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Chapter 7 The Firm. Business Firm. Employs factors of production Produces goods and services Sells to consumers, other firms, or the government We work for and buy from firms. Market. Two sides Buyers Utility is major decision making device Sellers How do they make decisions.

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Chapter 7 The Firm

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Chapter 7The Firm

Business Firm

  • Employs factors of production

  • Produces goods and services

  • Sells to consumers, other firms, or the government

  • We work for and buy from firms


  • Two sides

    • Buyers

      • Utility is major decision making device

    • Sellers

      • How do they make decisions

How do the two sides come together?

  • Market Coordination

    • Invisible Hand (Adam Smith)

    • Market guides individuals into activities at which they are the most efficient

    • Pushes sellers to produce certain things and buyers to instruct what to produce

    • Equates supply and demand

How does the firm decide what to produce?

  • Managerial Coordination

    • Guides individual firm production decisions

    • Thus…invisible hand of the firm

Why follow this invisible hand?

  • Firms are formed because greater benefits of working as a team than working as individuals

Problem with teamwork

  • Shirking

    • Putting forth less effort than your originally agreed to

    • Problem because shirker gains ALL benefits from shirking but costs are spread over the entire team

Can shirking increase or decrease?

  • Yes!!

  • As the benefits of shirking increase so does the amount

  • If the shirker must bear the full cost of shirking then shirking will decrease

How can we decrease shirking?

  • Manager’s duty or MONITORING

  • Reward productive workers and punish shirkers

  • Preserves the benefit of team production

  • Reduces the benefits of shirking

Who monitors the monitor?

  • Salary usually tied into production

  • Called Residual Claimant

    • Person who shares in the profits of the firm

    • More shirkers?? Less Production…so less pay for monitor

Another way to ward off shirking?

  • Pay higher than equilibrium wages

  • Decreases shirking because cost of losing job is greater.

  • Don’t need monitor because high wage makes worker monitor themselves

  • Called efficiency wage theory

Why do people submit to being monitored??

  • Monitoring decreases shirking

  • Monitoring increases benefits of teamwork

  • Monitoring maximizes benefits that can be achieved

Objective of the firm

  • Profit Maximization

  • Now…want to move to the Firm to see how they achieve this objective

Chapter 8Production and Costs

© South-Western College Publishing 1998

Cost Side

  • Explicit Cost

    • Actual money is exchanged

    • COST

  • Implicit Cost

    • Value of resources used in the production or acquisition of a good

    • No monetary payment



  • In order to have a cost, sacrifice must have taken place

  • Forfeited something else

  • No money must change hands for sacrifice to take place


  • Two types

    • Accounting

      • Difference between total revenue and explicit costs

      • Acct Profit = TR – EXPLICIT COSTS

    • Economic

      • Difference between total revenue and total cost (implicit and explicit)

      • Econ Profit = TR – Explicit Cost – Implicit Cost

Which do you think is lower??

  • Economic Profit

  • Usually lower but never higher

  • How can it be “usually” lower?

  • Implicit cost can equal 0 so accounting and economic profit would be equal

Accounting and Economic Profit

Zero Economic Profit

  • Total Revenue-explicit cost-implicit costs = 0

  • Also called NORMAL PROFIT

  • Equilibrium of profit for the firm

  • Would we want zero accounting profit?

  • NO!!! Implicit costs would not be covered

Sunk versus Fixed Costs

  • Sunk

    • Incurred in the past

    • Cannot be changed by a current decision

    • Cannot be recovered

    • Example: Time spent in school

    • Can’t recover so let it go…Release it

  • Fixed

    • Possibility of recovering some money for selling the good

    • Example: Land, equipment…


  • Takes time to produce

  • Costly to produce

  • Direct link between production, costs, and time

Two types of time

  • Short Run

    • Fixed and variable inputs

  • Long Run

    • All inputs are variable

Short Run

  • Fixed input

    • Quantity can not be changed

    • Independent of output produced

    • Example: Building, land…

  • Variable input

    • Quantity can be changed as output changes

    • Example: Labor


  • Fixed Cost (FC)

    • Associated with fixed inputs

    • Do not change with output

    • Example: Insurance premiums

  • Variable Costs (VC)

    • Associated with variable inputs

    • Changes as output changes

    • Example: Hire more people and must pay more wages

TotalFixed Cost


Periods of Production, Inputs, and Costs

Total Costs

  • Variable Cost + Fixed Cost


Other costs of importance…

  • Average Variable Cost (AVC)

  • Average Fixed Cost (AFC)

  • Average Total Cost (ATC)


Average FixedCost

Average Total Cost

Marginal Cost

  • Change in TC that results from a change in output

  • Additional cost of producing an additional unit of output

Why Change in Total Cost or Total Variable Cost????

  • Since total fixed cost doesn’t change the “additional” total fixed cost is zero

Marginal Costs

In-class exercise #9Using the knowledge

Shapes of Curves

  • Law of diminishing marginal returns

    • As larger amounts of a variable input are combined with fixed inputs eventually the Marginal Physical Product (MPP) declines

Marginal Physical Product (MPP)

  • What is the variable input?

  • What is the variable cost?


  • As more labor (VARIABLE INPUT) are added to land (FIXED INPUT) the variable inputs would yield smaller and smaller additions to output

Marginal Physical Product

Crowding Problem

  • The point at which MPP declines

  • Shows the law of diminishing returns

Average Physical Productivity

  • Output divided by Inputs (usually labor)

  • Good for comparing firms or countries.

So find that…

  • MC and MPP are related

  • What is the relationship?

In –class exercise 10 Does MPP show Diminishing Returns???

Law of Diminishing Marginal Returns

Marginal Cost

Does this relationship make sense?

  • Yes..

  • If productivity increases what would happen to costs??

    • Decrease (MPP increase & MC decrease)

  • Productivity decreases??

    • Increase (MPP decreases & MC increases)

MPP determines shape of MC

  • MPP must have a declining part because of diminishing returns

  • Can also define MC as:

In-class exercise 11

How do we calculate these costs??

Give two ways to get to the cost…

Average-Marginal Rule

  • Can use to see what the ATC and AVC curve look like

  • Tells us what happens when MC is above or below the “average” curves

  • If MC is above AVC and ATC

    • AVC and ATC are rising

  • If MC is below AVC and ATC

    • AVC and ATC are falling

From Average-Marginal Rule can infer…

  • MC intersects the AVC and ATC curves at their MINIMUM POINTS

  • Cannot infer anything about AFC

Average and Marginal Cost Curves

Average and Marginal Cost Curves


  • MC gains it shape from???

    • MPP and law of diminishing marginal returns

  • MC below ATC: What is ATC curve doing?

    • Falling

  • MC above ATC: What is ATC curve doing?

    • Rising

Average and Marginal Cost Curves

Tying Products to Costs



Variable Input

When MC is below



Production in the

short run: at

least one fixed input

When MC is above



Variable Input


Now switching to the Long Run

  • When does Long Run start?

    • As soon as all inputs (costs) are VARIABLE

    • No fixed costs

  • Important curves

    • LRTC

    • LRATC

    • LRMC

Short Run vs. Long Run

  • Short Run assumes FIXED plant size

  • Each plant size has a unique ATC curve associated with it

    • SRATC

  • LRATC combines all the SRATC curves

  • Which points of the SRATC???

  • Minimum points

Why minimum?

  • LRATC shows the lowest average cost at which a firm can produce any given level of output

  • LRATC is the lower ENVELOPE of the SRATC curves

  • Called envelope curve

Long-Run Average Total Cost Curve (LRATC)

Isn’t the LRATC curve smooth??

  • Yes!!

  • Have infinitely many SRATC curves so it would be smooth if use all curves

  • Each SRATC curve touches the LRATC curve only once

Shape of LRATC

  • U-shaped

  • Decreasing, Flat, then Increasing

  • Important when finding optimal long run output level

Long-Run Average Total Cost Curve (LRATC)

Economies of Scale

  • Downward part of LRATC

  • Average costs decrease as output increases

  • If have a 1% increase in input usage what happens to output??

    • Increases by MORE than 1%

  • Specialization

Constant Returns to Scale

  • Flat portion of LRATC

  • Costs remain the same as increase output

  • If have a 1% increase in input usage what happens to output??

    • Output increases by EXACTLY 1%

  • First point of constant returns to scale is called MINIMUM EFFICIENT SCALE

Diseconomies of Scale

  • Upward sloped portion of LRATC

  • Costs are rising as we increase output

  • If have a 1% increase in input usage what happens to output?

    • Increases by LESS THAN 1%

  • Why???

    • Firm too large (bad communication or coordination problems)

Long-Run Average Total Cost Curve (LRATC)

Are economies, diseconomies, and constant returns to scale in SR, LR, or both???


  • Why?

    • Inputs necessary for production are able to be changed

    • No fixed inputs

Is this the same as diminishing returns?

  • NO

  • Diminishing returns is from using ONE plant size intensely

    • Short run

  • Economies of scale is from CHANGING plant size

    • Long run


  • Economies of Scale

    • LRATC falling

  • Constant Returns to Scale

    • LRATC flat

  • Diseconomies of Scale

    • LRATC rising

Why does economies of scale exist?

  • Large firms offer more opportunity for workers to specialize

  • Growing firms can take advantage of efficient mass production techniques

    • Smooth cost over more units produced

Why does diseconomies of scale exist?

  • Communication problems

  • Shirking

  • Management problems

Why is minimum efficient scale important?

  • Lowest output level at which ATC are minimized

  • Which has a cost advantage??

    • Small firm at minimum efficient scale point

    • Larger firm producing more output but still within constant returns to scale area

    • Neither

Long-Run Average Total Cost Curve (LRATC)

Minimum Efficient Scale for Six Industries

Where would you expect to find less firms? (using MES)

  • Firms with higher MES

  • Why??

    • Produce until MES

    • If MES is higher then each firm will be producing more…so need less firms to cover quantity wanted by economy

  • Many SHOE companies (MES = .2)

  • Few REFRIGERATOR companies (MES = 14)

Efficient Number of Firms

  • 100 divided by MES

  • 100% of goods are wanted by consumers

  • MES is the percentage of consumption each firm will provide

  • Cigarette firm’s MES = 6.6

    • Need 15 firms

  • Petroleum firm’s MES = 1.9

    • Need 52 firms

  • Thus a larger MES means less firms needed

What cause SRTC, LRTC, and MC to shift?

  • Taxes

    • Does it affect FC??

      • Only if it is a lump sum tax (tax for existing)

      • If it is a per unit tax then FC doesn’t change

    • How does it change curves??

  • Input prices

    • How does it change curves??

  • Technology

    • Either improves production process (use less inputs) or lower input prices

    • How does it change curves??

Homework due Monday May 19th

  • Chapter 8

    • Questions: 3, 5, 10, and 11

  • Working with numbers and graphs

    • Questions 3, 6, and 7

In-class exercise 12

Do we understand Chapter 8??

Chapter 9

Perfect Competition


  • Many buyers and sellers

    • None powerful enough to alter price

  • Homogenous good

  • Full information

  • Easy entry and exit

Price Takers

  • Those who can’t influence price

  • Why can’t they??

    • Just a small fish in a large sea

  • Who sets the price then??

    • The market


  • Agriculture market

  • Milk Market

  • Pork Market

  • Beef Market

Demand Curve

  • Individual Market

    • Perfectly Horizontal

    • Horizontal where??

      • At the market price

  • Industry

    • Downward Sloping

Market & Firm Demand in Perfect Competition


  • Price Taker

  • Horizontal Demand means…

    • At price lower firm would sell ALL its output

    • At price higher firm would sell NOTHING

Would a firm sell at price lower than market price?

  • No!!

  • Why??

    • Wouldn’t maximize profit

    • Could increase price and not lose customers

Why horizontal though??

  • What happens to elasticity as increase the number of substitutes for the good?

    • Increases

  • How many substitutes exist for a homogenous good?

    • Many

  • What type of elasticity does this demand have?

    • Perfectly elastic

Does this go against the Law of Demand?

  • What is the Law of Demand??

    • Increases in the price decrease the quantity demanded for the good

  • Go against??

    • NO!!

    • Just pricing situation a single firm finds themselves in

    • Each firm produces small amount so can’t change price

Total Revenue

  • Price * Quantity

  • Marginal Revenue (MR)

  • For a perfectly competitive firm

    => MR = Price

  • Why???

    • Price won’t change as output changes

  • Why???

    • Each firm is a PRICE TAKER


  • For perfectly competitive the MR curve is the same as the Demand curve

    • MR = D

  • Since price taker – Demand horizontal at the market price

    • D = price

  • So…MR = D = P


Demand Curve and Marginal Revenue Curve for a Perfectly Competitive Firm

What if assumptions don’t hold?

  • Depends on degree to which assumptions don’t hold

  • Difference small?

    • Will approximately act like a perfectly competitive market

  • Difference big?

    • Will be categorized as a different “type” of market

When will firm produce??

  • Produce as long as MC < MR

  • Do not produce if MC > MR

  • Maximize profit where MC = MR

  • Remember if Maximize profit you implicitly mean you minimize costs

Profit Maximization Rule

  • Produce at the quantity where MR just equals MC

  • True for all market types not just perfect competition

  • Point we are interested in

    • MR = MC


  • P = MR

  • Profit Maximization is MR = MC

  • Can rewrite profit maximization rule as

    • P = MC

Quantity of Output the Perfectly Competitive Firm Will Produce

Four Cases: Produce or not?

  • Price equals ATC

  • Price above ATC

  • Price below AVC

  • Price below ATC but above AVC

  • Each case must start with profit maximization rule

  • What was that rule???

    • Price = MC = MR

Price equals ATC

  • Called Normal profit or Zero Economic Profit

  • Breakeven point

  • No profit or loss

Price above ATC

  • Profit

Profits in Perfect Competition

Price below AVC

  • Loss

  • Firm fails to cover even variable costs of firm

  • Should Shut Down!!

Shut Down Rule

  • If P < AVC should shut down

  • Why?

    • Minimize loses

    • If continue to produce have to pay variable and fixed costs

    • If shut down have to pay only fixed costs

Loss and Shut down

Price below ATC but above AVC

  • Loss

  • Continue to operate

    • Covering variable costs and some fixed costs

    • Minimize losses by continuing operation

  • Overtime alter production to cover all fixed costs

Loss but continue to operate

What Should a Firm Do in the Short Run?

Can we do this with numbers too?????

In-class exercise 13


Firm Supply Curve

What is the shut down rule??

  • Shut down if Price < AVC

  • So…produce if Price > AVC

  • Supply Curve is portion of MC above the AVC

  • Why??

  • Indicates quantities at which the firm would consider producing

Perfectly Competitive Firm's Short-Run Supply Curve

How find the market supply curve?

  • What is the individual firm’s supply curve?

    • MC above AVC

  • Horizontally sum all individual supply curves to get the market supply curve

  • Why are market supply curves upward sloping??

    • Horizontal sum of upward sloped curves

    • Law of diminishing marginal returns

Deriving the Market (Industry) Supply Curve

Job Security and fixed costs?

  • Is this the Short Run or Long Run?

    • Short because have fixed costs

  • Increases in FC/TC ratio means more job security

  • Why?

    • If true … FC is a larger portion of TC

    • TR can fall more before firm shuts down

Which firm has more job security?

Firm X has more job security!!

  • Unions know this so usually negotiate more benefits for workers before wages

  • Why??

    • Benefits are a fixed cost

    • Must pay for them even if workers aren’t using the benefit

Will there be the same number of firms in the short and long runs?

  • Probably not!!

  • If there is a profit

    • More firms will be in the long run

  • If there is a loss

    • Less firms will be in the long run

  • If there is normal profit

    • The same amount of firms will be in the long run

Long Run Competitive Equilibrium

  • Zero Economic Profit (normal profit)

    • P = SRATC

    • Incentive for no firms to enter or exit

  • Produce where P = MC

  • No incentive to change plant size

    • SRATC = LRATC where P = MC

    • Production is at optimal scale

Long-Run Competitive Equilibrium

Summary of Incentives present at Long Run Equilibrium

  • No incentive for firms to enter or exit

  • No incentive for firms to produce more or less

  • No incentive to change plant size

Perfect Competition

  • Resource Allocative Efficiency

    • Value of product to consumers = opportunity cost of resources

    • P = MC

  • Productive Efficiency

    • Producing at the lowest per unit cost

    • Long run equilibrium ATC = P at minimum point of ATC curve

    • Efficiently using resources (not wasting)

Do we understand Chapter 9???

In-class exercise 14

Homeworkdue Friday May 30th

Chapter 9

Questions 1, 6, 16

Working with Graphs and Numbers

Questions 1 and 9

Chapter 10



  • One seller

    • Firm is the industry

  • No substitutes for good

  • Many barriers to entry

Government can “grant” monopoly power in three ways…

  • Public franchise

    • Exclusive provider

      • Power companies, water companies

  • Patents

    • Exclusive provider for 17 years

    • Encourages people to invent new things

      • Zantac, Tagament

  • Licenses

    • Must have to operate

      • Cabs in New York City

Monopolies exist because:

  • Legal mandate

    • Government allows or doesn’t allow you to operate

  • Economic rational

    • Natural Monopolies

      • One firm can produce more efficiently than many

    • Exclusive ownership of resource to make the good

Two types of Monopolies

  • Government monopolies

    • Legally protected from competition

  • Market monopolies

    • Protected from competition due to economies of scale

Price maker

  • Firm is the market

  • Firm has some control over the price it sets

  • Law of Demand still hold

    • Price increases leads to less quantity demanded

Demand Curve

  • Remember the individual firm is the market

  • What does the demand curve look like??

    • Downward sloped

    • Want to sell more must lower the price


What differs here from Perfect Competition??

  • Price doesn’t equal MR!!!

    • Price > MR

  • Monopolist’s demand curve and marginal revenue curves are DIFFERENT

  • After the first point Marginal Revenue falls twice as fast as Demand


Demand and Marginal Revenue Curves


  • Profit Maximization

  • What is the profit maximization rule?

    • MR = MC

  • Want to charge the highest price per unit of quantity sold

Monopolist's Profit-Maximizing Price and Quantity of Output

Three cases

  • P > ATC

  • P < ATC

  • P=ATC

  • Where is AVC??

    • Since monopoly is the industry no need to segment total cost

    • If suffer a loss can just increase prices to cover the loss

Monopoly Profits and Losses

Differences between monopoly and perfect competition

  • P = MR for perfect competition but P > MR for monopoly

  • P = MC for perfect competition but P > MC for monopoly

  • Monopolist can change prices


  • Both try to maximize profits

  • Both are constrained by their demand curves

  • Both equate MR and MC

Long Run Profits

  • Perfect Competition

    • Zero Economic Profit (normal profit)

  • Monopoly

    • No entry

    • Profits can be reduced in two ways

      • Capitalization of profits

      • Monopoly rent seeking

Capitalization of Profits

  • Firm owner eventually may sell the business

  • When sell…include profits into the price

    • Include in TFC

  • New owner will face a higher ATC than previous owner

    • Includes old owner’s profits

  • Increase in ATC eliminates profit for new owner

Capitalization of Profits

Economic Rent

  • Profits that can’t be reduced by new entrants

  • Payment in excess of opportunity cost (profit)

  • May bring about Rent Seekers

    • Try to find markets that can gain monopoly status

    • Time and resources expended to try to get monopoly reduces economic rent

Monopolies are inefficient compared to Perfect Competition

  • Welfare cost of monopoly

    • Lower levels of output produced with monopoly than perfect competition

    • Perfect competition produce where P=MC

    • Monopoly produce where MR=MC and P > MC

    • Welfare cost is about 1% of total output

  • Rent seeking is socially wasteful

    • Use resources not in production but to gain monopoly power

Welfare Cost and Rent Seeking as Social Costs of Monopoly


  • Monopoly has no competition

  • No incentive to operate at lowest cost

Does monopolist have to charge same price to everyone?

  • No!!

  • Called Price Discrimination

  • Three types

    • First degree (perfect price discrimination)

    • Second degree (bulk pricing)

    • Third degree (group pricing)

Perfect Price discrimination

  • Highest price willing and able to pay is charged to each person

  • Price determined by placement on demand curve

  • Discrimination among units

    • Ex. Schools

Bulk Pricing

  • Different prices for different quantities sold

  • Discrimination among quantities

  • Ex. costco

Group Pricing

  • Different prices for different segments of the market

  • Ex. Senior citizen discounts, coupons, different seats in movie or plane…

Why Price Discriminate?

  • To gain some of the consumer surplus lost when charge everyone the same price

  • If successfully perfectly price discriminate

    • P=MR for all units sold

    • MR and TR increase

    • Eliminate consumer surplus

Why doesn’t everyone price discriminate?

  • Seller must be a price maker

  • Seller must know each consumer’s willingness to pay

  • Must be impossible for consumers to resell to others

    • Arbitrage

    • Buy for a low price and sell at a higher price

Does a monopolist exhibit resource allocative efficiency?

  • Perfect competition does!!

    • P = MC

  • Monopolist doesn’t!!

    • P > MC

  • Perfectly Price Discriminating Monopolist does!!

    • P = MC

Comparing P. C. Firm, Single-Price Monopolist, & Perfectly Price-Discriminating Monopolist

So does one person paying high prices mean that another can pay low prices??

  • No!!

  • Perfect Price Discrimination means that each person pays the highest price they are willing and able to pay

Would firms rather be a monopoly?

  • Yes!!

  • Rent seekers try to “buy” monopoly positions.

  • Why?

    • Fewer constraints on production behavior

    • Ability to charge different prices to different segments of the population


Chapter 10

Question 1

Working with graphs and numbers

Questions 5, 6, and 7


Chapter 10

Questions 1 and 4

Working with graphs and numbers

Questions 4, 5, and 6

Finally Chapter 11

Monopolistic Competition, Oligopoly, and Game Theory

Monopolistic CompetitionFour Assumptions

  • Many buyers and sellers

  • Heterogeneous Products

    • Brand names, location, services…

    • Real or Imagined

  • Easy Entry and Exit

  • Some control of prices


  • Retail clothing

  • Restaurants

  • Textbooks

  • Gas Stations

  • What about cereals??

    • No…many different brands but very few firms that produce them (GM, Post…)

Monopolistic is combination of Perfect Competition and Monopoly

  • Downward Sloped Demand Curve

    • Price Maker (Searcher)

  • Demand Curve more elastic than Monopoly

    • Easy entry limits control over price

    • More elastic because more substitutes

  • P > MR

    • No resource allocative efficiency

  • Most likely -- Zero Economic Profit in the long run

    • Not productive efficient

Why most likely????

  • Heterogeneous products

  • Not differentiated enough

    • Entry eats up profits

  • Differentiated

    • Barriers to entry

    • Profits

    • Example…7-up “The only uncola”

Still have three cases

  • P = ATC

  • P > ATC

  • P < ATC

Monopolistic Competitor in SR & in LR

Differs from perfect competition…

  • Produce less than perfectly competitive

  • Excess Capacity

    • Rid only with min ATC tangent to demand curve

    • Possible only with horizontal demand curve

  • Higher prices than perfectly competitive

Comparison of Perfect Competition and Monopolistic Competition: Excess Capacity

The more we differentiate our product the closer we get to monopoly. If we can’t differentiate our product we are closer to perfect competition.


OligopolyFour assumptions

  • Few sellers and many buyers

    • Firms mutually interdependent

  • Homogeneous or Heterogeneous Goods

  • Price Maker (Searcher)

    • Limited number of firms

  • Barriers to entry

    • Economies of scale, patents, legal barriers…

How find???

  • Concentration Ratio

    • Measures the % of some factor that is controlled by a certain number of firms in the industry

    • Employment, sales, assets, output…


  • High concentration ratio?

    • Oligopoly likely

    • Small number of firms controls much of the output

  • Small concentration ratio?

    • Oligopoly unlikely

    • Large number of firms control the outpu


How do firms react to actions of other firms??? Important since they are interdependent!

Three theories

  • Kinked Demand Curve Theory

  • Price Leadership Theory

  • Cartel Theory

Kinked Demand Theory

  • General Theory

    • If one firm decreases price all firms will match

    • If one firm increases price others many not match

  • So…each firm has a kink in the demand curve at the prevailing price

    • Why???

    • That is where decisions must be made

Demand Curve

  • Flatter above kink

    • More elastic

    • Increase price and people freak out

  • Steeper below kink

    • Less elastic

    • Decreases in price won’t increase quantity demand much

    • Why?

    • All firms decrease price

Why kinked

  • Made up of two separate demand curve with their own MR curves

  • One demand more elastic

  • One demand less elastic

  • Only use portions of demand curve that is relevant

    • More elastic above price and less elastic below


  • MR is not continuous

  • Expect price to remain at or near kink

  • Called sticky prices

Kinked Demand Curve Theory


  • Doesn’t say where price comes from

  • Real oligopolies don’t behave like this

    • Most will follow a price increase by one firm

    • Why wouldn’t they match???

    • Gain larger portion of market

Price Leadership Theory

  • Tries to explain where kinked price comes from

  • Assumption

    • One firm (dominate firm) sets the market price and other firms (fringe firms) take price as given

Price Leadership Theory


  • Dominate firm

    • Sets price to maximize its profits

    • Price Maker (Searcher)

    • Own supply and demand curve

  • Fringe Firm

    • Takes price as given

    • Price Taker

    • MC > AVC is supply curve

Dominate Firm does not have to be the largest!!! It could be the one with the lowest cost!!

How derive demand curve?

  • Dominate firm

    • See how much is left over for it to supply at a given price

From Demand Curve

  • Find price that will equate MR = MC

  • Fringe firms take price as given

  • At equilibrium price fringe firms cover all market demand

Cartel Theory

  • Several firms ban together and act as a monopoly

  • Produce less quantity and charge higher prices than if operated alone

  • Gain profits…then split among group members

Benefits of a Cartel (to Cartel Members)

Problems for a cartel

  • May be illegal

  • Expensive to set up

    • Free rider

    • Own priorities

    • Self interest

  • Profits may entice other firms to “try” to enter industry

  • Incentive to Cheat

Why Cheat???

  • Can increase output to increase individual profit

  • If one firm cheats…all will eventually cheat

  • Cartels will not stay in tact for long

The Government tries to keep some cartels together

  • Farmers

    • Acreage allotment program

  • Airlines

  • Each tends to increase price, TR, and profits

Game Theory

  • Mathematical technique used to analyze behavior of decision makers

    • Each player knows game is interactive

    • Needs to anticipate outcomes of other person

  • Matter of Trust

Prisoner’s dilemma

  • Two prisoners in separate rooms being questioned

  • Two ways to answer

    • Confess

    • Not confess

  • Four outcomes

Prisoner's Dilemma

Cartels and Prisoner's Dilemma

Do we understand Chapter 11?

In-class exercise 16

Homework due Monday June 9th

Chapter 11

Questions 1, 2, 5, and 6

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