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Boundless Economics
Monopoly
Introduction to Monopoly
Defining Monopoly
A monopoly is an economic market structure where a specific person or
enterprise is the only supplier of a particular good.
Learning Objectives
Differentiate monopolies and competitive markets
Key Takeaways
Key Points
A monopoly market is characterized by the profit maximizer, price maker, high
barriers to entry, single seller, and price discrimination.
Monopoly characteristics include profit maximizer, price maker, high barriers to
entry, single seller, and price discrimination.
Sources of monopoly power include economies of scale, capital requirements,
technological superiority, no substitute goods, control of natural resources,
legal barriers, and deliberate actions.
There are a few similarities between a monopoly and competitive market: the
cost functions are the same, both minimize cost and maximize profit, the
shutdown decisions are the same, and both are assumed to have perfectly
competitive market factors.
Differences between the two market structures including: marginal revenue and
price, product differentiation, number of competitors, barriers to entry, elasticity
of demand, excess profits, profit maximization, and the supply curve.
The most significant distinction is that a monopoly has a downward sloping
demand instead of the “perceived” perfectly elastic curve of the perfectly
competitive market.
Key Terms
monopoly: A market where one company is the sole supplier.
differentiation: The act of distinguishing a product from the others in the
market.
A monopoly is a specific type of economic market structure. A monopoly exists
when a specific person or enterprise is the only supplier of a particular good. As
a result, monopolies are characterized by a lack of competition within the
market producing a good or service.
Monopoly: The graph shows a monopoly and the price (P) and
change in price (P reg) as well as the output (Q) and output change
(Q reg).
Characteristics of a Monopoly
A monopoly can be recognized by certain characteristics that set it aside from
the other market structures:
Profit maximizer: a monopoly maximizes profits. Due to the lack of
competition a firm can charge a set price above what would be charged in a
competitive market, thereby maximizing its revenue.
Price maker: the monopoly decides the price of the good or product being
sold. The price is set by determining the quantity in order to demand the price
desired by the firm (maximizes revenue).
High barriers to entry: other sellers are unable to enter the market of the
monopoly.
Single seller: in a monopoly one seller produces all of the output for a good or
service. The entire market is served by a single firm. For practical purposes the
firm is the same as the industry.
Price discrimination: in a monopoly the firm can change the price and quantity
of the good or service. In an elastic market the firm will sell a high quantity of
the good if the price is less. If the price is high, the firm will sell a reduced
quantity in an elastic market.
Sources of Monopoly Power
In a monopoly, specific sources generate the individual control of the market.
Sources of power include:
Economies of scale
Capital requirements
Technological superiority
No substitute goods
Control of natural resources
Network externalities
Legal barriers
Deliberate actions
Monopoly vs. Competitive Market
Monopolies and competitive markets mark the extremes in regards to market
structure. There are a few similarities between the two including: the cost
functions are the same, both minimize cost and maximize profit, the shutdown
decisions are the same, and both are assumed to have perfectly competitive
market factors.
However, there are noticeable differences between the two market structures
including: marginal revenue and price, product differentiation, number of
competitors, barriers to entry, elasticity of demand, excess profits, profit
maximization, and the supply curve. The most significant distinction is that a
monopoly has a downward sloping demand instead of the “perceived” perfectly
elastic curve of the perfectly competitive market.
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Boundless Economics
Competitive Markets
Perfect Competition
Definition of Perfect Competition
Perfect competition is a market structure that leads to the Pareto-efficient
allocation of economic resources.
Learning Objectives
Describe degrees of competition in different market structures
Key Takeaways
Key Points
The major types of market structure include monopoly, monopolistic
competition, oligopoly, and perfect competition.
Perfect competition is an industry structure in which there are many firms
producing homogeneous products. None of the firms are large enough to
influence the industry.
The characteristics of a perfectly competitive market include insignificant
contributions from the producers, homogenous products, perfect information
about products, no transaction costs, and no long-term economic profits.
In practice, very few industries can be described as perfectly competitive,
though agriculture comes close.
Key Terms
monopoly: A situation, by legal privilege or other agreement, in which solely
one party (company, cartel etc. ) exclusively provides a particular product or
service, dominating that market and generally exerting powerful control over it.
Monopolistic competition: A market structure in which there is a large number
of firms, each having a small proportion of the market share and slightly
differentiated products.
oligopoly: An economic condition in which a small number of sellers exert
control over the market of a commodity.
Market structure is determined by the number and size distribution of firms in a
market, entry conditions, and the extent of product differentiation. The major
types of market structure include the following:
Monopoly: An industry structure where a single firm produces a product for
which there are no close substitutes. Monopolists are price makers. Barriers to
entry and exit exist, and, in order to ensure profits, a monopoly will attempt to
maintain them.
Monopolistic competition: A market structure in which there is a large number
of firms, each having a small portion of the market share and slightly
differentiated products. There are close substitutes for the product of any given
firm, so competitors have slight control over price. There are relatively
insignificant barriers to entry or exit, and success invites new competitors into
the industry.
Oligopoly: An industry structure in which there are a few firms producing
products that range from slightly differentiated to highly differentiated. Each
firm is large enough to influence the industry. Barriers to entry exist.
Perfect competition: An industry structure in which there are many firms, none
large enough to influence the industry, producing homogeneous products.
Firms are price takers. There are no barriers to entry. Agriculture comes close to
being perfectly competitive.
Perfect competition leads to the Pareto-efficient allocation of economic
resources. Because of this it serves as a natural benchmark against which to
contrast other market structures. However, in practice, very few industries can
be described as perfectly competitive. Nevertheless, it is used because it
provides important insights.
A perfectly competitive market has several important characteristics:
All producers contribute insignificantly to the market. Their own production
levels do not change the supply curve.
All producers are price takers. They cannot influence the market. If a firm tries to
raise its price consumers would buy from a competitor with a lower price
instead.
Products are homogeneous. The characteristics of a good or service do not vary
between suppliers.
Producers enter and exit the market freely.
Both buyers and sellers have perfect information about the price, utility, quality,
and production methods of products.
There are no transaction costs. Buyers and sellers do not incur costs in making
an exchange of goods in a perfectly competitive market.
Producers earn zero economic profits in the long run.
Conditions of Perfect Competition
A firm in a perfectly competitive market may generate a profit in the short-run,
but in the long-run it will have economic profits of zero.
Learning Objectives
Calculate total revenue, average revenue, and marginal revenue for a firm in a
perfectly competitive market
Key Takeaways
Key Points
A perfectly competitive market is characterized by many buyers and sellers,
undifferentiated products, no transaction costs, no barriers to entry and exit,
and perfect information about the price of a good.
The total revenue for a firm in a perfectly competitive market is the product of
price and quantity (TR = P * Q). The average revenue is calculated by dividing
total revenue by quantity. Marginal revenue is calculated by dividing the change
in total revenue by change in quantity.
A firm in a competitive market tries to maximize profits. In the short-run, it is
possible for a firm’s economic profits to be positive, negative, or zero. Economic
profits will be zero in the long-run.
In the short-run, if a firm has a negative economic profit, it should continue to
operate if its price exceeds its average variable cost. It should shut down if its
price is below its average variable cost.
Key Terms
economic profit: The difference between the total revenue received by the firm
from its sales and the total opportunity costs of all the resources used by the
firm.
The concept of perfect competition applies when there are many producers and
consumers in the market and no single company can influence the pricing. A
perfectly competitive market has the following characteristics:
There are many buyers and sellers in the market.
Each company makes a similar product.
Buyers and sellers have access to perfect information about price.
There are no transaction costs.
There are no barriers to entry into or exit from the market.
All goods in a perfectly competitive market are considered perfect substitutes,
and the demand curve is perfectly elastic for each of the small, individual firms
that participate in the market. These firms are price takers–if one firm tries to
raise its price, there would be no demand for that firm’s product. Consumers
would buy from another firm at a lower price instead.
Firm Revenues
A firm in a competitive market wants to maximize profits just like any other firm.
The profit is the difference between a firm’s total revenue and its total cost. For
a firm operating in a perfectly competitive market, the revenue is calculated as
follows:
Total Revenue = Price * Quantity
AR (Average Revenue) = Total Revenue / Quantity
MR (Marginal Revenue) = Change in Total Revenue / Change in Quantity
The average revenue (AR) is the amount of revenue a firm receives for each unit
of output. The marginal revenue (MR) is the change in total revenue from an
additional unit of output sold. For all firms in a competitive market, both AR and
MR will be equal to the price.
Profit Maximization
In order to maximize profits in a perfectly competitive market, firms set marginal
revenue equal to marginal cost (MR=MC). MR is the slope of the revenue curve,
which is also equal to the demand curve (D) and price (P). In the short-term, it is
possible for economic profits to be positive, zero, or negative. When price is
greater than average total cost, the firm is making a profit. When price is less
than average total cost, the firm is making a loss in the market.
MC
Price
Quantity
D=AR=P
ATCP
Q
MR
Economic
profit
Perfect Competition in the Short Run: In the short run, it is
possible for an individual firm to make an economic profit. This
scenario is shown in this diagram, as the price or average revenue,
denoted by P, is above the average cost denoted by C.
Over the long-run, if firms in a perfectly competitive market are earning positive
economic profits, more firms will enter the market, which will shift the supply
curve to the right. As the supply curve shifts to the right, the equilibrium price
will go down. As the price goes down, economic profits will decrease until they
become zero.
When price is less than average total cost, firms are making a loss. Over the
long-run, if firms in a perfectly competitive market are earning negative
economic profits, more firms will leave the market, which will shift the supply
curve left. As the supply curve shifts left, the price will go up. As the price goes
up, economic profits will increase until they become zero.
In sum, in the long-run, companies that are engaged in a perfectly competitive
market earn zero economic profits. The long-run equilibrium point for a
perfectly competitive market occurs where the demand curve (price) intersects
the marginal cost (MC) curve and the minimum point of the average cost (AC)
curve.
MC
Price
Quantity
D=AR=MR
ATC
P
Q
Perfect Competition in the Long Run: In the long-run,
economic profit cannot be sustained. The arrival of new firms in
the market causes the demand curve of each individual firm to
shift downward, bringing down the price, the average revenue
and marginal revenue curve. In the long-run, the firm will make
zero economic profit. Its horizontal demand curve will touch its
average total cost curve at its lowest point.
The Demand Curve in Perfect Competition
A perfectly competitive firm faces a demand curve is a horizontal line equal to
the equilibrium price of the entire market.
Learning Objectives
Describe the demand for goods in perfectly competitive markets
Key Takeaways
Key Points
In a perfectly competitive market individual firms are price takers. The price is
determined by the intersection of the market supply and demand curves.
The demand curve for an individual firm is different from a market demand
curve. The market demand curve slopes downward, while the firm’s demand
curve is a horizontal line.
The firm’s horizontal demand curve indicates a price elasticity of demand that is
perfectly elastic.
Key Terms
Perfectly elastic: Describes a situation when any increase in the price, no
matter how small, will cause demand for a good to drop to zero.
In a perfectly competitive market the market demand curve is a downward
sloping line, reflecting the fact that as the price of an ordinary good increases,
the quantity demanded of that good decreases. Price is determined by the
intersection of market demand and market supply; individual firms do not have
any influence on the market price in perfect competition. Once the market price
has been determined by market supply and demand forces, individual firms
become price takers. Individual firms are forced to charge the equilibrium price
of the market or consumers will purchase the product from the numerous other
firms in the market charging a lower price (keep in mind the key conditions of
perfect competition). The demand curve for an individual firm is thus equal to
the equilibrium price of the market.
Demand Curve for a Firm in a Perfectly Competitive Market: The demand
curve for an individual firm is equal to the equilibrium price of the market. The
market demand curve is downward-sloping.
The demand curve for a firm in a perfectly competitive market varies
significantly from that of the entire market.The market demand curve slopes
downward, while the perfectly competitive firm’s demand curve is a horizontal
line equal to the equilibrium price of the entire market. The horizontal demand
curve indicates that the elasticity of demand for the good is perfectly elastic.
This means that if any individual firm charged a price slightly above market
price, it would not sell any products.
A strategy often used to increase market share is to offer a firm’s product at a
lower price than the competitors. In a perfectly competitive market, firms cannot
decrease their product price without making a negative profit. Instead,
assuming that the firm is a profit-maximizer, it will sell its goods at the market
price.
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Boundless Economics
Introducing Supply and Demand
Demand
The Law of Demand
In general, the law of demand states that the quantity demanded and the price
of a good or service is inversely related, other things remaining constant.
Learning Objectives
Explain the concept of demand and discuss the factors that affect it
Key Takeaways
Key Points
The demand curve is downward sloping, indicating the negative relationship
between the price of a product and the quantity demanded.
For normal goods, a change in price will be reflected as a move along the
demand curve while a non-price change will result in a shift of the demand
curve.
Two exceptions to the law of demand are Giffen goods and Veblen goods.
Key Terms
Giffen good: A good which people consume more of as only the price rises;
Having a positive price elasticity of demand.
Veblen good: A good for which people’s preference for buying them increases
as a direct function of their price, as greater price confers greater status.
normal good: A good for which demand increases when income increases and
falls when income decreases but price remains constant.
In economics, the law of demand states that the quantity demanded and the
price of a good or service is inversely related, other things remaining constant.
Therefore, the demand curve will generally be downward sloping, indicating the
negative relationship between the price of a good or service and the quantity
demanded.
Movement along the Demand Curve
If the income of the consumer, prices of the related goods, and preferences of
the consumer remain unchanged, then the change in quantity of good
demanded by the consumer will be negatively correlated to the change in the
price of the good or service. The change in price will be reflected as a move
along the demand curve.
Shift in the Demand Curve
The demand curve will shift, move either inward or outward as a result of non-
price factors. A shift in demand can be related to the following factors (non-
exhaustive list):
Consumer preferences
Consumer income
Change in the price of related goods (i.e. compliments)
Change in the number of buyers
Consumer expectations
D1 D2 S
P
QQ2Q1
P2
P1
Law of Demand: A demand curve, shown in red and
shifting to the right, demonstrating the inverse
relationship between price and quantity demanded (the
curve slopes downwards from left to right; higher prices
reduce the quantity demanded).
Though in general terms and specific to normal goods, demand will exhibit a
downward slope, there are exceptions: Giffen goods and Veblen goods
Giffen Goods
A Giffen good describes an extreme case for an inferior good. In theory, a Giffen
good would display the characteristic that as price increases, demand for the
product increases. In the real world application, there has not been
a true example of a Giffen good, though a popular albeit historically inaccurate
example is the purchase of potatoes (an inferior good) as prices continued to
increase during the Irish potato famine.
Veblen Goods
Some expensive commodities like diamonds, expensive cars, designer clothing
and other high-price limited items, are used as status symbols to display wealth.
The more expensive these commodities become, the higher their value as a
status symbol and the greater the demand for them. The amount demanded of
these commodities increase with an increase in their price and decrease with a
decrease in their price. These goods are known as a Veblen goods.
Demand Schedules and Demand Curves
A demand curve depicts the price and quantity combinations listed in a demand
schedule.
Learning Objectives
Describe the relationship between demand curves and demand schedules
Key Takeaways
Key Points
Demand curves are a graphical representation of a demand schedule, which is
the table view of an economic agents’ price to quantity relationship.
Demand curves embody preferences, substitution potential and income, as well
as other characteristics that influence an economic agent’s ability to assess
willingness to pay at a specific point in time for goods and services.
Demand curves may be linear or curved.
Aggregate demand is the sum of the quantity demanded for a specific price
over a group of economic agents.
Key Terms
equilibrium: The condition of a system in which competing influences are
balanced, resulting in no net change.
The demand curve is a graphical representation depicting the relationship
between a commodity’s different price levels and quantities which consumers
are willing to buy. The curve can be derived from a demand schedule, which is
essentially a table view of the price and quantity pairings that comprise the
demand curve.
Demand Schedule and Curve: The demand curve is the graphical
representation of the economic entity’s willingness to pay for a good
or service. It is derived from a demand schedule, which is the table
view of the price and quantity pairs that comprise the demand curve.
Given that in most cases, as the price of a good increases, agents will likely
decrease consumption and substitute away to another good or service, the
demand curve embodies a negative price to quantity relationship. The curve
typically slopes downward from left to right; though there are some goods and
services that exhibit an upward sloping demand, these goods and services are
characterized as abnormal.
The demand curve of an individual agent can be combined with that of other
economic agents to depict a market or aggregate demand curve. Using a
demand schedule, the quantity demanded per each individual can be summed
by price, resulting in an aggregate demand schedule that provides the total
demanded specific to a given price level. The plotting of the aggregated
quantity to price pairings is what is referred to as an aggregate demand curve.
In this manner, the demand curve for all consumers together follows from the
demand curve of every individual consumer.
The demand curve in combination with the supply curve provides the market
clearing or equilibrium price and quantity relationship. This is found at the
intersection or point at which the supply and demand curves cross each other.
Market Demand
Market demand is the summation of the individual quantities that consumers
are willing to purchase at a given price.
Learning Objectives
Examine the relationship between market demand and individual demand
Key Takeaways
Key Points
The graphical representation of a market demand schedule is called the market
demand curve.
Following the law of demand, the demand curve is almost always represented as
downward-sloping. This means that as price decreases, consumers will buy
more of the good.
Two different hypothetical types of goods with upward-sloping demand curves
are Giffen goods and Veblen goods.
Key Terms
Market demand: The summation of the individual quantities that consumers
are willing to purchase at a given price.
The demand schedule represents the amount of some good that a buyer is
willing and able to purchase at various prices. The relationship between price
and quantity demanded reflected in this schedule assumes the following factors
remain constant:
Income levels;
Population;Tastes and preferences;
Price of substitute goods; and
Price of complementary goods
The demand schedule is depicted graphically as the demand curve. The demand
curve is shaped by the law of demand. In general, this means that the demand
curve is downward-sloping, which means that as the price of a good decreases,
consumers will buy more of that good.
D1 D2 S
P
QQ2Q1
P2
P1
Demand Curve: The demand curve is the graphical
depiction of the demand schedule. For most goods and
services, the demand curve exhibits a negative
relationship between price and quantity and is as a result
downward sloping.
A market demand schedule is a table that lists the quantity of a good all
consumers in a market will buy at every different price. A market demand
schedule for a product indicates that there is an inverse relationship between
price and quantity demanded. The graphical representation of a market demand
schedule is called the market demand curve.
Market Demand
Schedule: A market
demand schedule is a table
that lists the quantity of a
good all consumers in a
market will buy at every
different price.
The determinants of demand are:
Income
Tastes and preferences
Prices of related (AKA complimentary) goods and services
Prices of substitutes
Number of potential consumers
The market demand is the summation of the individual quantities that
consumers are willing to purchase at a given price.
As noted, both individual demand curves and market demand are typically
expressed as downward shaping curves. However, special cases exist where the
preference for the good or service may be perverse. Two different hypothetical
types of goods with upward-sloping demand curves are Giffen goods (an
inferior but staple good) and Veblen goods (goods characterized as being more
desirable the higher the price; luxury or status items).
Ceteris Paribus
Ceteris paribus is defined as “all else being equal,” or “holding all else constant”.
Learning Objectives
Explain the rationale for the assumption of ceteris paribus
Key Takeaways
Key Points
When ceteris paribus is employed in economics, all other variables with the
exception of the variables under evaluation are held constant.
An example of the use of ceteris paribus in macroeconomics is: what would
happen to the demand for labor by firms if a minimum wage was imposed at a
level above the prevailing wage rate, ceteris paribus.
An example of the use of ceteris paribus in microeconomics is: what would
happen for the demand for a normal good when income increases, ceteris
paribus.
Key Terms
ceteris paribus: all else equal; holding everything else constant
Economics seeks to interpret, analyze and or evaluate situations that occur
between individuals, firms and other entities. Due to the potential for multiple
agents and other known and unknown external activities to be involved or
present but not relevant to an analysis, economics employs the assumption of
“all else constant,” which is the English translation of the Latin phrase “ceteris
paribus”.
When the ceteris paribus assumption is employed in economics, all other
variables – with the exception of the variables under evaluation – are held
constant.
A Macroeconomic Example
What would happen to the demand for labor by firms if a minimum wage was
imposed at a level above the prevailing wage rate, ceteris paribus? As depicted
in below, the supply and demand curve are held constant, as are labor and
leisure preferences for workers, and output considerations for firms, in addition
to all other variables and characteristics embedded within the shape of the
supply and demand curves. Thus, what is being evaluated is the impact of a
constraint on market equilibrium.
Macroeconomics: Binding price floor: E is the
equilibrium wage level when there is no binding
minimum wage. When a minimum wage is
imposed, ceteris paribus, suppliers of labor are
willing to provide more labor than firms (demand
for labor) are willing to purchase at the binding
minimum wage rate. There is no shifting of either
curve related to behavior influenced by the
higher wage rate because ceteris paribus is
holding labor-leisure trade-off (of workers) and
substitution of labor (by firms) constant, along
with other potential influencing variables.
A Microeconomic Example
What would happen for the demand for a normal good when income increases,
ceteris paribus? In this case, as depicted in, a consumer’s preferences for the
good and his demand for complements and substitutes are being held constant
along with other attributes that could potentially impact his demand for a good,
such as the good’s price. The supply of the good and the market and firm
characteristics implicit in the shape of the supply curve are also held constant.
This allows for an analysis of the increase in income, on the consumer’s demand
for the single good alone.
D1 D2 S
P
QQ2Q1
P2
P1
Microeconomics: Income and Demand: A consumer is
able to purchase a normal good and has a demand
curve, D1, which provides the relationship between price
and quantity given his preferences, income and other
consumption attributes. Assuming an increase in his
income, ceteris paribus, his demand curve would shift
outward to D2, corresponding to a higher quantity for
each purchase price. The consumer would then move his
consumption for the good from Q1 to Q2, increasing his
purchase of the good.
Changes in Demand and Shifts in the Demand Curve
Demand is the relationship between the willingness to purchase a quantity of a
good or service at a specific price.
Learning Objectives
Distinguish between shifts in the demand curve and movement along the
demand curve
Key Takeaways
Key Points
A change in price will result in a movement along a demand curve.
A change in a non-price variable will result in a shift in the demand curve.
An outward shift in demand will occur if income increases, in the case of a
normal good; however, for an inferior good, the demand curve will shift inward
noting that the consumer only purchases the good as a result of an income
constraint on the purchase of a preferred good.
Key Terms
normal good: A good for which demand increases when income increases and
falls when income decreases but price remains constant.
inferior good: a good that decreases in demand when consumer income rises;
having a negative income elasticity of demand.
The demand curve is a graphical representation of an economic agent’s
willingness to purchase a given quantity of a good or service at a specific price
based on preferences, income, and other prevailing factors at a given point in
time. Demand curves in combination with supply curves, which depict the price
to quantity relationship of producers, are a representation of the goods and
services market. Where the two curves intersect is market equilibrium, the price
to quantity relationship where demand and supply are equal.
Movements in demand are specific to either movements along a given demand
curve or shifts of the entire demand curve.
Movements along the demand curve are due to a change in the price of a good,
holding constant other variables, such as the price of a substitute. If the price of
a good or service changes the consumer will adjust the quantity demanded
based on the preferences, income and prices of other factors embedded within
a given curve for the time period under consideration.
Shifts in the demand curve are related to non-price events that include income,
preferences and the price of substitutes and complements. An increase in
income will cause an outward shift in demand (to the right) if the good or
service assessed is a normal good or a good that is desirable and is therefore
positively correlated with income. Alternatively, an increase in income could
result in an inward shift of demand (to the left) if the good or service assessed is
an inferior good or a good that is not desirable but is acceptable when the
consumer is constrained by income.
D1 D2 S
P
QQ2Q1
P2
P1
Demand Curve: A demand curve provides an economic
agent’s price to quantity relationship related to a specific
good or service. Movements along a demand curve are
related to a change in price, resulting in a change in
quantity; shifts is demand (D1 to D2) are specific to
changes in income, preferences, availability of
substitutes and other factors.
A change in preferences could result in an increase (outward shift) or decrease
(inward shift) in the quantity level desired for a specific price; while a change in
the price of a substitute, could result in an outward shift if the price of the
substitute increases and an inward shift if the substitute’s price decreases. The
demand curve for a good will shift in parallel with a shift in the demand for a
complement.
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Boundless Economics
Monopolistic Competition
Monopolistic Competition
Defining Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many
producers sell products that are differentiated from one another.
Learning Objectives
Evaluate the characteristics and outcomes of markets with imperfect
competition
Key Takeaways
Key Points
Monopolistic competition is different from a monopoly. A monopoly exists
when a person or entity is the exclusive supplier of a good or service in a
market.
Markets that have monopolistic competition are inefficient for two reasons.
First, at its optimum output the firm charges a price that exceeds marginal costs.
The second source of inefficiency is the fact that these firms operate with excess
capacity.
Monopolistic competitive markets have highly differentiated products; have
many firms providing the good or service; firms can freely enter and exits in the
long-run; firms can make decisions independently; there is some degree of
market power; and buyers and sellers have imperfect information.
Key Terms
monopoly: A market where one company is the sole supplier.
Monopolistic competition: A type of imperfect competition such that one or
two producers sell products that are differentiated from one another as goods
but not perfect substitutes (such as from branding, quality, or location).
Monopolistic Competition
Monopolistic competition is a type of imperfect competition such that many
producers sell products that are differentiated from one another as goods but
not perfect substitutes (such as from branding, quality, or location). In
monopolistic competition, a firm takes the prices charged by its rivals as given
and ignores the impact of its own prices on the prices of other firms.
Unlike in perfect competition, firms that are monopolistically competitive
maintain spare capacity. Models of monopolistic competition are often used to
model industries. Textbook examples of industries with market structures similar
to monopolistic competition include restaurants, cereal, clothing, shoes, and
service industries in large cities.
Clothing: The clothing industry is monopolistically competitive because
firms have differentiated products and market power.
Monopolistic competition is different from a monopoly. A monopoly exists
when a person or entity is the exclusive supplier of a good or service in a
market. The demand is inelastic and the market is inefficient.
Monopolistic competitive markets:
have products that are highly differentiated, meaning that there is a perception
that the goods are different for reasons other than price;
have many firms providing the good or service;
firms can freely enter and exits in the long-run;
firms can make decisions independently;
there is some degree of market power, meaning producers have some control
over price; and
buyers and sellers have imperfect information.
Sources of Market Inefficiency
Markets that have monopolistic competition are inefficient for two reasons. The
first source of inefficiency is due to the fact that at its optimum output, the firm
charges a price that exceeds marginal costs. The monopolistic competitive firm
maximizes profits where marginal revenue equals marginal cost. A monopolistic
competitive firm’s demand curve is downward sloping, which means it will
charge a price that exceeds marginal costs. The market power possessed by a
monopolistic competitive firm means that at its profit maximizing level of
production there will be a net loss of consumer and producer surplus.
The second source of inefficiency is the fact that these firms operate with excess
capacity. The firm’s profit maximizing output is less than the output associated
with minimum average cost. All firms, regardless of the type of market it
operates in, will produce to a point where demand or price equals average cost.
In a perfectly competitive market, this occurs where the perfectly elastic demand
curve equals minimum average cost. In a monopolistic competitive market, the
demand curve is downward sloping. In the long run, this leads to excess
capacity.
Product Differentiation
Product differentiation is the process of distinguishing a product or service from
others to make it more attractive to a target market.
Learning Objectives
Define product differentiation
Key Takeaways
Key Points
Differentiation occurs because buyers perceive a difference between products.
Causes of differentiation include functional aspects of the product or service,
how it is distributed and marketed, and who buys it.
Differentiation affects performance primarily by reducing direct competition. As
the product becomes more different, categorization becomes more difficult, and
the product draws fewer comparisons with its competition.
There are three types of product differentiation: simple, horizontal, and vertical.
Key Terms
product differentiation: Perceived differences between the product of one firm
and that of its rivals so that some customers value it more.
One of the defining traits of a monopolistically competitive market is that there
is a significant amount of non- price competition. This means that product
differentiation is key for any monopolistically competitive firm. Product
differentiation is the process of distinguishing a product or service from others
to make it more attractive to a target market.
Kool-Aid: Kool-Aid is an individual
brand that competes with Kraft’s
other brand (Tang).
Although research in a niche market may result in changing a product in order
to improve differentiation, the changes themselves are not differentiation.
Marketing or product differentiation is the process of describing the differences
between products or services, or the resulting list of differences; differentiation
is not the process of creating the differences between the products. Product
differentiation is done in order to demonstrate the unique aspects of a firm’s
product and to create a sense of value.
In economics, successful product differentiation is inconsistent with the
conditions of perfect competition, which require products of competing firms to
be perfect substitutes.
Consumers do not need to know everything about the product for
differentiation to work. So long as the consumers perceive that there is a
difference in the products, they do not need to know how or why one product
might be of higher quality than another. For example, a generic brand of cereal
might be exactly the same as a brand name in terms of quality. However,
consumers might be willing to pay more for the brand name despite the fact
that they cannot identify why the more expensive cereal is of higher “quality.”
There are three types of product differentiation:
Simple: the products are differentiated based on a variety of characteristics;
Horizontal: the products are differentiated based on a single characteristic, but
consumers are not clear on which product is of higher quality; and
Vertical: the products are differentiated based on a single characteristic and
consumers are clear on which product is of higher quality.
Differentiation occurs because buyers perceive a difference. Drivers of
differentiation include functional aspects of the product or service, how it is
distributed and marketed, and who buys it. The major sources of product
differentiation are as follows:
Differences in quality, which are usually accompanied by differences in price;
Differences in functional features or design;
Ignorance of buyers regarding the essential characteristics and qualities of
goods they are purchasing;
Sales promotion activities of sellers, particularly advertising; and
Differences in availability (e.g. timing and location).
The objective of differentiation is to develop a position that potential customers
see as unique. Differentiation affects performance primarily by reducing direct
competition. As the product becomes more different, categorization becomes
more difficult, and the product draws fewer comparisons with its competition. A
successful product differentiation strategy will move the product from
competing on price to competing on non-price factors.
Demand Curve
The demand curve in a monopolistic competitive market slopes downward,
which has several important implications for firms in this market.
Learning Objectives
Explain how the shape of the demand curve affects the firms that exist in a
market with monopolistic competition
Key Takeaways
Key Points
The downward slope of a monopolistically competitive demand curve signifies
that the firms in this industry have market power.
Market power allows firms to increase their prices without losing all of their
customers.
The downward slope of the demand curve contributes to the inefficiency of the
market, leading to a loss in consumer surplus, deadweight loss, and excess
production capacity.
Key Terms
market power: The ability of a firm to profitably raise the market price of a
good or service over marginal cost. A firm with total market power can raise
prices without losing any customers to competitors.
elastic: Sensitive to changes in price.
The demand curve of a monopolistic competitive market slopes downward. This
means that as price decreases, the quantity demanded for that good increases.
While this appears to be relatively straightforward, the shape of the demand
curve has several important implications for firms in a monopolistic competitive
market.
Quantity
MC
D
Pr
ic
e
Pc
Pm
Qm Qc
Deadweight loss
MR
Consumer surplus
Producer
surplus
Monopolistic Competition: As you can
see from this chart, the demand curve
(marked in red) slopes downward,
signifying elastic demand.
Market Power
The demand curve for an individual firm is downward sloping in monopolistic
competition, in contrast to perfect competition where the firm’s individual
demand curve is perfectly elastic. This is due to the fact that firms have market
power: they can raise prices without losing all of their customers. In this type of
market, these firms have a limited ability to dictate the price of its products; a
firm is a price setter not a price taker (at least to some degree). The source of
the market power is that there are comparatively fewer competitors than in a
competitive market, so businesses focus on product differentiation, or
differences unrelated to price. By differentiating its products, firms in a
monopolistically competitive market ensure that its products are imperfect
substitutes for each other. As a result, a business that works on its branding can
increase its prices without risking its consumer base.
Inefficiency in the Market
Monopolistically competitive firms maximize their profit when they produce at a
level where its marginal costs equals its marginal revenues. Because the
individual firm’s demand curve is downward sloping, reflecting market power,
the price these firms will charge will exceed their marginal costs. Due to how
products are priced in this market, consumer surplus decreases below the
pareto optimal levels you would find in a perfectly competitive market, at least
in the short run. As a result, the market will suffer deadweight loss. The suppliers
in this market will also have excess production capacity.
Short Run Outcome of Monopolistic Competition
Monopolistic competitive markets can lead to significant profits in the short-
run, but are inefficient.
Learning Objectives
Examine the concept of the short run and how it applies to firms in a
monopolistic competition
Key Takeaways
Key Points
The “short run” is the time period when one factor of production is fixed in
terms of costs, while the other elements of production are variable.
Like monopolies, the suppliers in monopolistic competitive markets are price
makers and will behave similarly in the short-run.
Also like a monopoly, a monopolastic competitive firm will maximize its profits
when its marginal revenues equals its marginal costs.
Key Terms
short-run: The conceptual time period in which at least one factor of
production is fixed in amount and others are variable in amount.
In terms of production and supply, the “short run” is the time period when one
factor of production is fixed in terms of costs while the other elements of
production are variable. The most common example of this is the production of
a good that requires a factory. If demand spikes, in the short run you will only
be able to produce the amount of good that the capacity of the factory allows.
This is because it takes a significant amount of time to either build or acquire a
new factory. If demand for the good plummets you can cut production in the
factory, but will still have to pay the costs of maintaining the factory and the
associated rent or debt associated with acquiring the factory. You could sell the
factory, but again that would take a significant amount of time. The “short run”
is defined by how long it would take to alter that “fixed” aspect of production.
In the short run, a monopolistically competitive market is inefficient. It does not
achieve allocative nor productive efficiency. Also, since a monopolistic
competitive firm has powers over the market that are similar to a monopoly, its
profit maximizing level of production will result in a net loss of consumer and
producer surplus, creating deadweight loss.
Setting a Price and Determining Profit
Like monopolies, the suppliers in monopolistic competitive markets are price
makers and will behave similarly in the short-run. Also like a monopoly, a
monopolistic competitive firm will maximize its profits by producing goods to
the point where its marginal revenues equals its marginal costs. The profit
maximizing price of the good will be determined based on where the profit-
maximizing quantity amount falls on the average revenue curve. The profit the
firm makes is the the amount of the good produced multiplied by the difference
between the price minus the average cost of producing the good..
Short Run Equilibrium Under Monopolistic Competition: As you can see
from the chart, the firm will produce the quantity (Qs) where the marginal
cost (MC) curve intersects with the marginal revenue (MR) curve. The price is
set based on where the Qs falls on the average revenue (AR) curve. The
profit the firm makes in the short term is represented by the grey rectangle,
or the quantity produced multiplied by the difference between the price and
the average cost of producing the good.
Since monopolistically competitive firms have market power, they will produce
less and charge more than a firm would under perfect competition. This causes
deadweight loss for society, but, from the producer’s point of view, is desirable
because it allows them to earn a profit and increase their producer surplus.
Because of the possibility of large profits in the short-run and relatively low
barriers of entry in comparison to perfect markets, markets with monopolistic
competition are very attractive to future entrants.
Long Run Outcome of Monopolistic Competition
In the long run, firms in monopolistic competitive markets are highly inefficient
and can only break even.
Learning Objectives
Explain the concept of the long run and how it applies to a firms in monopolistic
competition
Key Takeaways
Key Points
In terms of production and supply, the ” long-run ” is the time period when all
aspects of production are variable and can therefore be adjusted to meet shifts
in demand.
Like monopolies, the suppliers in monopolistic competitive markets are price
makers and will behave similarly in the long-run.
Like a monopoly, a monopolastic competitive firm will maximize its profits by
producing goods to the point where its marginal revenues equals its marginal
costs.
In the long-run, the demand curve of a firm in a monopolistic competitive
market will shift so that it is tangent to the firm’s average total cost curve. As a
result, this will make it impossible for the firm to make economic profit; it will
only be able to break even.
Key Terms
long-run: The conceptual time period in which there are no fixed factors of
production.
In terms of production and supply, the “long-run” is the time period when there
is no factor that is fixed and all aspects of production are variable and can
therefore be adjusted to meet shifts in demand. Given a long enough time
period, a firm can take the following actions in response to shifts in demand:
Enter an industry;
Exit an industry;
Increase its capacity to produce more; and
Decrease its capacity to produce less.
In the long-run, a monopolistically competitive market is inefficient. It achieves
neither allocative nor productive efficiency. Also, since a monopolistic
competitive firm has power over the market that is similar to a monopoly, its
profit maximizing level of production will result in a net loss of consumer and
producer surplus.
Setting a Price and Determining Profit
Like monopolies, the suppliers in monopolistic competitive markets are price
makers and will behave similarly in the long-run. Also like a monopoly, a
monopolistic competitive firm will maximize its profits by producing goods to
the point where its marginal revenues equals its marginal costs. The profit
maximizing price of the good will be determined based on where the profit-
maximizing quantity amount falls on the average revenue curve.
While a monopolistic competitive firm can make a profit in the short-run, the
effect of its monopoly-like pricing will cause a decrease in demand in the long-
run. This increases the need for firms to differentiate their products, leading to
an increase in average total cost. The decrease in demand and increase in cost
causes the long run average cost curve to become tangent to the demand curve
at the good’s profit maximizing price. This means two things. First, that the firms
in a monopolistic competitive market will produce a surplus in the long run.
Second, the firm will only be able to break even in the long-run; it will not be
able to earn an economic profit.
Long Run Equilibrium of Monopolistic Competition: In the long run, a
firm in a monopolistic competitive market will product the amount of goods
where the long run marginal cost (LRMC) curve intersects marginal revenue
(MR). The price will be set where the quantity produced falls on the average
revenue (AR) curve. The result is that in the long-term the firm will break
even.
Monopolistic Competition Compared to Perfect Competition
The key difference between perfectly competitive markets and monopolistically
competitive ones is efficiency.
Learning Objectives
Differentiate between monopolistic competition and perfect competition
Key Takeaways
Key Points
Perfectly competitive markets have no barriers of entry or exit. Monopolistically
competitive markets have a few barriers of entry and exit.
The two markets are similar in terms of elasticity of demand, a firm ‘s ability to
make profits in the long-run, and how to determine a firm’s profit maximizing
quantity condition.
In a perfectly competitive market, all goods are substitutes. In a monopolistically
competitive market, there is a high degree of product differentiation.
Key Terms
perfect competition: A type of market with many consumers and producers, all
of whom are price takers
Perfect competition and monopolistic competition are two types of economic
markets.
Similarities
One of the key similarities that perfectly competitive and monopolistically
competitive markets share is elasticity of demand in the long-run. In both
circumstances, the consumers are sensitive to price; if price goes up, demand
for that product decreases. The two only differ in degree. Firm’s individual
demand curves in perfectly competitive markets are perfectly elastic, which
means that an incremental increase in price will cause demand for a product to
vanish ). Demand curves in monopolistic competition are not perfectly elastic:
due to the market power that firms have, they are able to raise prices without
losing all of their customers.
Demand curve in a perfectly competitive market: This is the demand
curve in a perfectly competitive market. Note how any increase in price
would wipe out demand.
Also, in both sets of circumstances the suppliers cannot make a profit in the
long-run. Ultimately, firms in both markets will only be able to break even by
selling their goods and services.
Both markets are composed of firms seeking to maximize their profits. In both
of these markets, profit maximization occurs when a firm produces goods to
such a level so that its marginal costs of production equals its marginal
revenues.
Differences
One key difference between these two set of economic circumstances is
efficiency. A perfectly competitive market is perfectly efficient. This means that
the price is Pareto optimal, which means that any shift in the price would benefit
one party at the expense of the other. The overall economic surplus, which is
the sum of the producer and consumer surpluses, is maximized. The suppliers
cannot influence the price of the good or service in question; the market
dictates the price. The price of the good or service in a perfectly competitive
market is equal to the marginal costs of manufacturing that good or service.
In a monopolistically competitive market the price is higher than the marginal
cost of producing the good or service and the suppliers can influence the price,
granting them market power. This decreases the consumer surplus, and by
extension the market’s economic surplus, and creates deadweight loss.
Another key difference between the two is product differentiation. In a perfectly
competitive market products are perfect substitutes for each other. But in
monopolistically competitive markets the products are highly differentiated. In
fact, firms work hard to emphasize the non-price related differences between
their products and their competitors’.
A final difference involves barriers to entry and exit. Perfectly competitive
markets have no barriers to entry and exit; a firm can freely enter or leave an
industry based on its perception of the market’s profitability. In a monopolistic
competitive market there are few barriers to entry and exit, but still more than in
a perfectly competitive market.
Efficiency of Monopolistic Competition
Monopolistic competitive markets are never efficient in any economic sense of
the term.
Learning Objectives
Discuss the effect monopolistic competition has on overall market efficiency
Key Takeaways
Key Points
Because a good is always priced higher than its marginal cost, a
monopolistically competitive market can never achieve productive or allocative
efficiency.
Suppliers in monopolistically competitive firms will produce below their
capacity.
Because monopolistic firms set prices higher than marginal costs, consumer
surplus is significantly less than it would be in a perfectly competitive market.
This leads to deadweight loss and an overall decrease in economic surplus.
Key Terms
consumer surplus: The difference between the maximum price a consumer is
willing to pay and the actual price they do pay.
producer surplus: The amount that producers benefit by selling at a market
price that is higher than the lowest price at which they would be willing to sell.
Monopolistically competitive markets are less efficient than perfectly
competitive markets.
Producer and Consumer Surplus
In terms of economic efficiency, firms that are in monopolistically competitive
markets behave similarly as monopolistic firms. Both types of firms’ profit
maximizing production levels occur when their marginal revenues equals their
marginal costs. This quantity is less than what would be produced in a perfectly
competitive market. It also means that producers will supply goods below their
manufacturing capacity.
Firms in a monopolistically competitive market are price setters, meaning they
get to unilaterally charge whatever they want for their goods without being
influenced by market forces. In these types of markets, the price that will
maximize their profit is set where the profit maximizing production level falls on
the demand curve.This price exceeds the firm’s marginal costs and is higher
than what the firm would charge if the market was perfectly competitive. This
means two things:
Consumers will have to pay a higher price than they would in a perfectly
competitive market, leading to a significant decline in consumer surplus; and
Producers will sell less of their goods than they would have in a perfectly
competitive market, which could offset their gains from charging a higher price
and could result in a decline in producer surplus.
Regardless of whether there is a decline in producer surplus, the loss in
consumer surplus due to monopolistic competition guarantees deadweight loss
and an overall loss in economic surplus.
Quantity
MC
D
Pr
ic
e
Pc
Pm
Qm Qc
Deadweight loss
MR
Consumer surplus
Producer
surplus
Inefficiency in Monopolistic
Competition: Monopolistic
competition creates deadweight loss
and inefficiency, as represented by
the yellow triangle. The quantity is
produced when marginal revenue
equals marginal cost, or where the
green and blue lines intersect. The
price is determined based on where
the quantity falls on the demand
curve, or the red line. In the short
run, the monopolistic competition
market acts like a monopoly.
Productive and Allocative Efficiency
Productive efficiency occurs when a market is using all of its resources
efficiently. This occurs when a product’s price is set at its marginal cost, which
also equals the product’s average total cost. In a monopolistic competitive
market, firms always set the price greater than their marginal costs, which
means the market can never be productively efficient.
Allocative efficiency occurs when a good is produced at a level that maximizes
social welfare. This occurs when a product’s price equals its marginal benefits,
which is also equal to the product’s marginal costs. Again, since a good’s price
in a monopolistic competitive market always exceeds its marginal cost, the
market can never be allocatively efficient.
Advertising and Brand Management in Monopolistic Competition
Advertising and branding help firms in monopolistic competitive markets
differentiate their products from those of their competitors.
Learning Objectives
Evaluate whether advertising is beneficial or detrimental to consumers
Key Takeaways
Key Points
A company’s brand can help promote quality in that company’s products.
Advertising helps inform consumers about products, which decreases selection
costs.
Costs associated with advertising and branding include higher prices, customers
mislead by false advertisements, and negative societal affects such as
perpetuating stereotypes and spam.
Key Terms
brand: The reputation of an organization, a product, or a person among some
segment of the population.
advertising: Communication with the purpose of influencing potential
customers about products and services
One of the characteristics of a monopolistic competitive market is that each firm
must differentiate its products. Two ways to do this is through advertising and
cultivating a brand. Advertising is a form of communication meant to inform,
educate, and influence potential customers about products and services.
Advertising is generally used by businesses to cultivate a brand. A brand is a
company’s reputation in relation to products or services sold under a specific
name or logo.
Listerine advertisement, 1932: From 1921 until the mid-1970s, Listerine was
also marketed as preventive and a remedy for colds and sore throats. In 1976, the
Federal Trade Commission ruled that these claims were misleading, and that
Listerine had “no efficacy” at either preventing or alleviating the symptoms of
sore throats and colds. Warner-Lambert was ordered to stop making the claims
and to include in the next $10.2 million dollars of Listerine ads specific mention
that “contrary to prior advertising, Listerine will not help prevent colds or sore
throats or lessen their severity. ”
Benefits of Advertising and Branding
The purpose of the brand is to generate an immediate positive reaction from
consumers when they see a product or service being sold under a certain name
in order to increase sales. A brand and the associated reputation are built on
advertising and consumers’ past experiences with the products associated with
that brand.
Reputation among consumers is important to a monopolistically competitive
firm because it is arguably the best way to differentiate itself from its
competitors. However, for that reputation to be maintained, the firm must
ensure that the products associated with the brand name are of the highest
quality. This standard of quality must be maintained at all times because it only
takes one bad experience to ruin the value of the brand for a segment of
consumers. Brands and advertising can thus help guarantee quality products for
consumers and society at large.
Advertising is also valuable to society because it helps inform consumers.
Markets work best when consumers are well informed, and advertising provides
that information. Advertising and brands can help minimize the costs of
choosing between different products because of consumers’ familiarity with the
firms and their quality.
Finally, advertising allows new firms to enter into a market. Consumers might be
hesitant to purchase products with which they are unfamiliar. Advertising can
educate and inform those consumers, making them comfortable enough to give
those products a try.
Costs of Advertising and Branding
There are some concerns about how advertising can harm consumers and
society as well. Some believe that advertising and branding induces customers
to spend more on products because of the name associated with them rather
than because of rational factors. Further, there is no guarantee that
advertisements accurately describe products; they can mislead consumers.
Finally, advertising can have negative societal effects such as the perpetuation
of negative stereotypes or the nuisance of “spam. ”
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Boundless Economics
Introducing Supply and Demand
Supply
The Law of Supply
The law of supply states that there is a positive relationship between the
quantity that suppliers are willing to sell and the price level.
Learning Objectives
Explain the Law of Supply
Key Takeaways
Key Points
Quantity supplied moves in the same direction as price.
The supply curve is an upward sloping curve.
Producers are willing to increase production at higher prices to increase profit.
Key Terms
surplus: That which remains when use or need is satisfied, or when a limit is
reached; excess; overplus.
shortage: a lack or deficiency
equilibrium: The condition of a system in which competing influences are
balanced, resulting in no net change.
The law of supply is a fundamental principle of economic theory. It states that
an increase in price will result in an increase in the quantity supplied, all else
held constant.
An upward sloping supply curve, which is also the standard depiction of the
supply curve, is the graphical representation of the law of supply. As the price of
a good or service increases, the quantity that suppliers are willing to produce
increases and this relationship is captured as a movement along the supply
curve to a higher price and quantity combination.
The Law of Supply: Supply has a positive
correlation with price. As the market price of a
good increases, suppliers of the good will
typically seek to increase the quantity supplied to
the market.
The rationale for the positive correlation between price and quantity supplied is
based on the potential increase in profitability that occurs with an increase in
price.
All else held constant, including the costs of production inputs, the supplier will
be able to increase his return per unit of a good or service as the price for the
item increases. Therefore, the net return to the supplier increases as the spread
or difference between the price and the cost of the good or service being sold
increases.
The law of supply in conjunction with the law of demand forms the basis for
market conditions resulting in a price and quantity relationship at which both
the price to quantity relationship of suppliers and demanders (consumers) are
equal. This is also referred to as the equilibrium price and quantity and is
depicted graphically at the point at which the demand and supply curve
intersect or cross one another. It is the point where there is no surplus or
shortage in the market.
Demand
Sup
ply
P
Q Quantity
Pr
ic
e
Law of Supply and Law of Demand: Equilibrium: The law
of supply and the law of demand form the foundation for
the establishment of an equilibrium–where the price to
quantity combination for both suppliers and demanders
are the same.
Supply Schedules and Supply Curves
A supply schedule is a tabular depiction of the relationship between price and
quantity supplied, represented graphically as a supply curve.
Learning Objectives
Explain the price to quantity relationship exhibited in the supply curve
Key Takeaways
Key Points
The supply curve plots the quantity that is willingly supplied at any given price.
The individual supply curves can be summed by quantity provided at a specific
price to achieve an aggregate supply curve.
The supply curve is upward sloping in the short run.
Key Terms
aggregate: A mass, assemblage, or sum of particulars; something consisting of
elements but considered as a whole.
equilibrium: The condition of a system in which competing influences are
balanced, resulting in no net change.
Supply is the amount of some product that producers are willing and able to
sell at a given price, all other factors being held constant. In general, supply
depicts a positive relationship between the price of a good or service and the
quantity that the producer is willing to supply: if a supplier believes it can sell
the product for more, it will want to make more of the product. As a result, as
the price of a good or service increases, suppliers increase the quantity available
for purchase.
A supply schedule is a table that shows the relationship between the price of a
good and the quantity supplied. The supply curve is a graphical depiction of the
supply schedule that illustrates that relationship between the price of a good
and the quantity supplied.
The Supply Schedule and Supply Curve: The
supply curve is a graphical depiction of the price
to quantity pairings presented in a supply
schedule. The supply schedule is a table view of
the relationship between the price suppliers are
willing to sell a specific quantity of a good or
service.
The supply curves of individual suppliers can be summed to determine
aggregate supply. One can use the supply schedule to do this: for a given price,
find the corresponding quantity supplied for each individual supply schedule
and then sum these quantities to provide a group or aggregate supply. Plotting
the summation of individual quantities per each price will produce an aggregate
supply curve.
In theory, in the long run the aggregate supply curve will not be upward sloping
but will instead be vertical, consistent with a fixed supply level. This is due to the
underlying assumption that in the long run, supply of a good only depends on
the fixed level of capital, technology, and natural resources available.
The supply curve provides one side of the price-to-quantity relationship that
ensures a functional market. The other component is demand. When the supply
and demand curves are graphed together they will intersect at a point that
represents the market equilibrium – the point where supply equals demand and
the market clears.
Market Supply
Market supply is the summation of the individual supply curves within a specific
market where the market is characterized as being perfectly competitive.
Learning Objectives
Identify the market conditions that yield a market supply curve.
Key Takeaways
Key Points
A supply curve is the graphical representation of the supplier’s positive
correlation between the price and quantity of a good or service.
The supply curve can only be attributed to a depiction of a perfectly competitive
market due to the unique attributes of perfect competition: firms are price
takers, no single firm’s actions can influence the market price, and ease of exit
and entry.
The market supply curve is derived by summing the quantity for a given price
across all market participants (suppliers). It depicts the price-to-quantity
combinations available to consumers of the good or service.
Key Terms
Supply curve: A graphical representation of the quantity producers are willing
to make when the product can be sold at a given price.
A supply curve is the graphical representation of the supplier’s positive
correlation between the price and quantity of a good or service. As a result, the
supply curve is upward sloping. Market supply is the summation of the
individual supply curves within a specific market.
Market Supply: The market supply curve is an
upward sloping curve depicting the positive
relationship between price and quantity supplied.
The market supply curve is derived by summing the quantity suppliers are
willing to produce when the product can be sold for a given price. As a result, it
depicts the price to quantity combinations available to consumers of the good
or service. In combination with market demand, the market supply curve is
requisite for determining the market equilibrium price and quantity.
By its very nature, conceptualizing a supply curve requires the firm to be a
perfect competitor, namely requires the firm to have no influence over the
market price. This is true because each point on the supply curve is the answer
to the question “If this firm is faced with this potential price, how much output
will it be able to and willing to sell? ” If a firm has market power, its decision of
how much output to provide to the market influences the market price, then the
firm is not “faced with” any price, and the question is meaningless.
The attributes of a competitive market signal that the price is set external to any
firm. Therefore, production in the market is a sliding scale dependent on price.
As price increases, quantity increases due to low barriers to entry, and as the
price falls, quantity decreases as some firms may even opt out of the market.
The supply curve can be derived by compiling the price-to-quantity relationship
of a seller. A seller could set the price of a good or service equal to zero and
then incrementally increase the price; at each price he could calculate the
hypothetical quantity he would be willing to supply. Following this process the
seller would be able to trace out its complete individual supply function. The
market supply curve is simply the sum of every seller’s individual supply curve.
Determinants of Supply
Supply levels are determined by price, which increases or decreases supply
along the price curve, and non-price factors, which shifts the entire curve.
Learning Objectives
Identify the factors that affect the supply of a good
Key Takeaways
Key Points
Supply is the quantity of a good or service that a supplier provides to the
market.
Suppliers will shift production for non- price changes related to the
determinants of supply and will slide production levels across the supply curve
for price related movements.
Innumerable factors and circumstances could affect a seller’s willingness or
ability to produce and sell a good.
Key Terms
intervention: The action of interfering in some course of events.
incentive: Something that motivates, rouses, or encourages.
Supply is the quantity of a good or service that a supplier provides to the
market. Innumerable factors and circumstances could affect a seller’s willingness
or ability to produce and sell a good. Some of the more common factors are:
Good’s own price: An increase in price will induce an increase in the quantity
supplied.
Prices of related goods: For purposes of supply analysis, related goods refer to
goods from which inputs are derived to be used in the production of the
primary good.
Conditions of production: The most significant factor here is the state of
technology. If there is a technological advancement related to the production of
the good, the supply increases.
Expectations: Sellers’ expectations concerning future market conditions can
directly affect supply.
Price of inputs: If the price of inputs increases the supply curve will shift left as
sellers are less willing or able to sell goods at any given price. Inputs include
land, labor, energy and raw materials.
Number of suppliers: As more firms enter the industry the market supply curve
will shift out driving down prices. The market supply curve is the horizontal
summation of the individual supply curves.
Government policies and regulations: Government intervention can take
many forms including environmental and health regulations, hour and wage
laws, taxes, electrical and natural gas rates and zoning and land use regulations.
These regulations can affect a good’s supply.
Suppliers will change their production levels along the supply curve in response
to a price change, so that their production level is equal to demand. However,
some factors unrelated to price can shift the production level. For example, a
technological improvement that reduces the input cost of a product will shift
the supply curve outward, allowing suppliers to provide a greater supply at the
same price level.
Determinants of Supply: If the price of a good
changes, there will be movement along the supply
curve. However, the supply curve itself may shift
outward or inward in response to non-price
related factors that affect the supply of a good,
such as technological advances or increased cost
of materials.
Changes in Supply and Shifts in the Supply Curve
The supply curve depicts the supplier’s positive relationship between price and
quantity.
Learning Objectives
Distinguish between shifts in the supply curve and movement along the supply
curve
Key Takeaways
Key Points
A change in the price of a good or service, holding all else constant, will result in
a movement along the supply curve.
A change in the cost of an input will impact the cost of producing a good and
will result in a shift in supply; supply will shift outward if costs decrease and will
shift inward if they increase.
A change in the expected demand for a good or service will result in a shift in
supply; supply will shift outward if enthusiasm is expected to increase and will
shift inward if there is an expectation for consumers preferences to change in
favor of an alternate good or service.
Key Terms
Non-price changes: Shocks, either exogenous or endogenous, that affect the
positioning of the supply curve.
Price changes and movement along supply curve
If the price of the good or service changes, all else held constant such as price
of substitutes, the supplier will adjust the quantity supplied to the level that is
consistent with its willingness to accept the prevailing price. The change in price
will result in a movement along the supply curve, called a change in quantity
supplied, but not a shift in the supply curve. Changes in supply are due to non-
price changes.
Non-price changes and shifts of the supply curve
If production costs increase, the supplier will face increasing costs for each
quantity level. Holding all else the same, the supply curve would shift inward (to
the left), reflecting the increased cost of production. The supplier will supply less
at each quantity level.
If production costs declined, the opposite would be true. Lower costs would
result in an increase in output, shifting the supply curve outward (to the right)
and the supplier will be willing sell a larger quantity at each price level. The
supply curve will shift in relation to technological improvements and
expectations of market behavior in very much the same way described for
production costs.
Technological improvements that result in an increase in production for a set
amount of inputs would result in an outward shift in supply.
Supply will shift outward in response to indications of heightened consumer
enthusiasm or preference and will respond by shifting inward if there is an
assessment of a negative impact to production costs or demand.
Supply Shifts: A shift in supply from S1 to S2
affects the equilibrium point, and could be
caused by shocks such as changes in
consumer preferences or technological
improvements.
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Boundless Economics
Principles of Economics
The Study of Economics
The Magic of the Economy
The study of economics makes individuals cognizant of their environment and
better decision makers.
Learning Objectives
Explain how the study of economics provides knowledge to understand the
system and policies that guide life.
Key Takeaways
Key Points
Economics also allows individual agents to balance expectations.
Economics provides distilled frameworks to analyze complex societal
interactions, as in the case of consumer and firm behavior.
Being knowledgable about economics foundations allows an individual to be an
active and aware participant rather than a passive economic agent.
Key Terms
externality: An impact, positive or negative, on any party not involved in a
given economic transaction or act.
circular flow: A model of market economy that shows the flow of dollars
between households and firms.
Economics is a social science. This means that economics has two important
attributes. Economics studies human activities and constructions in
environments with scarce resources, and uses the scientific method and
empirical evidence to build its base of knowledge.
The evaluation of human interactions as it relates to preferences, decision
making, and constraints is a significant foundation of economic theory. The
complexity of the dynamics of human motivation and systems has led to the
establishment of assumptions that form the basis of the theory of consumer
and firm behavior, both of which are used to model circular flow interactions
within the economy.
Circular Flow of the Economy: Economics provides an accessible foundation for
understanding the complexity of the interactions in the world. For example, the
circular flow diagram displays the economic framework related to the dynamic
interconnectedness of economic agents. In the graph above the display is limited
to households and firms but other depictions of circular flow incorporate the
government and international trading partners.
Economics provides distilled frameworks to analyze complex societal
interactions, as in the case of consumer and firm behavior. An understanding of
how wages and consumption flow between consumers and producers provides
agents with an ability to understand the symbiosis of the relationship rather
than fixating on the contentious components that surface from time to time.
Economics also allows individual agents to balance expectations. An
understanding of the ebb and flow of the economy through the boom and bust
of the business cycles, creates the potential for emotional balance by reminding
agents to limit desperation in downturns and exuberance in expansions.
By developing an understanding of the foundations of economics, individuals
can become better decision makers with respect to their own lives and maintain
a balance with respect to an externality that has the potential to supplement or
deter their plans. Since economic theories are a basis of decision making and
regulatory policy, being knowledgable about economics foundations allows an
individual to be an active and aware participant rather than a passive economic
agent.
Is Economics a Science?
Economics is a social science that has diverse applications.
Learning Objectives
Explain how economic theory and analysis can be applied throughout society
Key Takeaways
Key Points
Economics incorporates both qualitative and quantitative assessment.
Economics is divided into two broad areas: microeconomics and
macroeconomics.
Economics can be applied throughout society from business to individual
behavior with further application in the study of crime, family and other social
institutions and interactions.
Key Terms
social science: A branch of science that studies the society and human behavior
in it, including anthropology, communication studies, criminology, economics,
geography, history, political science, psychology, social studies, and sociology.
Economics is a social science that assesses the relationship between the
consumption and production of goods and services in an environment of finite
resources. A focus of the subject is how economic agents behave or interact
both individually (microeconomics) and in aggregate (macroeconomics).
Microeconomics examines the behavior individual consumers and firms within
the market, including assessment of the role of preferences and constraints.
Macroeconomics analyzes the entire economy and the issues affecting it.
Primary focus areas are unemployment, inflation, economic growth, and
monetary and fiscal policy.
The discipline of economics evolved in the mid-19th century through the
combination of political economy, social science and philosophy and gained
entrenchment with the increased scrutiny of the asymmetric financial and
welfare distribution attributed to sovereign rule. Early writings are attributable
to Jeremy Bentham, David Ricardo, John Stuart Mill and his son John Mill and
are focused on human welfare and benefits rather than capitalism and free
markets.
Founders of Economics:
John Stuart Mill, along with
David Ricardo, Jeremy
Bentham and other political
and social philosophers of
the mid-nineteenth century
are credited with the
founding of the social-
political theory that has
evolved to be the discipline
of economics.
As in other social sciences, economics does incorporate mathematics in the
theoretical and analytics framework of the discipline. Formal economic
modeling began in the 19th century with the use of differential calculus to
represent and explain economic behavior, such as utility maximization, an early
economic application of mathematical optimization in microeconomics.
Economics utilizes mathematics to assess the relationships between economic
actors in environments in which resources are finite.
The use of mathematics in economics increased the quantitative analysis
inherent in the discipline; however, given the discipline’s essentially social
science roots, many economists from John Maynard Keynes to Robert
Heilbroner and others criticized the broad use of mathematical models for
human behavior, arguing that some human choices can not be modeled or
evaluated in a mathematical equation.
Economic theory and analysis may be applied throughout society, including
business, finance, health care, and government. The underlying components of
economic theory can also be applied to variety of other subjects, such as crime,
education, the family, law, politics, religion, social institutions, war, and science.
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Boundless Economics
The Market System
Introducing the Market System
Defining a Market System
A market system is a way to match buyers and sellers.
Learning Objectives
Identify the characteristics of a market system
Key Takeaways
Key Points
Publishing current prices is a key component with a market system.
Competition is the primary regulatory mechanism in a market system.
Economists recognize a number of different structures of market systems based
on characteristics such as the level of competition.
Key Terms
price: The quantity of payment or compensation given by one party to another
in return for goods or services.
In an economy, a market system is any systematic process that enables many
market players to bid and ask. In other words, a market system is a place (virtual
or physical) that facilitates the matching of buyers and sellers. Many markets
exist, and each can be defined based on a number of characteristics, such as
what is being exchanged in the market, the regulations, who is allowed to
participate, and how transactions occur.
One defining component of markets is the medium of exchange, or the price. In
most American markets, the medium of exchange is dollars. Both buyers and
sellers look at the price to determine whether or not they want to trade. A seller
has a certain minimum price at which s/he is willing to sell, though s/he would
happily accept more. Likewise, a buyer has a certain maximum price at which
s/he is willing to buy, though s/he would happily pay less. If the minimum the
seller would accept is less than the maximum a buyer would pay, a transaction
can occur. Markets help such buyers and sellers meet to trade.
In market systems, prices are discoverable; both buyers and sellers are capable
of finding out the current price at which a transaction could occur. Publishing
current prices is a key component with a market system. The chosen prices
impact the immediate group of buyers and sellers, but also may impact long
term supply and demand decisions within the market.
There are many examples of market systems. Perhaps the most famous is the
stock market in which buyers and sellers trade stocks. The prices at which those
sales occur is recorded, and is the basis for the stock price you may have seen in
the newspaper or on TV. There are markets for many types of products other
than stocks: the global oil market, your local farmers’ market, and eBay are all
forms of markets with their own defining characteristics.
NASDAQ Stock Market Display: The NASDAQ is a stock market where
buyers and sellers of stocks can meet and trade.
Another important component of market systems is that there is competition,
which serves as the main regulatory mechanism. Based on the level of
competition in a market system, economists have identified a number of
different types of structures, such as monopoly, oligopoly, and perfect
competition. We will go into more detail on different market structures later in
the book.
Gains from Markets
Gains in a market are referred to as total welfare or economic surplus.
Learning Objectives
Explain how to calculate total welfare
Key Takeaways
Key Points
Within total welfare, economists look at consumer surplus and producer surplus.
Consumer surplus is the monetary gain that consumers receive when they
purchase a good for less than the highest price they are willing to pay.
Producer surplus is the amount that producers benefit by selling a good at a
market price that is higher than the least that they would be willing to sell it for.
In order to calculate the total welfare, the supply and demand of the good must
be used to determine the economic gain.
When the supply of a good increases, the price falls which increases consumer
surplus. When the demand for a good increases, the price increases and the
supply decreases resulting in producer surplus.
Key Terms
welfare: Health, safety, happiness and prosperity; well-being in any respect.
Gains within a market are referred to as total welfare or economic surplus.
Within total welfare, economists look at consumer surplus and producer surplus.
A surplus is defined as the excess of a good or service when the quantity
supplied exceeds the quantity demanded; this occurs when the price is above
the equilibrium price.
Consumer
surplus
Producer
surplus
Supply curve
Demand
curve
Equilibrium
Equilibrium quantity
M
ar
ke
t p
ric
e
Price
Quantity
Economic Surpluses: The total welfare (or economic surplus)
is the sum of the consumer surplus and the producer surplus.
Consumer surplus is the monetary gain that consumers receive when they
purchase a good for less than the highest price they are willing to pay. For
example, a customer is willing to pay $50 for a new pair of running shoes. They
are able to purchase the pair for $35 and consumer surplus is $15.
Producer surplus is the amount that producers benefit by selling a good at a
market price that is higher than the least that they would be willing to sell it for.
An example would be a manufacturer that makes jeans. The lowest price the
producer is willing to sell a pair of jeans for is $40, but the jeans actually sell for
$50. The producer surplus is $10.
In order to calculate the total welfare, the supply and demand of the good must
be used to determine the economic gain. On a demand and supply curve graph,
the consumer surplus is located under the demand curve and above a
horizontal line that shows the actual price of a good (equilibrium price).
When the supply of a good increases, the price falls which increases consumer
surplus. When the demand for a good increases, the price increases and the
supply decreases resulting in producer surplus. When a good is in high demand,
consumers are willing to pay more in order to obtain the good.
Production Possibility Frontier
A production-possibility frontier (PPF) graphs the combinations for the
production of two commodities with which the same amounts are used.
Learning Objectives
Explain the benefits of trade and exchange using the production possibilities
frontier (PPF)
Key Takeaways
Key Points
A PPF graph shows the maximum production level for one commodity for any
production level of the other commodity.
If a point on the graph is above the curve it indicates efficiency, while a point
below the curve signifies inefficiency.
The PPF graph shows how resources must be shared among goods during the
production process.
Within an economy, if the capacity to produce both goods increases which
results in economic growth.
Key Terms
commodity: Raw materials, agricultural and other primary products as objects
of large-scale trading in specialized exchanges.
marginal: Of, relating to, or located at or near a margin or edge; also figurative
usages of location and margin (edge).
Within a market system, economists use the production possibility frontier (PPF)
to graph the combinations of the amounts of two commodities that can be
produced using the same amount of each factor of production. A PPF graph
chooses specific input quantities. As a result, it shows the maximum production
level for one commodity for any production level of the other commodity. PPF is
used to define production efficiency.
Q
ua
nt
ity
o
f G
un
s P
ro
du
ce
d
Quantity of Butter Produced
D
A
C
B
– 5
0
– 5
+10 +10
A common PPF: A common PPF where there is an
increase in opportunity cost.
Within a PPF graph, the use of a curve or line acts as a benchmark for
measuring efficiency. If a point on the graph is above the curve it indicates
efficiency, while a point below the curve signifies inefficiency. For further
analysis, additional information is always supplied with a PPF including the
period of time taken for the observation, production technologies, and the
amounts of inputs that were available.
Economists can use a PPF to illustrate a number of economic concepts including
scarcity, opportunity cost, productive efficiency, allocative efficiency, and
economies of scale.
When an economy is operating on the PPF curve it is efficient. It is not possible
to produce more of one good without decreasing the amount produced for the
other good. Likewise, if the economy is operating below the PPF curve, it is
inefficient. In this case, the economy can reallocate resources and produce more
of both the goods.
The PPF graph shows how resources must be shared among goods during the
production process. The points of the graph show the trade -off that takes place
between two goods. For example, if more of Good A needs to be produced, the
amount of resources in use by Good B must be reduced and transferred to
Good A. The sacrifice in production of Good B is called opportunity cost. When
graphing PPF there are three types: the common, the straight line, and the
inverted PPF. All three of the PPF graphs are directly influenced by the
opportunity cost.
Q
ua
nt
ity
o
f G
un
s P
ro
du
ce
d
Quantity of Butter Produced
D
A
C
B- 5
0
– 5
+10 +10
An inverted PPF: An inverted PPF where the
opportunity cost is decreasing.
Q
ua
nt
ity
o
f G
un
s P
ro
du
ce
d
Quantity of Butter Produced
– 2
5
– 2
5
+10 +10
B
A
D
C
A straight line PPF: A straight line PPF where the
opportunity cost is constant.
The slope of the PPF shows the rate at which the production of one good can
be transferred to another. The slope is called the marginal rate of
transformation (MRT).
Within an economy, if the capacity to produce both goods increases, the result
is economic growth. Factors that influence economic capacity include
technology, an increase in the supply of factors of production, and production
interactions such as trade and exchange. When any of these factors are used it
allows for an increase in capacity so that the production of neither good has to
be sacrificed.
PPF graphs help economists study the current state of production as well as
possible production scenarios. The output of the economy is impacted by many
factors. When production can be graphed and monitored it allows adjustments
to be made to work towards attaining economic growth and stability.
The Circular Flow Model
In economics, a circular flow model is a diagram that is used to represent the
monetary transactions in an economy.
Learning Objectives
State the function of the circular flow diagram and the production possibilities
frontier
Key Takeaways
Key Points
There are two flows present within the model including flows of physical things
(goods or labor) and flows of money (what pays for physical things).
The circular flow of income follows a specific pattern: Production → Income →
Expenditure → Production.
The production possibility frontier can be used to illustrate the circular flow
model.
Economists use data, statistics, and natural experiments in order to make
economic “laws” that explain general patterns.
Key Terms
expenditure: Act of expending or paying out.
Factors of production: In economics, factors of production are inputs. They
may also refer specifically to the primary factors, which are stocks including
land, labor, and capital goods applied to production.
In economics, a circular flow model is a diagram that is used to represent the
monetary transactions in an economy. There are two flows present within the
model including flows of physical things (goods or labor) and flows of money
(what pays for physical things). A circular flow model depicts the inner workings
of a market system and specific portions of the economy.
The basic circular flow model consists of two sectors that determine income,
expenditure, and output. A state of equilibrium is reached when there is no
tendency for the levels of income (
), expenditure (
), and output (
) to change (
). This equation means that the expenditure of buyers (households) becomes
income for sellers ( firms ). The firms spend the income on factors of production,
which “transfers” the income to the factor owners. The factor owners spend the
income on goods which leads to the circular flow of payments.
Y
E
O
Y = E = O
Circular flow of goods income: The circular flow model shows the flow of
payments between households and firms.
The circular flow of payments is important within an economy because it 1)
measures the national income, 2) provides knowledge of interdependence, 3)
illustrates the unending nature of economic activities, and 4) shows injections
and leakages.
The circular flow of income follows a specific pattern: Production → Income →
Expenditure → Production. This circular flow is ongoing between households
and firms.
The circular flow of income can also be analyzed using the production
possibility frontier (PPF). The PPF is a graph that shows the various
combinations of amounts of two commodities that could be produced using the
same fixed total amount of each of the factors of production. The graph shows
the maximum possible production level of one commodity for any production
level of the other, based on the state of technology. The PPF defines production
efficiency. A point of the frontier line indicates the efficient use of available
inputs, while a point beneath the curve shows inefficiency. A PPF graphs shows
opportunity cost, actual output, potential output, and economic growth.
Q
ua
nt
ity
o
f G
un
s P
ro
du
ce
d
Quantity of Butter Produced
D
A
B
X
C
Production Possibilities Frontier Curve: The graph
illustrates a typical production possibilities frontier
curve. When a market is operating on the PPF it is said
to be efficient.
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Sociology
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Academic Integrity
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