Issues in Economics Today 8th Edition Guell Solutions Manual 1

Chapter 5
Perfect Competition, Monopoly, and Economic versus

Normal Profit
Solution Manual for Issues in Economics Today
8th Edition Guell 1259746399 9781259746390
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Learning Objectives
After reading this chapter you should be able to
LO1 Distinguish between perfect competition and monopoly and between normal
and economic profit.
LO2 Demonstrate and explain why economic profit disappears under perfect
competition but not under monopoly.
LO3 Illustrate why, under perfect competition, the supply curve from Chapter 2 is
marginal cost.
Chapter Outline
 From Perfect Competition to Monopoly
 Supply Under Perfect Competition
FROM PERFECT COMPETITION TO MONOPOLY

 Perfect Competition
 Monopolistic Competition
 Oligopoly
 Monopoly
Picking Quantity to Maximize Profit: The Perfectly Competitive Case
Drawing Tips
1) There will be two diagrams side
by side.
2) Draw an MC-ATC-AVC set of
cost curves.
Page 1 Teaching Tips

1) Alert
© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor students
use. Not toforthe
authorized saleside-by-
or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or side
postednature
on a website,
of thein whole
graphs.or part.
2) Alert students to draw this

graph big.
Drawing Tips
1) Draw in a marginal revenue
curve.
2) Label the quantity where
MC=MR as Q*.
3) Label the price as P*.
Drawing Tips
1) Draw in the second graph.
2) Draw the same MC-ATC-AVC
set of cost curves.
Picking Quantity to Maximize Profit: The Monopoly Case
Page 2
© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Drawing Tips
1) Draw in the downward-sloping
demand curve.
2) Draw the MR curve (making
sure to cut the horizontal
intercept of the demand curve
in half).
Teaching Tip
Remind students of 2) above.
Drawing Tips
1) Mark the quantity where
MC=MR as Q*.
2) Go up to the demand curve to
get P*.
Teaching Tips
1) Be sure to emphasize that the
quantity is where MC=MR,
NOT THE PRICE.
2) Emphasize that price is read off
of the demand curve.
Characteristics of Perfect Competition

 There are a large number of competitors, such that no one firm can influence the
price.
 The good a firm sells is indistinguishable from the ones its competitors sell.
 Firms have good sales and cost forecasts.
 There is no legal or economic barrier to its entry into or exit from the market.
Teaching Tip
Let students discuss the kinds of firms that match these assumptions. Go through several industries
trying to see if the assumptions for perfect competition are satisfied in that industry.
Monopoly
 There is one seller of a good or service.
 Some monopolies are generated because of legal rights (patents and copyrights).
 Some monopolies are utilities (gas, water, electricity etc.) that result from high
fixed costs.
Page 3
Teaching Tip
trying to see if the assumptions for monopoly are satisfied in that industry.
Page 4
Monopolistic Competition
 Monopolistic Competition: a situation in a market where there are many firms
producing similar but not identical goods.
 Example: the fast-food industry
o McDonald’s as a monopoly on the “Happy Meal” but has much competition
in the market to feed kids burgers and fries.
Teaching Tip
trying to see if the assumptions for monopolistic competition are satisfied in that industry.
Oligopoly
 Oligopoly: a situation in a market where there are very few discernible
competitors
 Examples:
o Satellite TV service (Direct TV, Dish Network)
o Airlines (American, Delta etc.)
Teaching Tips
1) Let students discuss the kinds of firms that match these assumptions. Go through several
industries trying to see if the assumptions for oligopoly are satisfied in that industry.
2) Be clear that the airline industry is tough because you have to know who is flying to and from
particular places. Note also that there are nonstop vs. 1-stop options. Call up a travel site to
show.
3) Note that an industry with many companies can be considered oligopolistic if just a few
dominate.
Which Model Fits Reality?

 Perfect competition is rare outside agriculture though it fits some labor markets.
 Monopolies are common in utilities.
 Major branded companies are typically either in oligopolistic or monopolistically
competitive industries.
Teaching Tips
1) Go back to the idea of the simplifying assumption from Chapter 1 and let students discuss
whether using perfect competition for models is a good use of that concept for an issue like
Rent Control or Minimum Wage.
2) Begin to get students comfortable with the ease-of-understanding vs. realism tradeoff that
exists.
Page 5
Table 5.1
Examples of different market forms.
Perfect Competition Monopolistic Oligopoly Monopoly
Competition
1) Agriculture 1) Fast Food 1) Smartphones 1) Windows
2) Lumber 2) Clothing 2) Soft Drinks Operating System
2) Local Residential
Electric Power
Table 5.2
Distinguishing characteristics between market forms.
Perfect Monopolistic Oligopoly Monopoly
Competition Competition
Number of Firms Many-often Several* Few*- usually One
thousands or two to five
even millions
Barriers to Entry None Few Substantial Insurmountable,
at least in the
short run
Product Identical Similar but not Similar or NA
similarity identical Identical
* The line between “several” and “few” is not definite.
Concentration Ratios
 There is no magic line that separates oligopoly from monopolistic competition.
 a “concentration ratio” measures the percentage of total market sales for the top
firms (from 4 firms to 100 firms).
Teaching Tips
1) Ask what the four-firm concentration ratio is under monopoly. (100)
2) Ask what the four-firm concentration ratio is under oligopoly. Where there are only two firms
(satellite TV). (100) Note that the concentration ratio can’t distinguish these.
Herfindahl-Hirschman Index
 Sum of Squared Market Share
o 0 Perfect Competition
o 10,000 Monopoly
o (10,000/N) N equally sized firms
Teaching Tips
1) Ask what the HHI is under monopoly. (1002=10,000)
2) Ask what the HHI is under oligopoly where there are only two firms with a 60-40 split (such as
satellite TV). (602+402=3600+1600=5200) Note that the concentration ratio can’t distinguish
these, but the HHI does.
3)
Page 6
Table 5.3
Concentration ratios and Herfindahl-Hirschman
indices for various industries, 2012.
Industry Group Concentration Ratios
4 Largest 8 Largest 50 Largest Herfindahl-
Firms Firms Firms Hirschman
Index
Breakfast Cereals 79.2% 93.7% 100.0% 2332.5
Ice Cream 45.9 64.6 94.0 665.8
Beer 87.8 90.8 95.9 3560.7
Clothing 10.3 15.0 38.3 54.0
Computers and 31.5 46.0 80.6 421.9
Peripherals
Furniture 23.7 30.9 52.8 233.7
Cellular Service 89.1 95.2 98.8 *
*This industry is so concentrated that the Census Bureau cannot report exactly how
concentrated it is because doing so would provide competing firms with sales information
of their individual competitors.
**Abridged; complete table found on page 72.
SUPPLY UNDER PERFECT COMPETITION

Normal vs. Economic Profit
 Normal Profit: the level of profit that business owners could get in their next best
alternative investment
 Economic Profit: any profit above normal profit
Teaching Tip
Try to get students to see that for a small business owner “normal profit” would be how much they
would earn working for someone else plus the interest they would get on the money they invested in
their business.
When and Why Economics Profit Go to Zero
Time Horizons
 Short Run: the period of time where we cannot change things like plant and
equipment
 Long Run: the period of time where we can change things like plant and
equipment
Page 7
Entry and Exit Example: Crude Oil
 In 2014 the price of oil hovered above $100/barrel.
 High profit potential motivated innovation.
o Hydraulic fracturing (fracking)
o Horizontal (directional) drilling
 U.S. oil production doubled (between 2008 and 2015).
 In late 2014 into 2015, prices plummeted because of over-supply.
 The over-reaction caused prices to dip below $30.
 Drillers went bankrupt (exited).
 Prices stabilized around $50.
Teaching Tips
1) The oil story of 2014-2016 is illustrative of the impact of the entry and exit of firms. This is an
easier story to tell than the one of farmers exiting and entering because in agriculture you
have to make a seasonal decision to plant.
2) In oil (in the era of fracking), the firm may have a map of likely locations of pools to exploit.
At high prices, they are motivated drill for that oil. At low prices, they may pump from an
existing well, but are not likely to drill new ones when a pool is exhausted.
Market Forms and Economic Profits

 Under perfect competition or monopolistic competition economic profits go to
zero because of the entry of new firms increases market supply and lowers prices.
 Economic Profits are under no pressure to shrink under oligopoly or monopoly
because entry doesn’t occur so prices do not fall.
Teaching Tips
1) If you have agriculture students or “farmer’s kids” in your class let those students discuss
what would happen if a certain crop began to be highly profitable. Get them to see that entry
would drive price lower and economic profits to zero.
2) Recount the experience of very high grain prices in the mid-2000s.
The Pressures on Price in Perfect Competition
Drawing Tip
Draw an ATC-AVC-MC diagram.
Page 8
Drawing Tips
1) Put an MR line lower than the
minimum of AVC.
2) Note that there would be
upward pressure on price in
both the short run (the short
arrow) and the long run (the
longer arrow).
Drawing Tips
1) Put an MR line lower than the
minimum of ATC but above the
minimum of AVC.
2) Note that there would not be
upward pressure on price in the
short run (no short arrow).
upward pressure on price in the
long run (the long arrow).
Teaching Tip
Remind students that there is not short
run pressure, i.e. that firms would stay
in business at this price, because they
are losing less than their fixed costs.
Drawing Tip
Put an MR line right at the minimum of
ATC.
Teaching Tip
Note that there would not be upward
pressure on price in either the short run
or long run.
Page 9
Drawing Tips
1) Put an MR line above the
minimum of ATC.
downward pressure on price in
both the short run (the short
arrow) and the long run (the
longer arrow).
Points of Production in Perfect Competition
Drawing Tip
Draw a ATC-AVC-MC diagram.
Drawing Tips
1) Draw an MR line lower than
the minimum of AVC.
2) Mark the point on the vertical
axis on that MR line.
Teaching Tip
Note that the reason for the point in 2)
above is that the firm shuts down.
Page 10
Drawing Tips
1) Draw an MR line between the
minimum of ATC and AVC.
2) Place a point where MC = MR.
Drawing Tips
1) Draw an MR line at the
minimum of ATC.
Drawing Tips
1) Draw an MR line above the
minimum of ATC.
Teaching Tip
Emphasize that above the minimum of AVC you are simply placing points on MC.
Page 11
Supply in Perfect Competition
Drawing Tips
1) Draw an ATC-AVC-MC
diagram.
2) Darken the portion of the MC
curve above the minimum of
AVC and label that supply.
Page 12
End of Chapter Questions
Quiz Yourself
1. An industry in which there are many competitors with specific marketing niches is
likely to be characterized by
a) monopoly.
b) oligopoly.
c) monopolistic competition.
d) perfect competition.
Explanation: When a firm faces a large number of competitors, such that no one firm can
influence the price, when the good a firm sells is indistinguishable from those its
competitor sells, when firms have good sales and cost forecasts, and when there is no
legal or economic barrier to its entry into or exit from the market, then we have what
economists call perfect competition. Monopolistic competition refers to a situation in
which there are many firms producing similar but not identical goods.
2. An industry in which there are a very limited number of large firms is likely to be
characterized by
a) monopoly.
b) oligopoly.
c) monopolistic competition.
d) perfect competition.
Explanation: An oligopolistic market is a situation in a market where there are very few
discernible competitors.
3. Owing to its usefulness and relative simplicity, the supply and demand model is often
used
a) because nearly every major industry in the United States is governed by perfect
competition.
b) because nearly every major industry in the United States is governed by
monopoly.
c) even though, strictly speaking, few industries in the United States are
governed by perfect competition.
d) even though it has no connection to economic reality.
Explanation: Most of the products that meet the criteria of perfect competition are
agricultural; few products outside this area can make that claim. We often assume that
most markets are perfectly competitive and use a supply and demand model to analyze
them. The supply and demand model is simple enough so that it can be used to explain
and describe most markets where there are several competitors and the products are
similar.
Page 13
4. Whether a firm stays in business or shuts down depends heavily on the concept of
a) economic profit.
b) actual profit.
c) market share.
d) concentration ratios.
Explanation: Normal profit is the level of profit that business owners could get in their
next best alternative investment. The next best alternative would be whatever investment
an owner would choose if he or she decided to go out of business. Any profit above
normal profit is called economic profit. If business owners do not make their normal
profit, they will quit the business and move into another. This means that we might think
of normal profit as the salary the business owners pay themselves and, as such, part of the
“cost of doing business.” If they make less than normal profit, then the salary they can
pay themselves is too low to keep them in the industry. On the other hand, if profits are
routinely more than that, others will want to enter the industry. This means that in the
long run profit will shrink to normal levels.
5. Economic theory would suggest that the profitability of an industry would be

a) directly related to the number of firms competing in the industry.
b) inversely related to the number of firms competing in the industry.
c) unrelated to the number of firms competing in the industry.
d) zero in the long run, regardless of market structure.
Explanation: When a firm faces a large number of competitors, such that no one firm can
influence the price (the case of perfect competition), the entry and exit will drive profits
to a normal level. When a firm faces few competitors, such that the firm can influence the
price (the case of monopoly), profits can be above the normal level.
6. Under perfect competition, the supply curve is

a) the marginal cost curve for all price quantity combinations.
b) the marginal cost curve, but only that portion that is downward sloping.
c) the marginal cost curve, but only that portion that is upward sloping.
d) the marginal cost curve, but only that portion that is above the minimum of
average variable cost.
Explanation: Under perfect competition, an upward-sloping supply curve stems from the
check-shaped marginal cost curve. The firm’s supply curve is its marginal cost curve
above the minimum of its average variable cost.
Page 14
7. An indicator of the degree of competition in an industry is the concentration ratio. It
measures
a) the percentage of sales in the industry by the largest firms.
b) the percentage of profit in the industry by the smallest firms.
c) the sales in the industry as a percentage of all consumption in the United States.
d) the profitability of the industry.
Explanation: The concentration ratio is a measure of the market power held by the top
firms in an industry. For a specific number of firms (n), it is the percentage of total sales
in the industry accounted for by top n firms.
8. Local telephone service was once an area in which consumers had no choices. Many
young people no longer use “landlines,” preferring instead to use their cellular phones.
This means that the market has moved toward
a) monopoly.
b) oligopoly.
c) perfect competition.
d) monopsony.
Explanation: Local telephone service used to be a monopoly. It became an oligopoly as
fewer consumers used this option for phone service.
9. In a diagram of perfect competition, the marginal revenue line moves up and down
when there is exit and entry, respectively, because
a) the market demand for the good rises and falls when there is exit and entry,
respectively.
b) the market demand for the good rises and falls when there is entry and exit,
respectively.
c) the market supply for the good rises and falls when there is exit and entry,
respectively.
d) the market supply for the good rises and falls when there is entry and exit,
respectively.
Explanation: The marginal revenue is the same as the price in a perfectly competitive
market. The effect of free entry and exit in a competitive market will cause the marginal
revenue curve to move down if there is entry and up if there is exit.
10. If MR > MC, then when an additional unit is sold, the firm’s
a) profit will be positive.
b) profit will increase.
c) profit will be negative.
d) profit will decrease.
Explanation: If the additional revenue (MR) exceeds the additional cost (MC), producing
another unit will add more to revenue than to cost, and if produced, will increase profit.
Page 15
Short Answer Questions
1. Imagine an owner of a firm is thinking about raising prices. Describe the consequences
of doing so as a monopolist, oligopolist, monopolistic competitor, and perfect competitor.
2. What are the key differences between monopolistic competition and perfect
competition?
3. Describe why there is pressure on the price to fall when P > ATC. Is there a long- and
short-run distinction in the answer?
4. Describe why there is pressure on the price to fall when P < ATC. Is there a long- and
short-run distinction in the answer?  
Think about This

One of the concerns about Walmart’s entry into the grocery business in the latter part of
the 1990s was that it would set low prices, drive little stores out of business and then raise
prices to monopoly levels when it had no competition. That hasn’t happened but that
doesn’t mean it couldn’t happen. Under what conditions, and in what industries, might
such a strategy work?
Talk about This

List the monopolies that used to exist when you were growing up that are now facing
increased competition. Compare that list to a list provided by your instructor (who is
presumably older than you). What current monopolies are likely to be threatened with
entry in the future?
Page 16

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Chapter 5

Perfect Competition, Monopoly, and Economic versus

After reading this chapter you should be able to

FROM PERFECT COMPETITION TO MONOPOLY

Picking Quantity to Maximize Profit: The Perfectly Competitive Case

Page 1 Teaching Tips

2) Alert students to draw this

Picking Quantity to Maximize Profit: The Monopoly Case

Characteristics of Perfect Competition

Which Model Fits Reality?

SUPPLY UNDER PERFECT COMPETITION

When and Why Economics Profit Go to Zero

Market Forms and Economic Profits

The Pressures on Price in Perfect Competition

Points of Production in Perfect Competition

5. Economic theory would suggest that the profitability of an industry would be

6. Under perfect competition, the supply curve is

Think about This

Talk about This

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