity (Ql) or a high quantity (Qh) at exactly the same price (P). (b) A monopolist perceives the demand curve that it faces to be the same as the market demand curve, which for most goods is downward sloping. Thus, if the monopolist chooses a high level of output (Qh), it can charge only a relatively low price (Pl); conversely, if the monopolist chooses a low level of output (Ql), it can then charge a higher price (Ph). The challenge for the monopolist is to choose the combination of price and quantity that maximizes profits.

Total Cost and Total Revenue for a Monopolist

Profits for a monopolist can be illustrated with a graph of total revenues and total costs, as shown with the example of the hypothetical HealthPill firm in the figure below. The total cost curve has its typical shape: total costs rise and the curve grows steeper as output increases.

Total Revenue and Total Cost for the HealthPill Monopoly

Total revenue for the monopoly firm called HealthPill first rises, then falls. Low levels of output bring in relatively little total revenue, because the quantity is low. High levels of output bring in relatively less revenue, because the high quantity pushes down the market price. The total cost curve is upward-sloping. Profits will be highest at the quantity of output where total revenue is most above total cost.

Of the choices in the following table, the highest profits happen at an output of four. The profit-maximizing level of output is not the same as the revenue-maximizing level of output, which should make sense, because profits take costs into account and revenues do not.

Total Costs and Total Revenues of HealthPill
Quantity	Total cost	Quantity	Price	Total revenue	Profit = total revenue – total cost
1	1,500	1	1,200	1,200	–300
2	1,800	2	1,100	2,200	400
3	2,200	3	1,000	3,000	800
4	2,800	4	900	3,600	800
5	3,500	5	800	4,000	500
6	4,200	6	700	4,200	0
7	5,600	7	600	4,200	–1,400
8	7,400	8	500	4,000	–3,400

To calculate total revenue for a monopolist, start with the demand curve perceived by the monopolist. The table above shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output. (In this example, the output is given as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer greater realism, you can imagine that these output levels and the corresponding prices are measured per 1,000 or 10,000 pills.) As the figure illustrates, total revenue for a monopolist rises, flattens out, and then falls. In this example, total revenue is highest at a quantity of six or seven.

Clearly, the total revenue for a monopolist is not a straight upward-sloping line, in the way that total revenue was for a perfectly competitive firm. The different total revenue pattern for a monopolist occurs because the quantity that a monopolist chooses to produce affects the market price, which was not true for a perfectly competitive firm. If the monopolist charges a very high price, then quantity demanded drops, and so total revenue is very low. If the monopolist charges a very low price, then, even if quantity demanded is very high, total revenue will not add up to much. At some intermediate level, total revenue will be highest.

However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. Profits are calculated in the final row of the table. In the HealthPill example in the figure above, Total Revenue and Total Cost for the HealthPill Monopoly, the highest profit will occur at the quantity where total revenue is the farthest above total cost. Of the choices given in the table, the highest profits occur at an output of four, where profit is 800.

Marginal Revenue and Marginal Cost for a Monopolist

In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total costs curves; after all, the firm does not know exactly what would happen if it were to alter production dramatically. But a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience. A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price.

The first four columns of the table below, Costs and Revenues of HealthPill, use the numbers on total cost from the HealthPill example in the previous example and calculate marginal cost and average cost. This monopoly faces a typical upward-sloping marginal cost curve, as shown in the following figure, Marginal Revenue and Marginal Cost for the HealthPill Monopoly. The second four columns of the table use the total revenue information from the previous exhibit and calculate marginal revenue.

Notice that marginal revenue is zero at a quantity of seven, and turns negative at quantities higher than seven. It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, doesn’t an increase in quantity sold always mean more revenue? For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price. But a monopolist can sell a larger quantity and see a decline in total revenue. When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because every other unit must now be sold at a lower price. As the quantity sold becomes higher, the drop in price affects a greater quantity of sales, eventually causing a situation where more sales cause marginal revenue to be negative.

Marginal Revenue and Marginal Cost for the HealthPill Monopoly

For a monopoly like HealthPill, marginal revenue decreases as additional units are sold. The marginal cost curve is upward-sloping. The profit-maximizing choice for the monopoly will be to produce at the quantity where marginal revenue is equal to marginal cost: that is, MR = MC. If the monopoly produces a lower quantity, then MR > MC at those levels of output, and the firm can make higher profits by expanding output. If the firm produces at a greater quantity, then MC > MR, and the firm can make higher profits by reducing its quantity of output.

Costs and Revenues of HealthPill
Cost information	Revenue information
Quantity	Total cost	Marginal cost	Average cost	Quantity	Price	Total revenue	Marginal revenue
1	1,500	1,500	1,500	1	1,200	1,200	1,200
2	1,800	300	900	2	1,100	2,200	1,000
3	2,200	400	733	3	1,000	3,000	800
4	2,800	600	700	4	900	3,600	600
5	3,500	700	700	5	800	4,000	400
6	4,200	700	700	6	700	4,200	200
7	5,600	1,400	800	7	600	4,200	0
8	7,400	1,800	925	8	500	4,000	–200

A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit.

For example, at an output of three, marginal revenue is 800 and marginal cost is 400, so producing this unit will clearly add to overall profits. At an output of four, marginal revenue is 600 and marginal cost is 600, so producing this unit still means overall profits are unchanged. However, expanding output from four to five would involve a marginal revenue of 400 and a marginal cost of 700, so that fifth unit would actually reduce profits. Thus, the monopoly can tell from the marginal revenue and marginal cost that of the choices given in the table, the profit-maximizing level of output is four.

Indeed, the monopoly could seek out the profit-maximizing level of output by increasing quantity by a small amount, calculating marginal revenue and marginal cost, and then either increasing output as long as marginal revenue exceeds marginal cost or reducing output if marginal cost exceeds marginal revenue. This process works without any need to calculate total revenue and total cost. Thus, a profit-maximizing monopoly should follow the rule of producing up to the quantity where marginal revenue is equal to marginal cost—that is, MR = MC.

Illustrating Monopoly Profits

It is straightforward to calculate profits of given numbers for total revenue and total cost. However, the size of monopoly profits can also be illustrated graphically, as in the figure below, Illustrating Profits at the HealthPill Monopoly, which takes the marginal cost and marginal revenue curves from the previous exhibit and adds an average cost curve and the monopolist’s perceived demand curve.

Illustrating Profits at the HealthPill Monopoly

This figure begins with the same marginal revenue and marginal cost curves from the HealthPill monopoly presented above. It then adds an average cost curve and the demand curve faced by the monopolist. The HealthPill firm first chooses the quantity where MR = MC; in this example, the quantity is four. The monopolist then decides what price to charge by looking at the demand curve it faces. The large box, with quantity on the horizontal axis and marginal revenue on the vertical axis, shows total revenue for the firm. Total costs for the firm are shown by the lighter-shaded box, which is quantity on the horizontal axis and marginal cost of production on the vertical axis. The large total revenue box minus the smaller total cost box leaves the darkly shaded box that shows total profits. Since the price charged is above average cost, the firm is earning positive profits.

The next figure, How a Profit-Maximizing Monopoly Decides Price, illustrates a three-step process:

1. The monopolist selects the profit-maximizing quantity to produce.

2. The monopolist decides what price to charge,

3. The monopolist determines total revenue, total cost, and profit.

Step 1: The Monopolist Determines Its Profit-Maximizing Level of Output

The firm can use the points on the demand curve D to calculate total revenue, and then, based on total revenue, calculate its marginal revenue curve. The profit-maximizing quantity will occur where MR = MC—or at the last possible point before marginal costs start exceeding marginal revenue. In the figure directly above, MR = MC occurs at an output of four.

Step 2: The Monopolist Decides What Price to Charge

The monopolist will charge what the market is willing to pay. A dotted line drawn straight up from the profit-maximizing quantity to the demand curve shows the profit-maximizing price. This price is above the average cost curve, which shows that the firm is earning profits.

Step 3: Calculate Total Revenue, Total Cost, and Profit

Total revenue is the overall shaded box, where the width of the box is the quantity being sold and the height is the price. In the figure above, the bottom part of the shaded box, which is shaded more lightly, shows total costs; that is, quantity on the horizontal axis multiplied by average cost on the vertical axis. The larger box of total revenues minus the smaller box of total costs will equal profits, which is shown by the darkly shaded box. In a perfectly competitive market, the forces of entry would erode this profit in the long run. But a monopolist is protected by barriers to entry. In fact, one telltale sign of a possible monopoly is when a firm earns profits year after year, while doing more or less the same thing, without ever seeing those profits eroded by increased competition.

How a Profit-Maximizing Monopoly Decides Price

In Step 1, the monopoly chooses the profit-maximizing level of output Q1, by choosing the quantity where MR = MC. In Step 2, the monopoly decides how much to charge for output level 1 by drawing a line straight up from Q1 to point R on its perceived demand curve. Thus, the monopoly will charge a price (P1). In Step 3, the monopoly identifies its profit. Total revenue will be Q1 multiplied by P1. Total cost will be Q1 multiplied by the average cost of producing Q1, which is shown by point S on the average cost curve to be P2. Profits will be the total revenue rectangle minus the total cost rectangle, shown by the shaded zone in the figure.

Why is a Monopolist’s Marginal Revenue Always Less Than the Price?

The marginal revenue curve for a monopolist always lies beneath the market demand curve. To understand why, think about increasing the quantity along the demand curve by one unit, so that you take one step down the demand curve to a slightly higher quantity but a slightly lower price. A demand curve is not sequential: It is not that first we sell Q1 at a higher price, and then we sell Q2 at a lower price. Rather, a demand curve is conditional: If we charge the higher price, we would sell Q1. If, instead, we charge a lower price (on all the units that we sell), we would sell Q2.

So when we think about increasing the quantity sold by one unit, marginal revenue is affected in two ways. First, we sell one additional unit at the new market price. Second, all the previous units, which could have been sold at the higher price, now sell for less. Because of the lower price on all units sold, the marginal revenue of selling a unit is less than the price of that unit—and the marginal revenue curve is below the demand curve. 

Tip: For a straight-line demand curve, MR and demand have the same vertical intercept. As output increases, marginal revenue decreases twice as fast as demand, so that the horizontal intercept of MR is halfway to the horizontal intercept of demand. You can see this in the next figure, The Monopolist’s Marginal Revenue Curve versus Demand Curve.

The Monopolist’s Marginal Revenue Curve versus Demand Curve

Because the market demand curve is conditional, the marginal revenue curve for a monopolist lies beneath the demand curve.

The Inefficiency of Monopoly

Most people criticize monopolies because they charge too high a price, but what economists object to is that monopolies do not supply enough output to be allocatively efficient. To understand why a monopoly is inefficient, it is useful to compare it with the benchmark model of perfect competition.

Allocative efficiency is a social concept. It refers to producing the optimal quantity of some output—the quantity where the marginal benefit to society of one more unit just equals the marginal cost. The rule of profit maximization in a world of perfect competition was for each firm to produce the quantity of output where P = MC, where the price (P) is a measure of how much buyers value the good and the marginal cost (MC) is a measure of what marginal units cost society to produce. Following this rule assures allocative efficiency. If P > MC, then the marginal benefit to society (as measured by P) is greater than the marginal cost to society of producing additional units, and a greater quantity should be produced. But in the case of monopoly, price is always greater than marginal cost at the profit-maximizing level of output, as can be seen by looking back at the figure titled, Illustrating Profits at the HealthPill Monopoly. Thus, consumers will suffer from a monopoly because a lower quantity will be sold in the market, at a higher price, than would have been the case in a perfectly competitive market.

The problem of inefficiency for monopolies often runs even deeper than these issues, and also involves incentives for efficiency over longer periods of time. There are counterbalancing incentives here. On one side, firms may strive for new inventions and new intellectual property because they want to become monopolies and earn high profits—at least for a few years until the competition catches up. In this way, monopolies may come to exist because of competitive pressures on firms. However, once a barrier to entry is in place, a monopoly that does not need to fear competition can just produce the same old products in the same old way—while still ringing up a healthy rate of profit. John Hicks, who won the Nobel Prize for economics in 1972, wrote in 1935: “The best of all monopoly profits is a quiet life.” He did not mean the comment in a complimentary way. He meant that monopolies may bank their profits and slack off on trying to please their customers.

When AT&T provided all of the local and long-distance phone service in the United States, along with manufacturing most of the phone equipment, the payment plans and types of phones did not change much. The old joke was that you could have any color phone you wanted, as long as it was black. But in 1982, AT&T was split up by government litigation into a number of local phone companies, a long-distance phone company, and a phone equipment manufacturer. An explosion of innovation followed. Services like call waiting, caller ID, three-way calling, voicemail through the phone company, mobile phones, and wireless connections to the Internet all became available. A wide range of payment plans was offered, as well. It was no longer true that all phones were black; instead, phones came in a wide variety of shapes and colors. The end of the telephone monopoly brought lower prices, a greater quantity of services, and also a wave of innovation aimed at attracting and pleasing customers.

Step 3 Notes:

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Fixed, Variable, and Marginal Costs

Total cost is combination of fixed costs and variable costs. We will cover those concepts first, before discussing marginal cost (MC).

Fixed and Variable Costs

Fixed costs are expenditures that do not change regardless of the level of production, at least not in the short term. Whether you produce a lot or a little, the fixed costs are the same. One example is the rent on a factory or a retail space. Once you sign the lease, the rent is the same regardless of how much you produce, at least until the lease runs out. Fixed costs can take many other forms: the cost of machinery or equipment to produce the product, research and development costs to develop new products, even an expense like advertising to popularize a brand name. The level of fixed costs varies according to the specific line of business: for instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed.

Variable costs, on the other hand, are incurred in the act of producing—the more you produce, the greater the variable cost. Labor is treated as a variable cost, since producing a greater quantity of a good or service typically requires more workers or more work hours. Variable costs would also include raw materials.

As a concrete example of fixed and variable costs, consider the barber shop called The Clip Joint shown in the figure below. The data for output and costs are shown in the table that follows. The fixed costs of operating the barber shop, including the space and equipment, are $160 per day. The variable costs are the costs of hiring barbers, which in our example is $80 per barber each day. The first two columns of the table show the quantity of haircuts the barbershop can produce as it hires additional barbers. The third column shows the fixed costs, which do not change regardless of the level of production. The fourth column shows the variable costs at each level of output. These are calculated by taking the amount of labor hired and multiplying by the wage. For example, two barbers cost $2 × $80 = $160. Adding together the fixed costs in the third column and the variable costs in the fourth column produces the total costs in the fifth column. So, for example, with two barbers the total cost is $160 + $160 = $320.

How Output Affects Total Costs

At zero production, the fixed costs of $160 are still present. As production increases, variable costs are added to fixed costs, and the total cost is the sum of the two.

Output and Total Costs
Labor	Quantity	Fixed cost	Variable cost	Total cost
1	16	$160	$80	$240
2	40	$160	$160	$320
3	60	$160	$240	$400
4	72	$160	$320	$480
5	80	$160	$400	$560
6	84	$160	$480	$640
7	82	$160	$560	$720

 

The relationship between the quantity of output being produced and the cost of producing that output is shown graphically in the figure. The fixed costs are always shown as the vertical intercept of the total cost curve; that is, they are the costs incurred when output is zero, so there are no variable costs.

You can see from the graph that once production starts, total costs and variable costs rise. While variable costs may initially increase at a decreasing rate, at some point they begin increasing at an increasing rate. This is caused by diminishing marginal returns, which is easiest to see with an example. As the number of barbers increases from zero to one in the table, output increases from 0 to 16 for a marginal gain of 16; as the number rises from one to two barbers, output increases from 16 to 40, a marginal gain of 24. From that point on, though, the marginal gain in output diminishes as each additional barber is added. For example, as the number of barbers rises from two to three, the marginal output gain is only 20; and as the number rises from three to four, the marginal gain is only 12.

To understand the reason behind this pattern, consider that a one-man barber shop is a very busy operation. The single barber needs to do everything: say hello to people entering, answer the phone, cut hair, sweep up, and run the cash register. A second barber reduces the level of disruption from jumping back and forth between these tasks, and allows a greater division of labor and specialization. The result can be greater increasing marginal returns. However, as other barbers are added, the advantage of each additional barber is less, since the specialization of labor can only go so far. The addition of a sixth or seventh or eighth barber just to greet people at the door will have less impact than the second one did. This is the pattern of diminishing marginal returns. As a result, the total costs of production will begin to rise more rapidly as output increases. At some point, you may even see negative returns as the additional barbers begin bumping elbows and getting in each other’s way. In this case, the addition of still more barbers would actually cause output to decrease, as shown in the last row of the table above.

This pattern of diminishing marginal returns is common in production. As another example, consider the problem of irrigating a crop on a farmer’s field. The plot of land is the fixed factor of production, while the water that can be added to the land is the key variable cost. As the farmer adds water to the land, output increases. But adding more and more water brings smaller and smaller increases in output, until at some point the water floods the field and actually reduces output. Diminishing marginal returns occur because, at a given level of fixed costs, each additional input contributes less and less to overall production.

Average Total Cost, Average Variable Cost, Marginal Cost

The breakdown of total costs into fixed and variable costs can provide a basis for other insights as well. The first five columns of the next table duplicate the previous table, but the last three columns show average total cost (ATC), average variable costs, and marginal costs. These new measures analyze costs on a per-unit (rather than a total) basis and are reflected in the curves shown in the figure below.

Different Types of Costs
Labor	Quantity	Fixed cost	Variable cost	Total cost	Marginal cost	Average total cost	Average variable cost
1	16	$160	$80	$240	$5.00	$15.00	$5.00
2	40	$160	$160	$320	$3.30	$8.00	$4.00
3	60	$160	$240	$400	$4.00	$6.60	$4.00
4	72	$160	$320	$480	$6.60	$6.60	$4.40
5	80	$160	$400	$560	$10.00	$7.00	$5.00
6	84	$160	$480	$640	$20.00	$7.60	$5.70

Cost Curves at the Clip Joint

The information on total costs, fixed cost, and variable cost can also be presented on a per-unit basis. Average total cost (ATC) is calculated by dividing total cost by the total quantity produced. The average total cost curve is typically U-shaped. Average variable cost (AVC) is calculated by dividing variable cost by the quantity produced. The average variable cost curve lies below the average total cost curve and is typically U-shaped or upward-sloping. Marginal cost (MC) is calculated by taking the change in total cost between two levels of output and dividing by the change in output. The marginal cost curve is upward-sloping.

Average total cost (sometimes referred to simply as average cost) is total cost divided by the quantity of output. Since the total cost of producing 40 haircuts is $320, the average total cost for producing each of 40 haircuts is $320/40, or $8 per haircut. Average cost curves are typically U-shaped, as the figure above shows. Average total cost starts off relatively high, because at low levels of output total costs are dominated by the fixed cost; mathematically, the denominator is so small that average total cost is large. Average total cost then declines, as the fixed costs are spread over an increasing quantity of output. In the average cost calculation, the rise in the numerator of total costs is relatively small compared to the rise in the denominator of quantity produced. But as output expands still further, the average cost begins to rise. At the right side of the average cost curve, total costs begin rising more rapidly as diminishing returns kick in.

Average variable cost is obtained when variable cost is divided by quantity of output. For example, the variable cost of producing 80 haircuts is $400, so the average variable cost is $400/80, or $5 per haircut. Note that at any level of output, the average variable cost curve will always lie below the curve for average total cost, as shown in the figure above. The reason is that average total cost includes average variable cost and average fixed cost. Thus, for Q = 80 haircuts, the average total cost is $8 per haircut, while the average variable cost is $5 per haircut. However, as output grows, fixed costs become relatively less important (since they do not rise with output), so average variable cost sneaks closer to average cost.

Average total and variable costs measure the average costs of producing some quantity of output. Marginal cost is somewhat different. Marginal cost is the additional cost of producing one more unit of output. So it is not the cost per unit of all units being produced, but only the next one (or next few). Marginal cost can be calculated by taking the change in total cost and dividing it by the change in quantity. For example, as quantity produced increases from 40 to 60 haircuts, total costs rise by 400 – 320, or 80. Thus, the marginal cost for each of those marginal 20 units will be 80/20, or $4 per haircut. The marginal cost curve is generally upward-sloping, because diminishing marginal returns implies that additional units are more costly to produce. A small range of increasing marginal returns can be seen in the figure as a dip in the marginal cost curve before it starts rising. There is a point at which marginal and average costs meet.

Where Do Marginal and Average Costs Meet?

The marginal cost line intersects the average cost line exactly at the bottom of the average cost curve—which occurs at a quantity of 72 and cost of $6.60 in the figure above. The reason the intersection occurs at this point is built into the economic meaning of marginal and average costs. If the marginal cost of production is below the average cost for producing previous units, as it is for the points to the left of where MC crosses ATC, then producing one more additional unit will reduce average costs overall—and the ATC curve will be downward-sloping in this zone. Conversely, if the marginal cost of production for producing an additional unit is above the average cost for producing the earlier units, as it is for points to the right of where MC crosses ATC, then producing a marginal unit will increase average costs overall—and the ATC curve must be upward-sloping in this zone. The point of transition, between where MC is pulling ATC down and where it is pulling it up, must occur at the minimum point of the ATC curve.

This idea of the marginal cost “pulling down” the average cost or “pulling up” the average cost may sound abstract, but think about it in terms of your own grades. If the score on the most recent quiz you take is lower than your average score on previous quizzes, then the marginal quiz pulls down your average. If your score on the most recent quiz is higher than the average on previous quizzes, the marginal quiz pulls up your average. In this same way, low marginal costs of production first pull down average costs and then higher marginal costs pull them up.

The numerical calculations behind average cost, average variable cost, and marginal cost will change from firm to firm. However, the general patterns of these curves, and the relationships and economic intuition behind them, will not change.

Lessons from Alternative Measures of Costs

Breaking down total costs into fixed cost, marginal cost, average total cost, and average variable cost is useful because each statistic offers its own insights for the firm.

Whatever the firm’s quantity of production, total revenue must exceed total costs if it is to earn a profit. Fixed costs are often sunk costs that cannot be recouped. In thinking about what to do next, sunk costs should typically be ignored, since this spending has already been made and cannot be changed. However, variable costs can be changed, so they convey information about the firm’s ability to cut costs in the present and the extent to which costs will increase if production rises.

Average cost tells a firm whether it can earn profits given the current price in the market. If we divide profit by the quantity of output produced we get average profit, also known as the firm’s profit margin. Expanding the equation for profit yields:

averageprofit=profitquantityproduced=totalrevenue−totalcostquantityproduced=totalrevenuequantityproduced−totalcostquantityproduced=averagerevenue−averagecostaverageprofit=profitquantityproduced=totalrevenue−totalcos⁡tquantityproduced=totalrevenuequantityproduced−totalcos⁡tquantityproduced=averagerevenue−averagecos⁡t

But note that:

averagerevenue=price×quantityproducedquantityproduced=priceaveragerevenue=price×quantityproducedquantityproduced=price

Thus:

averageprofit=price−averagecostaverageprofit=price−averagecos⁡t

 

This is the firm’s profit margin. This definition implies that if the market price is above average cost, average profit, and thus total profit, will be positive; if price is below average cost, then profits will be negative.

The marginal cost of producing an additional unit can be compared with the marginal revenue gained by selling that additional unit to reveal whether the additional unit is adding to total profit. Thus, marginal cost helps producers understand how profits would be affected by increasing or decreasing production.

 

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Total Revenue and Marginal Revenue

The increase in total revenue from a one-unit increase in quantity is marginal revenue. Thus marginal revenue (MR) equals the slope of the total revenue curve. Each total revenue curve is a linear, upward-sloping curve. At any price, the greater the quantity a perfectly competitive firm sells, the greater its total revenue. Notice that the greater the price, the steeper the total revenue curve is. A firm’s total revenue is found by multiplying its output by the price at which it sells that output. For a perfectly competitive firm, total revenue (TR) is the market price (P) times the quantity the firm produces (Q), or TR = P × Q. 

Marginal revenue equals the market price. Because the market price is not affected by the output choice of a single firm, the marginal revenue the firm gains by producing one more unit is always the market price. The marginal revenue curve shows the relationship between marginal revenue and the quantity a firm produces. In perfect competition, a firm’s marginal revenue curve is a horizontal line at the market price.

The average and marginal revenue curves are given by the same horizontal line. When the marginal value exceeds the average value, the average value will be rising. When the marginal value is less than the average value, the average value will be falling.

We have seen that a perfectly competitive firm’s marginal revenue curve is simply a horizontal line at the market price and that this same line is also the firm’s average revenue curve. For the perfectly competitive firm, MR = P = AR. The marginal revenue curve has another meaning as well. It is the demand curve facing a perfectly competitive firm.

Price, Marginal Revenue, and Average Revenue

The slope of a total revenue curve is particularly important. It equals the change in the vertical axis (total revenue) divided by the change in the horizontal axis (quantity) between any two points. The slope measures the rate at which total revenue increases as output increases. We can think of it as the increase in total revenue associated with a one-unit increase in output. The increase in total revenue from a one-unit increase in quantity is marginal revenue. Thus marginal revenue (MR) equals the slope of the total revenue curve.

How much additional revenue does a radish producer gain from selling one more pound of radishes? The answer, of course, is the market price for one pound. Marginal revenue equals the market price. Because the market price is not affected by the output choice of a single firm, the marginal revenue the firm gains by producing one more unit is always the market price. The marginal revenue curve shows the relationship between marginal revenue and the quantity a firm produces. For a perfectly competitive firm, the marginal revenue curve is a horizontal line at the market price. If the market price of a pound of radishes is $0.40, then the marginal revenue is $0.40. In perfect competition, a firm’s marginal revenue curve is a horizontal line at the market price.

Price also equals average revenue, which is total revenue divided by quantity. To obtain average revenue (AR), we divide total revenue by quantity (Q). Because total revenue equals price (P) times quantity (Q), dividing by quantity leaves us with price.

AR=TRQ=P×QQ=PAR=TRQ=P×QQ=P

The marginal revenue curve is a horizontal line at the market price, and average revenue equals the market price. The average and marginal revenue curves are given by the same horizontal line. This is consistent with what we have learned about the relationship between marginal and average values. When the marginal value exceeds the average value, the average value will be rising. When the marginal value is less than the average value, the average value will be falling. What happens when the average and marginal values do not change, as in the horizontal curves of Panel (b) of the figure below, titled Total Revenue, Marginal Revenue, and Average Revenue? The marginal value must equal the average value; the two curves coincide.

Marginal Revenue, Price, and Demand for the Perfectly Competitive Firm

We have seen that a perfectly competitive firm’s marginal revenue curve is simply a horizontal line at the market price and that this same line is also the firm’s average revenue curve. For the perfectly competitive firm, MR = P = AR. The marginal revenue curve has another meaning as well. It is the demand curve facing a perfectly competitive firm.

Consider the case of a single radish producer, Tony Gortari. We assume that the radish market is perfectly competitive and that Mr. Gortari runs a perfectly competitive firm. Suppose the market price of radishes is $0.40 per pound. How many pounds of radishes can Mr. Gortari sell at this price? The answer comes from our assumption that he is a price taker: he can sell any quantity he wishes at this price. How many pounds of radishes will he sell if he charges a price that exceeds the market price? None. His radishes are identical to those of every other firm in the market, and everyone in the market has complete information. That means the demand curve facing Mr. Gortari is a horizontal line at the market price as illustrated in the following figure Price, Marginal Revenue, and Demand. The horizontal line is also Mr. Gortari’s marginal revenue curve, his average revenue curve, and the price market.

Of course, Mr. Gortari could charge a price below the market price, but why would he? We assume he can sell all the radishes he wants at the market price; there would be no reason to charge a lower price. Mr. Gortari faces a demand curve that is a horizontal line at the market price. In our subsequent analysis, we shall refer to the horizontal line at the market price simply as marginal revenue. We should remember, however, that this same line gives us the market price, average revenue, and the demand curve facing the firm.

Price, Marginal Revenue, and Demand

A perfectly competitive firm faces a horizontal demand curve at the market price. Here, radish grower Tony Gortari faces demand curve d at the market price of $0.40 per pound. He could sell q1 or q2—or any other quantity per month—at a price of $0.40 per pound.

More generally, we can say that any perfectly competitive firm faces a horizontal demand curve at the market price. We saw an example of a horizontal demand curve in the chapter on elasticity. Such a curve is perfectly elastic, meaning that any quantity is demanded at a given price.

Economic Profit in the Short Run

A firm’s economic profit is the difference between total revenue and total cost. Recall that total cost is the opportunity cost of producing a certain good or service. When we speak of economic profit we are speaking of a firm’s total revenue excluding the total opportunity cost of its operations.

A firm’s total cost curve in the short run intersects the vertical axis at some positive value equal to the firm’s total fixed costs. Total cost then rises at a decreasing rate over the range of increasing marginal returns to the firm’s variable factors. It rises at an increasing rate over the range of diminishing marginal returns. The next figure, Total Revenue, Total Cost, and Economic Profit, shows the total cost curve for Mr. Gortari, as well as the total revenue curve for a price of $0.40 per pound. Suppose that his total fixed cost is $400 per month. For any given level of output, Mr. Gortari’s economic profit is the vertical distance between the total revenue curve and the total cost curve at that level.

Total Revenue, Total Cost, and Economic Profit

Economic profit is the vertical distance between the total revenue and total cost curves (revenue minus costs). Here, the maximum profit attainable by Tony Gortari for his radish production is $938 per month at an output of 6,700 pounds.

Let us examine the total revenue and total cost curves in the above figure. At zero units of output, Mr. Gortari’s total cost is $400 (his total fixed cost); total revenue is zero. Total cost continues to exceed total revenue up to an output of 1,500 pounds per month, at which point the two curves intersect. At this point, economic profit equals zero. As Mr. Gortari expands output above 1,500 pounds per month, total revenue becomes greater than total cost. We see that at a quantity of 1,500 pounds per month, the total revenue curve is steeper than the total cost curve. Because revenues are rising faster than costs, profits rise with increased output. As long as the total revenue curve is steeper than the total cost curve, profit increases as the firm increases its output.

The total revenue curve’s slope does not change as the firm increases its output. But the total cost curve becomes steeper and steeper as diminishing marginal returns set in. Eventually, the total cost and total revenue curves will have the same slope. In our example, that happens at an output of 6,700 pounds of radishes per month. Notice that a line drawn tangent to the total cost curve at that quantity has the same slope as the total revenue curve.

As output increases beyond 6,700 pounds, the total cost curve continues to become steeper. It becomes steeper than the total revenue curve, and profits fall as costs rise faster than revenues. At an output slightly above 8,000 pounds per month, the total revenue and cost curves intersect again, and economic profit equals zero. Mr. Gortari achieves the greatest profit possible by producing 6,700 pounds of radishes per month, the quantity at which the total cost and total revenue curves have the same slope. More generally, we can conclude that a perfectly competitive firm maximizes economic profit at the output level at which the total revenue curve and the total cost curve have the same slope.

Applying the Marginal Decision Rule

The slope of the total revenue curve is marginal revenue; the slope of the total cost curve is marginal cost. Economic profit, the difference between total revenue and total cost, is maximized where marginal revenue equals marginal cost. This is consistent with the marginal decision rule, which holds that a profit-maximizing firm should increase output until the marginal benefit of an additional unit equals the marginal cost. The marginal benefit of selling an additional unit is measured as marginal revenue. Finding the output at which marginal revenue equals marginal cost is thus an application of our marginal decision rule.

The figure below, titled Applying the Marginal Decision Rule, shows how a firm can use the marginal decision rule to determine its profit-maximizing output. Panel (a) shows the market for radishes; the market demand curve (D), and supply curve (S); and a market price of $0.40 per pound. In Panel (b), the MR curve is given by a horizontal line at the market price. The firm’s marginal cost curve (MC) intersects the marginal revenue curve at the point where profit is maximized. Mr. Gortari maximizes profits by producing 6,700 pounds of radishes per month. That is, of course, the result we obtained in the figure above, where we saw that the firm’s total revenue and total cost curves differ by the greatest amount at the point at which the slopes of the curves, which equal marginal revenue and marginal cost, respectively, are equal.

Applying the Marginal Decision Rule

The market price is determined by the intersection of demand and supply. As always, the firm maximizes profit by applying the marginal decision rule. It takes the market price, $0.40 per pound, as given and selects an output at which MR equals MC. Economic profit per unit is the difference between average total cost (ATC) and price (here, $0.14 per pound); economic profit is profit per unit times the quantity produced ($0.14 × 6,700 = $938).

Demand and Marginal Revenue

Again, in the perfectly competitive case, the additional revenue a firm gains from selling an additional unit—its marginal revenue—is equal to the market price. The firm’s demand curve, which is a horizontal line at the market price, is also its marginal revenue curve. But a monopoly firm can sell an additional unit only by lowering the price. That fact complicates the relationship between the monopoly’s demand curve and its marginal revenue.

Suppose the firm in the following figure sells two units at a price of $8 per unit. Its total revenue is $16. Now it wants to sell a third unit and wants to know the marginal revenue of that unit. To sell three units rather than two, the firm must lower its price to $7 per unit. Total revenue rises to $21. The marginal revenue of the third unit is thus $5. But the price at which the firm sells three units is $7. Marginal revenue is less than price.

Data for Demand, Elasticity, and Total Revenue
Price in $	10	9	8	7	6	5	4	3	2	1	0
Quantity	0	1	2	3	4	5	6	7	8	9	10
Total revenue in $	0	9	16	21	24	25	24	21	16	9	0

Demand Elasticity and Total Revenue

Suppose a monopolist faces the downward-sloping demand curve shown in Panel (a). In order to increase the quantity sold, it must cut the price. Total revenue is found by multiplying the price and quantity sold at each price. Total revenue, plotted in Panel (b), is maximized at $25, when the quantity sold is five units and the price is $5. At that point on the demand curve, the price elasticity of demand equals −1.

To see why the marginal revenue of the third unit is less than its price, we need to examine more carefully how the sale of that unit affects the firm’s revenues. The firm brings in $7 from the sale of the third unit. But selling the third unit required the firm to charge a price of $7 instead of the $8 the firm was charging for two units. Now the firm receives less for the first two units. The marginal revenue of the third unit is the $7 the firm receives for that unit minus the $1 reduction in revenue for each of the first two units. The marginal revenue of the third unit is thus $5. (In this chapter we assume that the monopoly firm sells all units of output at the same price. In the next chapter, we will look at cases in which firms charge different prices to different customers.)

Marginal revenue is less than price for the monopoly firm. The following figure shows the relationship between demand and marginal revenue, based on the demand curve introduced in the figure above, Demand, Elasticity, and Total Revenue. As always, we follow the convention of plotting marginal values at the midpoints of the intervals. For instance, the marginal revenue for the first unit is $9, and so is graphed in the interval between 0 and 1 units.

Data for Demand and Marginal Revenue
Price in $	10	9	8	7	6	5	4	3	2	1	0
Quantity	0	1	2	3	4	5	6	7	8	9	10
Total Revenue in $	0	9	16	21	24	25	24	21	16	9	0
Marginal Revenue $	_	9	7	5	3	1	-1	-3	-5	-7	-9

The marginal revenue curve for the monopoly firm lies below its demand curve. It shows the additional revenue gained from selling an additional unit. Notice that, as always, marginal values are plotted at the midpoints of the respective intervals.

When the demand curve is linear, the marginal revenue curve can be placed according to the following rules: the marginal revenue curve is always below the demand curve and the marginal revenue curve will bisect any horizontal line drawn between the vertical axis and the demand curve. To put it another way, the marginal revenue curve will be twice as steep as the demand curve. The demand curve in the figure above is given by the equation Q = 10 − P, which can be written P = 10 − Q. The marginal revenue curve is given by P = 10 − 2Q, which is twice as steep as the demand curve.

The marginal revenue and demand curves in the figure above follow these rules. The marginal revenue curve lies below the demand curve and bisects any horizontal line drawn from the vertical axis to the demand curve. At a price of $6, for example, the quantity demanded is four. The marginal revenue curve passes through two units at this price. At a price of zero, the quantity demanded is 10; the marginal revenue curve passes through five units at this point.

Just as there is a relationship between the firm’s demand curve and the price elasticity of demand, there is a relationship between its marginal revenue curve and elasticity. Where marginal revenue is positive, demand is price elastic. Where marginal revenue is negative, demand is price inelastic. Where marginal revenue is zero, demand is unit-price elastic.

Relationship between Marginal Revenue and Demand
When marginal revenue is …	then demand is …
positive	price elastic
negative	price inelastic
zero	unit price elastic

A firm would not produce an additional unit of output with negative marginal revenue. And, assuming that the production of an additional unit has some cost, a firm would not produce the extra unit if it has zero marginal revenue. Because a monopoly firm will generally operate where marginal revenue is positive, we see once again that it will operate in the elastic range of its demand curve.

Monopoly Equilibrium: Applying the Marginal Decision Rule

Profit-maximizing behavior is always based on the marginal decision rule: additional units of a good should be produced as long as the marginal revenue of an additional unit exceeds the marginal cost. The maximizing solution occurs where marginal revenue equals marginal cost. As always, firms seek to maximize economic profit, and costs are measured in the economic sense of opportunity cost.

The next figure, The Monopoly Solution, shows a demand curve and an associated marginal revenue curve facing a monopoly firm. The marginal cost curve is like those we derived earlier; it falls over the range of output in which the firm experiences increasing marginal returns, then rises as the firm experiences diminishing marginal returns.

The Monopoly Solution

The monopoly firm maximizes profit by producing an output Qm at point G, where the marginal revenue and marginal cost curves intersect. It sells this output at price Pm.

To determine the profit-maximizing output, we note the quantity at which the firm’s marginal revenue and marginal cost curves intersect (Qm in The Monopoly Solution above). We read up from Qm to the demand curve to find the price Pm at which the firm can sell Qm units per period. The profit-maximizing price and output are given by point E on the demand curve.

Thus we can determine a monopoly firm’s profit-maximizing price and output by following three steps:

1. Determine the demand, marginal revenue, and marginal cost curves.

2. Select the output level at which the marginal revenue and marginal cost curves intersect.

3. Determine from the demand curve the price at which that output can be sold.

Computing Monopoly Profit

A monopoly firm’s profit per unit is the difference between price and average total cost. Total profit equals profit per unit times the quantity produced. Total profit is given by the area of the shaded rectangle ATCmPmEF.

Once we have determined the monopoly firm’s price and output, we can determine its economic profit by adding the firm’s average total cost curve to the graph showing demand, marginal revenue, and marginal cost, as shown in the figure above, Computing Monopoly Profit. The average total cost (ATC) at an output of Qm units is ATCm. The firm’s profit per unit is thus Pm – ATCm. Total profit is found by multiplying the firm’s output, Qm, by profit per unit, so total profit equals Qm(Pm – ATCm)—the area of the shaded rectangle in the figure above.