Microeconomics Mankiw Second Quarter

N.
GREGORY
MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER
The Costs
13 of Production
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1
management system for classroom use.
Active Learning 1 Brainstorming costs
You run Ford Motor Company.
• List three different costs you have.
• List three different
business decisions
that are affected
by your costs
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Look for the answers to these questions:
• What is a production function? What is
marginal product? How are they related?
• What are the various costs? How are they
related to each other and to output?
• How are costs different in the short run vs.
the long run?
• What are “economies of scale”?
Total Revenue, Total Cost, Profit
• We assume that the firm’s goal is to
maximize profit.
Profit = Total revenue – Total cost
the amount a firm the market value of

receives from the the inputs a firm
sale of its output uses in production
TR = P×Q
Costs: Explicit vs. Implicit
• ‘The cost of something is what you give
up to get it.’
• Explicit costs
– Require an outlay of money
• E.g., paying wages to workers.
• Implicit costs
– Do not require a cash outlay
• E.g., the opportunity cost of the owner’s time.
• Total cost = Explicit + Implicit costs
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The
interest rate is 5%.
• Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = $3000 (5%) interest on the loan
– implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000
Economic Profit vs. Accounting Profit
• Accounting profit
=total revenue minus total explicit costs
• Economic profit
=total revenue minus total costs (including
explicit and implicit costs)
• Accounting profit ignores implicit costs,
so it’s higher than economic profit.
Active Learning 2
Economic profit vs. accounting profit
The equilibrium rent on office space has just
increased by $500/month.
Determine the effects on accounting profit and
economic profit if:
a. you rent your office space
b. you own your office space
Active Learning 2 Answers
The rent on office space increases $500/month.

a.You rent your office space.
• Explicit costs increase $500/month. Accounting
profit & economic profit each fall $500/month.
b.You own your office space.
• Explicit costs do not change, so accounting
profit does not change.
• Implicit costs increase $500/month (opp. cost
of using your space instead of renting it) so
economic profit falls by $500/month.
Production Function
• Production function
– Relationship between
• Quantity of inputs used to make a good
• And the quantity of output of that good
– Gets flatter as production rises
EXAMPLE 1: Farmer Jack
Example 1:
• Farmer Jack grows wheat.
• He has 5 acres of land (fixed resource).
• He can hire as many workers as he wants.
– The quantity of output produced varies with the
number of workers hired
EXAMPLE 1: Farmer Jack’s Production Function
L Q 3,000
(no. of (bushels
workers) of wheat) 2,500
Quantity of output
0 0 2,000
1 1000 1,500
2 1800 1,000
3 2400 500
4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
12
12
Marginal Product
• Marginal product
– Increase in output that arises from an
additional unit of input
• Other inputs constant
– Slope of the production function
• Marginal product of labor, MPL
– MPL = ∆Q/∆L
– If Jack hires one more worker, his output
rises by the marginal product of labor.
EXAMPLE 1: Total & Marginal Product
L Q
(no. of (bushels
MPL
workers) of wheat)
0 0
∆L = 1 ∆Q = 1000 1000
1 1000
∆L = 1 ∆Q = 800 800
2 1800
∆L = 1 ∆Q = 600 600
3 2400
∆L = 1 ∆Q = 400 400
4 2800
∆L = 1 ∆Q = 200 200
5 3000
Diminishing MPL
• Diminishing marginal product
– Marginal product of an input declines as
the quantity of the input increases
– Production function gets flatter as more
inputs are being used:
• The slope of the production function
decreases
EXAMPLE 1: MPL = Slope of Prod Function
L Q MPL
3,000 equals the
(no. of (bushels MPL
slope of the
workers) of wheat) 2,500
Quantity of output
production function.
0 0 2,000
Notice that
1000
1 1000 MPL diminishes
1,500
800 as L increases.
2 1800 1,000
600 This explains why
3 2400 the
500 production
400 function gets flatter
4 2800 0
200 as L0 increases.
1 2 3 4 5
5 3000
No. of workers
16
16
Why MPL Is Important
• ‘Rational people think at the margin’
• When Farmer Jack hires an extra worker
– His costs rise by the wage he pays the
worker
– His output rises by MPL
– Comparing them helps Jack decide
whether he should hire the worker.
Why MPL Diminishes
• Farmer Jack’s output rises by a smaller
and smaller amount for each additional
worker. Why?
– As Jack adds workers, the average worker
has less land to work with and will be less
productive.
– In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
EXAMPLE 1: Farmer Jack’s Costs
Farmer Jack must pay $1000 per month for

the land, regardless of how much wheat he
grows.
The market wage for a farm worker is $2000
per month.
• So Farmer Jack’s costs are related to how
much wheat he produces….
EXAMPLE 1: Farmer Jack’s Costs
L Q
Cost of Cost of Total
(no. of (bushels
land labor cost
workers) of wheat)
0 0 $1,000 $0 $1,000
1 1000 $1,000 $2,000 $3,000
2 1800 $1,000 $4,000 $5,000
3 2400 $1,000 $6,000 $7,000

4 2800 $1,000 $8,000 $9,000
5 3000 $1,000 $10,000 $11,000
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q $12,000
Total
(bushels
Cost $10,000
of wheat)
$8,000
Total cost
0 $1,000
$6,000
1000 $3,000
$4,000
1800 $5,000
$2,000
2400 $7,000
$0
2800 $9,000
0 1000 2000 3000
3000 $11,000 Quantity of wheat
21
21
Marginal Cost
• Marginal cost, MC
– Increase in total cost arising from an extra
unit of production
– Marginal cost = Change in total cost /
Change in quantity
– MC = ΔTC / ΔQ
– Increase in total cost
• From producing an additional unit of output
EXAMPLE 1: Total and Marginal Cost
Q
Total Marginal
(bushels
Cost Cost (MC)
of wheat)
0 $1,000
∆Q = 1000 ∆TC = $2000 $2.00
1000 $3,000
∆Q = 800 ∆TC = $2000 $2.50
1800 $5,000
∆Q = 600 ∆TC = $2000 $3.33
2400 $7,000
∆Q = 400 ∆TC = $2000 $5.00
2800 $9,000
∆Q = 200 ∆TC = $2000 $10.00
3000 $11,000
EXAMPLE 1: The Marginal Cost Curve
$12
Q
(bushels TC MC $10 MC usually rises
of wheat) as Q rises,
Marginal Cost ($)

$8 as in this example.
0 $1,000
$2.00 $6
1000 $3,000
$2.50 $4
1800 $5,000
$3.33 $2
2400 $7,000
$5.00
$0
2800 $9,000
$10.00 0 1,000 2,000 3,000
3000 $11,000 Q
Why MC Is Important
• Farmer Jack is rational and wants to
maximize his profit
– To increase profit, should he produce
more or less wheat?
• Farmer Jack needs to “think at the margin”
– If the cost of additional wheat (MC) is less
than the revenue he would get from selling
it, then Jack’s profits rise if he produces
more.
Fixed and Variable Costs
• Fixed costs, FC, do not vary with the quantity
of output produced
– For Farmer Jack, FC = $1000 for his land
– Other examples: cost of equipment, loan
payments, rent
• Variable costs, VC, vary with the quantity of
output produced
• For Farmer Jack, VC = wages he pays workers
• Other example: cost of materials
• Total cost = Fixed cost + Variable cost
EXAMPLE 2: Production Costs
• Our second example is more general,
applies to any type of firm producing any
good with any types of inputs.
– Calculate and graph TC knowing FC and VC
– Calculate and graph marginal and average
costs
– Understand the relationship between marginal
cost and average cost
EXAMPLE 2: Costs: TC = FC + VC
$800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $100 $600
1 100 70 170 $500
Costs
2 100 120 220 $400
3 100 160 260
$300
4 100 210 310
$200
5 100 280 380
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
EXAMPLE 2: Marginal Cost
Recall,
$200 Marginal Cost (MC)
Q TC MC is the change in total cost from
$175
producing one more unit:
0 $100 $150
∆TC
$70 MC =
1 170 $125 ∆Q
Costs
50 $100
2 220
40 $75
3 260 Usually, MC rises as Q rises, due to
50 diminishing
$50 marginal product.
4 310
70 Sometimes
$25 (as here), MC falls
5 380 before
100 $0 rising.
6 480 (In other
0 examples,
1 2 3 MC 4 may
5 be
6 7
140 constant.) Q
7 620
EXAMPLE 2: Average Fixed Cost, AFC
Q FC AFC Average
$200 fixed cost (AFC)
is$175
fixed cost divided by the
0 $100 n/a
quantity
$150 of output:
1 100 $100 $125
AFC = FC/Q
Costs
2 100 50 $100
3 100 33.33 $75
4 100 25
Notice
$50 that AFC falls as Q
rises:
$25 The firm is spreading its
5 100 20
fixed
$0 costs over a larger and
6 100 16.67 larger number
0 1 2 of3 units.
4 5 6 7
7 100 14.29 Q
EXAMPLE 2: Average Variable Cost, AVC
$200
Q VC AVC Average variable cost
$175
(AVC)
0 $0 n/a
is variable cost divided by
$150
1 70 $70 the quantity of output:
$125
Costs
2 120 60 $100AVC = VC/Q
3 160 53.33 $75
As Q rises, AVC may fall
4 210 52.50 $50
initially. In most cases,
5 280 56.00 AVC will eventually rise as
$25
output
$0 rises.
6 380 63.33 0 1 2 3 4 5 6 7
7 520 74.29 Q
EXAMPLE 2: Average Total Cost
Q TC ATC AFC AVC

Average total cost
(ATC) equals total cost
0 $100 n/a n/a n/a divided by the quantity
1 170 $170 $100 $70 of output:
2 220 110 50 60
ATC = TC/Q
3 260 86.67 33.33 53.33

Also,
4 310 77.50 25 52.50
ATC = AFC + AVC
5 380 76 20 56.00
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29
EXAMPLE 2: Average Total Cost, usually U-shaped
Usually,
$200 as in this example, the ATC
Q TC ATC curve
$175is U-shaped.
0 $100 n/a $150
1 170 $170 $125
Costs
2 220 110 $100
3 260 86.67 $75

As Q rises: initially, Eventually,
4 310 77.50 $50 falling AFC pulls rising AVC
Efficient
$25 scale: ATC down. pulls ATC up.
5 380 76
The quantity that minimizes ATC.
$0
6 480 80
0 1 2 3 4 5 6 7
7 620 88.57 Efficient scale
Q
EXAMPLE 2: The Various Cost Curves Together
$200
$175
$150
ATC
$125
Costs
AVC
$100
AFC
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
EXAMPLE 2: ATC and MC
When MC < ATC, $200 ATC

ATC is falling. MC
$175
$150
When MC > ATC,
$125
ATC is rising.
Costs
$100
The MC curve $75
crosses the ATC $50

curve $25
at the ATC curve’s $0
minimum. 0 1 2 3 4 5 6 7
Q
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use 35
Active Learning 3 Calculating costs
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 $50 n/a n/a n/a
$10
1 10 $10 $60.00
2 30 80
30
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30
60
6 210 260 8.33 35 43.33
Use
First,relationship
AFC
ATC
AVC
deduce= TC/Q
FC/Q
VC/Q
FC between MC
= $50 and and
use FCTC
+ VC = TC.
Q VC TC AFC AVC ATC MC

0 $0 $50 n/a n/a n/a
$10
1 10 60 $50.00 $10 $60.00
20
2 30 80 25.00 15 40.00
30
3 60 110 16.67 20 36.67
40
4 100 150 12.50 25 37.50
50
5 150 200 10.00 30 40.00
60
6 210 260 8.33 35 43.33
Costs in the Short Run & Long Run
• Short run:
– Some inputs are fixed (e.g., factories, land)
– The costs of these inputs are FC
• Long run:
– All inputs are variable (e.g., firms can build more
factories or sell existing ones)
• In the long run
• ATC at any Q is cost per unit using the most
efficient mix of inputs for that Q (e.g., the
factory size with the lowest ATC)
EXAMPLE 3: LRATC with 3 factory sizes
Firm can choose

Avg
from three factory
Total
sizes: S, M, L. Cost ATCS ATCM
ATCL
Each size has its
own SRATC curve.
The firm can change

to a different factory
size in the long run, Q
but not in the short
run.
EXAMPLE 3: LRATC with 3 factory sizes
To produce less than
QA, firm will choose Avg
size S in the long Total
run. Cost ATCS ATCM
ATCL
To produce between
QA and QB, firm will LRATC
choose size M in the
long run.
To produce more Q
QA QB
than QB, firm will
choose size L in the
long run.
A Typical LRATC Curve
In the real world,

factories come in ATC
many sizes, each
with its own LRATC
SRATC curve.
So a typical
LRATC curve
looks like this:
Q
How ATC Changes as
the Scale of Production Changes
Economies of scale:
ATC
ATC falls as Q
increases.
LRATC
Constant returns to
scale: ATC stays the
same as Q
increases.
Diseconomies of Q
scale: ATC rises as
Q increases.
Costs in Short and Long Run
• Economies of scale
– Long-run average total cost falls as the
quantity of output increases
• Increasing specialization among workers
• More common when Q is low
• Constant returns to scale
– Long-run average total cost stays the
same as the quantity of output changes
Costs in Short and Long Run
• Diseconomies of scale
– Long-run average total cost rises as the
quantity of output increases
– Increasing coordination problems in large
organizations.
• E.g., management becomes stretched, can’t
control costs.
• More common when Q is high.
Summary
• The goal of firms is to maximize profit, which
equals total revenue minus total cost.
• When analyzing a firm’s behavior, it is important
to include all the opportunity costs of production.
– Explicit: wages a firm pays its workers
– Implicit: wages the firm owner gives up by
working at the firm rather than taking another job
• Economic profit takes both explicit and implicit
costs into account, whereas accounting profit
considers only explicit costs.
Summary
• A firm’s costs reflect its production process.
– Diminishing marginal product: production
function gets flatter as Q of an input increases
– Total-cost curve gets steeper as the quantity
produced rises.
• Firm’s total costs = fixed costs + variable costs.
– Fixed costs: do not change when the firm alters
the quantity of output produced.
– Variable costs: change when the firm alters the
quantity of output produced.
Summary
• Average total cost is total cost divided by the
quantity of output.
• Marginal cost is the amount by which total cost
rises if output increases by 1 unit.
• Graph average total cost and marginal cost.
– Marginal cost rises with the quantity of output.
– Average total cost first falls as output increases
and then rises as output increases further.
– The marginal-cost curve always crosses the
average total-cost curve at the minimum of
average total cost
Summary
• A firm’s costs often depend on the time horizon
considered.
– In particular, many costs are fixed in the short
run but variable in the long run.
– As a result, when the firm changes its level of
production, average total cost may rise more in
the short run than in the long run.
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER
Firms in
14 Competitive Markets
• What is a perfectly competitive market?
• What is marginal revenue? How is it related to
total and average revenue?
• How does a competitive firm determine the
quantity that maximizes profits?
• When might a competitive firm shut down in the
short run? Exit the market in the long run?
• What does the market supply curve look like in
the short run? In the long run?
Introduction: A Scenario
Three years after graduating, you run your
own business. You must decide how much
to produce, what price to charge, how many
workers to hire, etc.
• What factors should affect these
decisions?
– Your costs (studied in preceding chapter)
– How much competition you face
We begin by studying the behavior of firms
in perfectly competitive markets.
What is a Competitive Market?
Perfectly competitive market:

1. Market with many buyers and sellers
2. Trading identical products
– Because of the first two: each buyer and
seller is a price taker (takes the price as
given)
3. Firms can freely enter or exit the market
Revenue of a Competitive Firm
• Total revenue, TR = P ˣ Q
• Average revenue, AR = TR / Q
• Marginal revenue, MR = ∆TR / ∆Q
– Change in TR from an additional unit sold
• For competitive firms
– AR = P
– MR = P
Active Learning 1 Calculating TR, AR,
MR
Fill in the empty spaces of the table.
Q P TR AR MR
0 $10 n/a
1 $10 $10
2 $10
3 $10
4 $10 $40
$10
5 $10 $50
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n/a
$10
1 $10 $10 $10
Notice that $10
2 $10 $20 $10
MR = P $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
MR = P for a Competitive Firm
• A competitive firm
– Can keep increasing its output without
affecting the market price.
– So, each one-unit increase in Q causes
revenue to rise by P, i.e., MR = P.
MR = P is only true for firms in
competitive markets
Profit Maximization
• What Q maximizes a firm’s profit?
– Think at the margin
– If Q increases by one unit
• Revenue rises by MR, cost rises by MC
• Compare marginal revenue with marginal
cost
– If MR > MC: increase Q to raise profit
– If MR < MC: decrease Q to raise profit
– Maximize profit for Q where MR = MC
Profit Maximization
(continued from earlier exercise)
•At any Q with
MR > MC, ∆Profit =
Q TR TC Profit MR MC
increasing Q MR – MC
raises profit. 0 $0 $5 –$5
$10 $4 $6
1 10 9 1
10 6 4
2 20 15 5
•At any Q with 10 8 2
3 30 23 7
MR < MC, 10 10 0
reducing Q 4 40 33 7
10 12 –2
raises profit. 5 50 45 5
•
MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR.

Costs
So, increase Q
to raise profit. MC
At Qb, MC > MR.

So, reduce Q
to raise profit. P1 MR
At Q1, MC = MR.
Changing Q
Q
would lower profit. Qa Q1 Qb
MC and the Firm’s Supply Decision
If price rises to P2, the MC curve is the
firm’s supply curve.
then the profit-
maximizing quantity Costs
rises to Q2. MC
The MC curve P2 MR2

determines the
firm’s Q at any P1 MR
price.
Hence, the MC
curve is the firm’s Q
supply curve Q1 Q2
Shutdown vs. Exit
• Shutdown:
– A short-run decision not to produce
anything because of market conditions.
• Exit:
– A long-run decision to leave the market.
• A key difference:
– If shut down in SR, must still pay FC.
– If exit in LR, zero costs.
Short-run Decision to Shut Down
• Should a firm shut-down in the short run?
– Cost of shutting down = revenue loss
= TR
– Benefit of shutting down = cost savings
= VC
(because the firm must still pay FC)
• Shut down if TR < VC, or P < AVC
A Competitive Firm’s SR Supply Curve
The firm’s short run The firm’s short run
supply curve is the
portion of its MC
Costs curve above AVC.
If P > AVC, then MC
firm produces Q
where P = MC. ATC
AVC
If P < AVC, then

firm shuts down
Q
(produces Q = 0).
The Irrelevance of Sunk Costs
• Sunk cost
– A cost that has already been committed
and cannot be recovered
– Should be ignored when making decisions
– You must pay them regardless of your
choice
– In the short run, FC are sunk costs
• So, FC should not matter in the decision to
shut down
A Firm’s Long-Run Decision
• Should a firm exit or enter in the long run?
– Cost of exiting market = revenue loss = TR
– Benefit of exiting market = cost savings = TC
(remember, FC = 0 in long run)
• Firm’s long-run decision
– Exit the market if: TR < TC
(same as: P < ATC)
– Enter the market if: TR > TC
(same as: P > ATC)
The Competitive Firm’s LR Supply Curve
The firm’s LR supply curve
is the portion of its MC
Costs curve above LRATC.
MC
LRATC
Active Learning 2 Identifying a firm’s profit
Determine A competitive firm

this firm’s
Costs, P
total profit.
MC
Identify the area P = $10 MR

on the graph ATC
that represents $6
the firm’s profit.
Q
50
A competitive firm
Costs, P
Profit per unit MC
P = $10 MR
= P – ATC ATC
= $10 – 6 profit
= $4 $6
Total profit
= (P – ATC) x Q
= $4 x 50 Q
50
= $200
Active Learning 3 Identifying a firm’s loss
Determine this
firm’s total loss, A competitive firm
assuming Costs, P
AVC < $3. MC
Identify the area ATC

on the graph that
represents $5
the firm’s loss. P = $3 MR
Q
30
A competitive firm
Costs, P
Total loss MC
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR
Q
30
Market Supply: Assumptions
1. All existing firms and potential entrants
have identical costs.
2. Each firm’s costs do not change as other
firms enter or exit the market.
3. The number of firms in the market is
– fixed in the short run (due to fixed costs)
– variable in the long run (due to free entry
and exit)
The SR Market Supply Curve
• As long as P ≥ AVC
– Each firm will produce its profit-
maximizing quantity, where MR = MC.
• Recall from Chapter 4:
– At each price, the market quantity
supplied is the sum of quantities supplied
by all firms
The SR Market Supply Curve
•Example: 1000 identical firms
•At each P, market Qs = 1000 x (one firm’s Qs)
One firm Market

P MC P S
P3 P3
P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)
10,000 20,000 30,000

Entry & Exit in the Long Run
• In the long run, the number of firms can
change due to entry and exit:
– If existing firms earn positive economic
profit:
• New firms enter, SR market supply shifts right
• P falls, reducing profits and slowing entry

– If existing firms incur losses:
• Some firms exit, SR market supply shifts left
• P rises, reducing remaining firms’ losses
The Zero-Profit Condition
• Long-run equilibrium:
– The process of entry or exit is complete
– Remaining firms earn zero economic profit
• Zero economic profit: when P = ATC

– Since firms produce where P = MR = MC
– The zero-profit condition is P = MC = ATC
– Recall that MC intersects ATC at min ATC
– Hence, in the long run, P = min ATC
The Zero-Profit Condition
• Why do competitive firms stay in business
if they make zero profit?
– Profit = total revenue – total cost
– Total cost includes all implicit costs like the
opportunity cost of the owner’s time and money
– Zero-profit equilibrium
• Economic profit is zero
• Accounting profit is positive
The LR Market Supply Curve
In the long run, The LR market supply
the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.
One firm Market

P MC P
LRATC
P=
long-run
min. supply
ATC
Q Q
(firm) (market)
SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…
P One firm P Market

MC S1
S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
Long-Run Supply Curve
• Long-run supply curve is horizontal if:
– All firms have identical costs, and
– And costs do not change as other firms
enter or exit the market
• Long-run supply curve might slope
upward if:
– Firms have different costs
– Or costs rise as firms enter the market
• Firms have different costs
– As P rises, firms with lower costs enter the
market before those with higher costs.
– Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
– Hence, LR market supply curve slopes
upward
• Costs rise as firms enter the market
– In some industries, the supply of a key input
is limited (e.g., amount of land suitable for
farming is fixed).
– The entry of new firms increases demand for
this input, causing its price to rise.
– This increases all firms’ costs.
– Hence, an increase in P is required to
increase the market quantity supplied, so the
supply curve is upward-sloping.
Efficiency of a Competitive Market
• Profit-maximization: Q where MC = MR
– Perfect competition: P = MR
– So, in the competitive equilibrium: P = MC
• The competitive equilibrium is efficient
– Maximizes total surplus because P = MC
• MC is the cost of producing the marginal unit
• P is value to buyers of the marginal unit
Summary
• A competitive firm is a price taker
– Its revenue is proportional to the amount of
output it produces.
– P = MR = AR
– The firm’s marginal-cost curve is its supply
curve
• Short run: a firm cannot recover its FC
– Shut down temporarily if P < AVC
• Long run: the firm can recover both FC and VC
– Exit if P < ATC
Summary
• In a market with free entry and exit, profit is
driven to zero in the long run.
– All firms produce at efficient scale, P = min ATC
– The number of firms adjusts to satisfy the
quantity demanded at this price.
• Changes in demand have different effects over
different time horizons.
– Short run, an increase in demand raises prices
and leads to profits (a decrease in demand
lowers prices and leads to losses).
– Long run: zero-profit equilibrium
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER
Monopoly
15
• Why do monopolies arise?
• Why is MR < P for a monopolist?
• How do monopolies choose their P and Q?
• How do monopolies affect society’s well-
being?
• What can the government do about
monopolies?
• What is price discrimination?
Introduction
• Monopoly
– A firm that is the sole seller of a product
without close substitutes
– Has market power
• The ability to influence the market price of the
product it sells
• A competitive firm has no market power
– Arise due to barriers to entry
• Other firms cannot enter the market to
compete with it
Three Barriers to Entry
1. Monopoly resources
– A single firm owns a key resource.
• E.g., DeBeers owns most of the world’s
diamond mines
2. Government regulation
– The government gives a single firm the
exclusive right to produce the good.
• E.g., patents, copyright laws
Three Barriers to Entry
3. The production process
– Natural monopoly: a single firm can
produce the entire market Q at lower cost
than could several firms
Cost Electricity
Example: 1000 homes ATC slopes
need electricity. downward due
ATC is lower if one firm to huge FC and
services all 1000 homes $80 small MC
than if two firms each $50 ATC
service 500 homes. Q
500 1000
Monopoly vs. Competition: Demand
Curves
P A competitive firm’s P A monopolist’s
demand curve demand curve
D
Q Q
•In a competitive market, the market demand curve slopes
downward. But the demand curve for any individual firm’s
product is horizontal at the market price. The firm can increase Q
without lowering P, so MR = P for the competitive firm.
•A monopolist is the only seller, so it faces the market demand
curve. To sell a larger Q, the firm must reduce P. Thus, MR ≠ P.
Active Learning 1 A monopoly’s revenue
Common Grounds is
the only seller of
cappuccinos in town. Q P TR AR MR
The table shows the 0 $4.50 n.a.
market demand for
cappuccinos. 1 4.00
Fill in the missing 2 3.50

spaces of the table. 3 3.00
What is the relation 4 2.50
between P and AR?
Between P and MR? 5 2.00
6 1.50
• P = AR, Q P TR AR MR
same as for a 0 $4.50 $0 n.a.
$4
competitive 1 4.00 4 $4.00
3
firm. 2 3.50 7 3.50
• MR < P, 2
3 3.00 9 3.00
1
whereas MR = 4 2.50 10 2.50
P for a 5 2.00 10 2.00
0
competitive –1
6 1.50 9 1.50
firm.
Common Grounds’ D and MR Curves
P, MR
Q P MR
$5
0 $4.50
$4 4
Demand curve (P)
1 4.00 3
3
2 3.50 2
2 1
3 3.00
1 0
4 2.50
0 -1 MR
5 2.00 -2
–1
6 1.50 -3
0 1 2 3 4 5 6 7 Q
Understanding the Monopolist’s MR
• Increasing Q has two effects on revenue:
– Output effect: higher output raises revenue
– Price effect: lower price reduces revenue
• Marginal revenue, MR < P
– To sell a larger Q, the monopolist must
reduce the price on all the units it sells
– Is negative if price effect > output effect
• e.g., when Common Grounds increases Q
from 5 to 6
Profit-Maximization
• Like a competitive firm, a monopolist
maximizes profit by producing the quantity
where MR = MC
– Sets the highest price consumers are
willing to pay for that quantity
– It finds this price from the D curve
Profit-Maximization
Costs and
Revenue MC
The profit- P
maximizing Q is
where MR = MC.
D
Find P from the
demand curve at MR
this Q.
Q Quantity
Profit-maximizing output
The Monopolist’s Profit
Costs and
Revenue MC
As with a
competitive firm, P
ATC
the monopolist’s ATC
profit equals
(P – ATC) x Q D
MR
Q Quantity
A Monopoly Does Not Have an S Curve
• A competitive firm takes P as given
– Has a supply curve that shows how its Q
depends on P
• A monopoly firm is a “price-maker”
– Q does not depend on P
– Q and P are jointly determined by MC,
MR, and the demand curve
– Hence, no supply curve for monopoly.
CASE STUDY: Monopoly vs. Generic Drugs
Patents on new The market for
Price a typical drug
drugs give a
temporary
monopoly to the PM
seller.
PC = MC
When the
patent expires, D
the market MR
becomes
QM Quantity
competitive,
QC
generics appear.
The Welfare Cost of Monopoly
• Recall:
– Competitive market equilibrium: P = MC
and total surplus is maximized
• Monopoly equilibrium, P > MR = MC
– The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC)
– The monopoly Q is too low – could increase
total surplus with a larger Q.
– Monopoly results in a deadweight loss
The Welfare Cost of Monopoly
Competitive equilibrium:
Price Deadweight
• quantity = QC MC
•P = MC loss
•total surplus is P
P = MC
maximized
MC
Monopoly equilibrium:
D
•quantity = QM
MR
•P > MC
•deadweight loss QM QC Quantity
Price Discrimination
• Price discrimination:
– Sell the same good at different prices to
different buyers
– A firm can increase profit by charging a
higher price to buyers with higher
willingness to pay
– Requires the ability to separate customers
according to their willingness to pay
– Can raise economic welfare
Price Discrimination
• Perfect price discrimination
– Charge each customer a different price
• Exactly his or her willingness to pay
– Monopoly firm gets the entire surplus
(Profit)
– No deadweight loss
Single Price Monopoly
Here, the Consumer

Price
monopolist surplus
charges the Deadweight
same price (PM) PM
loss
to all buyers.
MC
Monopoly
profit D
MR
A deadweight
loss results. QM Quantity
Perfect Price Discrimination vs. Single Price
Monopoly
Here, the monopolist
produces the
competitive quantity, but Price
Monopoly
charges each buyer his
profit
or her WTP.
This is called perfect
price discrimination.
MC
The monopolist captures D
all CS as profit.
MR
But there’s no DWL.
Quantity
Q
Price Discrimination in the Real World
• Perfect price discrimination
– Not possible in the real world
• No firm knows every buyer’s WTP
• Buyers do not reveal it to sellers
• Price discrimination
– Firms divide customers into groups
based on some observable trait
that is likely related to willingness to pay
(WTP), such as age
Examples of Price Discrimination
• Movie tickets
– Discounts for seniors, students, and
people who can attend during weekday
afternoons.
• Lower WTP than people who pay full price on
Friday night
• Airline prices
– Discounts for Saturday-night stayovers
• Business travelers (higher WTP) vs. more
price-sensitive leisure travelers
• Discount coupons
– People who have time to clip and organize
coupons are more likely to have lower
income and lower WTP than others
• Need-based financial aid
– Low income families have lower WTP for
their children’s college education
– Schools price-discriminate by offering
need-based aid to low income families
• Quantity discounts
– A buyer’s WTP often declines with
additional units, so firms charge less per
unit for large quantities than small ones.
• Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s
twice as big
Public Policy Toward Monopolies
1. Increasing competition with antitrust laws

– Sherman Antitrust Act, 1890
– Clayton Antitrust Act, 1914
– Prevent mergers
– Break up companies
– Prevent companies from coordinating their
activities to make markets less
competitive
ASK THE EXPERTS
Airline Mergers
“If regulators had not approved mergers in the
past decade between major networked
airlines, travelers would be better off today.”
2. Regulation
– Regulate the behavior of monopolists
• Set the monopolists’ price
– Common in case of natural monopolies
• MC < ATC at all Q
• Marginal-cost pricing would result in losses
– Regulator might subsidize the monopolist
or set P = ATC for zero economic profit
3. Public ownership
– How the ownership of the firm affects the
costs of production
– Private owners: incentive to min costs
– Public owners (government)
• If it does a bad job, losers are the customers
and taxpayers
• Public ownership is usually less efficient since
no profit motive to minimize costs
4. Do nothing
– Some economists argue that it is often
best for the government not to try to
remedy the inefficiencies of monopoly
pricing
– Determining the proper role of the
government in the economy requires
judgments about politics as well as
economics
The Prevalence of Monopoly
• Pure monopoly – rare in the real world
• Many firms have market power, due to:
– Selling a unique variety of a product
– Having a large market share and few
significant competitors
• In many such cases, most of the results
from this chapter apply, including:
– Markup of price over marginal cost
– Deadweight loss
Summary
• A monopoly is a firm that is the sole seller in its
market.
– A monopoly arises when a single firm owns a
key resource, when the government gives a firm
the exclusive right to produce a good, or when a
single firm can supply the entire market at a
lower cost than many firms could.
– Faces a downward-sloping demand curve for its
product.
Summary
• Monopoly increases production by 1 unit
– Causes the price of its good to fall, which
reduces the amount of revenue earned on all
units produced.
– Marginal revenue is always below the price
• A monopoly firm maximizes profit by producing
the quantity at which marginal revenue equals
marginal cost.
– Sets the price at which that quantity is
demanded. P > MR, so P > MC
Summary
• A monopolist’s profit-maximizing level of output
is below the level that maximizes the sum of
consumer and producer surplus.
– Causes deadweight losses
• A monopolist can often increase profits by
charging different prices for the same good
based on a buyer’s willingness to pay.
– Price discrimination can raise economic welfare
– Perfect price discrimination, the deadweight loss
of monopoly is completely eliminated
Summary
• Policymakers can respond to the inefficiency of
monopoly behavior in four ways
– Use antitrust laws to try to make the industry
more competitive
– Regulate the prices that the monopoly charges
– Turn the monopolist into a government-run
enterprise
– Can do nothing at all
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER
Monopolistic
16 Competition
• What market structures lie between perfect
competition and monopoly, and what are
their characteristics?
• How do monopolistically competitive firms
choose price and quantity? Do they earn
economic profit?
• How does monopolistic competition affect
society’s welfare?
• What are the social costs and benefits of
advertising?
Introduction
• Two extremes
• Perfect competition: many firms, identical
products
• Monopoly: one firm
• Imperfect competition – in between the
extremes:
– Oligopoly: only a few sellers offer similar
or identical products.
– Monopolistic competition: many firms sell
similar but not identical products.
Monopolistic Competition
• Characteristics:
– Many sellers
– Product differentiation
• Not price takers; downward sloping D curve
– Free entry and exit
• Zero economic profit in the long run
• Examples of monopolistic competition:
– Apartments, books, bottled water, clothing,
fast food, night clubs
Comparisons
• Perfect Monopolistic
• Competition Competition Monopoly
•Number of sellers Many Many One
•Free entry/exit Yes Yes No
•Long-run
•economic profits Zero Zero Positive
•The products No close
•firms sell Identical Differentiated substitutes
•Firm has market None;
• power? price-taker Yes Yes
•D curve Downward- Downward-
•facing firm Horizontal sloping sloping
(market D)
Short Run Equilibrium
• Profit maximization in the short-run for the
monopolistically competitive firm:
– Produce the quantity where MR = MC
– Price: on the demand curve
– If P > ATC: profit
– If P < ATC: loss
– Similar to monopoly
A Monopolistically Competitive Firm Earning Profits
in the Short Run
The firm faces a Price

downward-sloping profit MC
D curve. P ATC
At each Q, MR < P. ATC

D
To maximize profit,
firm produces Q
MR
where MR = MC.
The firm uses the Q Quantity
D curve to set P.
A Monopolistically Competitive Firm
With Losses in the Short Run
Price
For this firm, MC
P < ATC losses ATC
at the output where
ATC
MR = MC.
P
The best this firm
can do is to D
minimize its losses. MR
Q Quantity
Long Run Equilibrium
• If monopolistically competitive firms are
making profit in short run
– New firms: incentive to enter the market
• Increase number of products
– Reduces demand faced by each firm
• Demand curve shifts left; prices fall
– Each firm’s profit declines to zero
• If losses in the short run:
– Some firms exit the market, remaining firms
enjoy higher demand and prices
A Monopolistic Competitor in the Long Run
Entry and exit occurs
until P = ATC and Price
MC
profit = zero.
ATC
Notice that the firm
P = ATC
charges a markup of
price over marginal markup
cost and does not D
produce at minimum MC MR
ATC. Q Quantity
Why Monopolistic Competition Is
Less Efficient than Perfect Competition
• Monopolistic competition
– Excess capacity: quantity is not at
minimum ATC (it is on the downward-
sloping portion of ATC)
– Markup over marginal cost: P > MC
• Perfect competition
– Quantity: at minimum ATC (efficient scale)
– P = MC
Welfare of Society
• Monopolistically competitive markets
– Do not have all the desirable welfare
properties of perfectly competitive markets
• Sources of inefficiency
– Markup of price over marginal cost
– Too much or too little entry (number of
firms in the market)
• Product-variety externality
• Business-stealing externality
Welfare of Society
• Markup, P > MC
– Market quantity < socially efficient quantity
• Deadweight loss of monopoly pricing
• The product-variety externality:
– Consumers get extra surplus from the
introduction of new products
• The business-stealing externality:
– Losses incurred by existing firms when
new firms enter market
Active Learning 1 Advertising
1. So far, we have studied three market

structures: perfect competition,
monopoly, and monopolistic competition.
– In each of these, would you expect to see
firms spending money to advertise their
products? Why or why not?
2. Is advertising good or bad from society’s
viewpoint? Try to think of at least one
“pro” and “con.”
Advertising
• Incentive to advertise
– When firms sell differentiated products
and charge prices above marginal cost
– Advertise to attract more buyers
• Advertising spending
– Highly differentiated goods: 10-20% of
revenue
– Industrial products: Little advertising
– Homogenous products: No advertising
Advertising
• In monopolistically competitive industries
– Product differentiation and markup pricing
lead naturally to the use of advertising
• The more differentiated the products
– The more advertising firms buy
• Economists disagree about the social
value of advertising:
– Wasting resources?
– Valuable purpose?
The Critique of Advertising
• Firms advertise to manipulate people’s
tastes
– Psychological rather than informational
• Creates a desire that otherwise might not
exist
• Advertising impedes competition
– Increase perception of product differentiation
• Foster brand loyalty; higher markups
• Makes buyers less concerned with price
differences among similar goods
The Defense of Advertising
• The defense of advertising
– It provides useful information to buyers
– Informed buyers can more easily find and
exploit price differences
– Advertising promotes competition and
reduces market power
• Results of a prominent study:
– Eyeglasses were more expensive in states that
prohibited advertising by eyeglass makers than
in states that did not restrict such advertising
Advertising
• Advertising as a signal of quality
– Little apparent information
– Real information offered – a signal
• Willingness to spend large
amount of money
• = signal about quality of the product
– Content of advertising = irrelevant
Brand Names
• In many markets, brand name products
coexist with generic ones.
• Brand names
– Spend more on advertising and charge
higher prices than generic substitutes
• As with advertising, there is disagreement
about the economics of brand names…
Advertising
• Critics of brand names
– Products – not differentiated
– Irrationality: consumers are willing to pay
more for brand names
• Defenders of brand names
– Consumers – information about quality
– Firms – incentive to maintain high quality
to protect the reputation of their brand
name
Summary
• A monopolistically competitive market has
many firms, differentiated products, and free
entry.
• Each firm in a monopolistically competitive
market has excess capacity—it produces
less than the quantity that minimizes ATC.
Each firm charges a price above marginal
cost.
Summary
• Monopolistic competition does not have all
of the desirable welfare properties of perfect
competition.
– There is a deadweight loss caused by the
markup of price over marginal cost.
– Also, the number of firms (and thus
varieties) can be too large or too small.
– There is no clear way for policymakers to
improve the market outcome.
Summary
• Product differentiation and markup pricing
lead to the use of advertising and brand
names.
– Critics of advertising and brand names
argue that firms use them to reduce
competition and take advantage of
consumer irrationality.
– Defenders argue that firms use them to
inform consumers and to compete more
vigorously on price and product quality.
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER
Oligopoly
17
• What outcomes are possible under
oligopoly?
• Why is it difficult for oligopoly firms to
cooperate?
• How are antitrust laws used to foster
competition?
Measuring Market Concentration
• Concentration ratio
– Percentage of total output in the market
supplied by the four largest firms
– The higher the concentration ratio, the
less competition
• This chapter focuses on oligopoly, a
market structure with high concentration
ratios.
Concentration Ratios in Selected U.S. Industries
Industry Concentration ratio
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%
Soft drinks 94%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
Oligopoly
• Oligopoly
– Market structure in which only a few
sellers offer similar or identical products
– Strategic behavior in oligopoly:
• A firm’s decisions about P or Q can affect
other firms and cause them to react
• The firm will consider these reactions when
making decisions
• Game theory: the study of how people
behave in strategic situations
EXAMPLE: Cell Phone Duopoly in Smalltown
P Q • Smalltown has 140 residents
$0 140 • The “good”: cell phone service with
5 130 unlimited anytime minutes and free
10 120 phone
15 110 • Smalltown’s demand schedule
20 100
• Two firms: AT&T, Verizon
25 90
(duopoly: an oligopoly with two firms)
30 80
35 70 • Each firm’s costs: FC = $0, MC = $10
40 60
45 50
EXAMPLE: Cell Phone Duopoly in Smalltown
Competitive
P Q Revenue Cost Profit
outcome:
$0 140 $0 $1,400 –1,400
P = MC = $10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350 Monopoly
outcome:
30 80 2,400 800 1,600
P = $40
35 70 2,450 700 1,750
Q = 60
40 60 2,400 600 1,800
45 50 2,250 500 1,750
Profit = $1,800
Cell Phone Duopoly in Smalltown
• One possible duopoly outcome: collusion
• Collusion:
– Agreement among firms in a market about
quantities to produce or prices to charge
– AT&T and Verizon could agree to each
produce half of the monopoly output:
• For each firm: Q = 30, P = $40, profits = $900
• Cartel:
– A group of firms acting in unison
Active Learning 1 Collusion vs. self-
interest
P Q Duopoly outcome with collusion:
$0 140 Each firm agrees to produce Q =
5 130
30,
10 120
earns profit = $900.
15 110
20 100 1. If AT&T reneges on the agreement
25 90
and produces Q = 40, what happens
30 80
to the market price? AT&T’s profits?
35 70 2. Is it in AT&T’s interest to renege on
40 60 the agreement?
45 50 3. If both firms renege and produce Q =
40, determine each firm’s profits.
P If both firms stick to agreement, each firm’s
Q
profit = $900
$0 140
5 130 1. If AT&T reneges on agreement, produces
Q = 40:
10 120
15 110 – Market quantity = 70, P = $35
20 100 – AT&T’s profit = 40 x ($35 –
25 90 10)=$1000
30 80 2. AT&T’s profits are higher if it reneges.
35 70 3. Verizon will conclude the same, both firms
40 60 renege, each produces Q = 40:
45 50 – Market quantity = 80, P = $30
– Each firm’s profit =40x($30–10) =
Collusion vs. Self-Interest
• Both firms would be better off if both stick
to the cartel agreement.
– But each firm has incentive to renege on
the agreement.
– Lesson: It is difficult for oligopoly firms to
form cartels and honor their agreements.
Active Learning 2 The oligopoly
equilibrium
P Q If each firm produces Q = 40,
$0 140 market quantity = 80, P = $30,
5 130 each firm’s profit = $800
10 120
• Is it in AT&T’s interest to
15 110
20 100
increase its output further, to Q
25 90 = 50?
30 80 • Is it in Verizon’s interest to
35 70 increase its output to Q = 50?
40 60
45 50
P Q • If each firm produces Q = 40,
$0 140 then each firm’s profit = $800.
5 130 • If AT&T increases output to Q = 50:
10 120
– Market quantity = 90, P = $25
15 110
20 100
– AT&T’s profit = 50 x ($25 – 10)
25 90 = $750
30 80 • AT&T’s profits are higher at Q =
35 70 40 than at Q = 50.
40 60 • The same is true for Verizon.
45 50
Equilibrium for an Oligopoly
• Nash equilibrium
– Economic actors interacting with one
another, each choose their best strategy
– Given the strategies that all the other
actors have chosen
• Duopoly example has a Nash equilibrium
• Given that Verizon produces Q = 40,
AT&T’s best move is to produce Q = 40
• Given that AT&T produces Q = 40,
Verizon’s best move is to produce Q = 40
Equilibrium for an Oligopoly
• When firms in an oligopoly individually
choose production to maximize profit
– Produce Q
• Greater than monopoly Q
• Less than competitive Q
– The price is
• Less than the monopoly P
• Greater than the competitive P = MC
The Output & Price Effects
• Increasing output has two effects on a
firm’s profits:
– Output effect:
If P > MC, increasing output raises profits
– Price effect:
Raising output increases market quantity,
which reduces price and reduces profit
on all units sold
The Size of the Oligopoly
• As the number of sellers in an oligopoly
increases:
– The price effect becomes smaller
– The oligopoly looks more and more like a
competitive market
– P approaches MC
– The market quantity approaches the
socially efficient quantity
• Another benefit of international trade
ASK THE EXPERTS
Nash Equilibrium
“Behavior in many complex and seemingly intractable
strategic settings can be understood more clearly by working
out what each party in the game will choose to do if they
realize that the other parties will be solving the same
problem. This insight has helped us understand behavior as
diverse as military conflicts, price setting by competing firms
and penalty kicking in soccer.”
The Economics of Cooperation
• The prisoners’ dilemma
– Particular “game” between two captured
prisoners
– Illustrates why cooperation is difficult to
maintain even when it is mutually beneficial
• Dominant strategy
– Strategy that is best for a player in a game
– Regardless of the strategies chosen by
the other players
Prisoners’ Dilemma Example
The police have caught Bonnie and Clyde, two
suspected bank robbers, but only have enough
evidence to imprison each for 1 year.
• The police question each in separate rooms, offer
each the following deal:
– If you confess and implicate your partner,
you go free.
– If you do not confess but your partner implicates
you, you get 20 years in prison.
– If you both confess, each gets 8 years in prison.
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess Remain silent
Bonnie gets Bonnie gets
Confess 8 years 20 years

Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie Bonnie gets
Remain goes free
1 year
silent Clyde Clyde
gets 20 years gets 1 year
• Outcome: Bonnie and Clyde both
confess, each gets 8 years in prison.
– Both would have been better off if both
remained silent.
– But even if Bonnie and Clyde had agreed
before being caught to remain silent, the
logic of self-interest takes over and leads
them to confess.
Oligopolies as a Prisoners’ Dilemma
• When oligopolies form a cartel
– In hopes of reaching the monopoly
outcome, they become players in a
prisoners’ dilemma.
• Our earlier duopoly example:
• AT&T and Verizon are duopolists in Smalltown
– The cartel outcome maximizes profits:
– Each firm agrees to serve Q = 30
customers.
AT&T & Verizon in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
AT&T
Q = 30 Q = 40
AT&T’s profit AT&T’s profit
= $900 = $1000
Q = 30
Verizon’s Verizon’s
profit = $900 profit = $750
Verizon
AT&T’s profit = AT&T’s profit
$750 = $800
Q = 40
Verizon’s Verizon’s
profit = $1000 profit = $800
Active Learning 3 The fare wars game
The players: Delta Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone
– If both airlines cut fares, each airline’s
profit = $400 million
– If neither airline cuts fares, each airline’s
profit = $600 million
– If only one airline cuts its fares, its profit =
$800 million; the other airline’s profits =
$200 million
• Draw the payoff matrix, find the Nash
equilibrium
Nash equilibrium:
Delta Airlines
both firms cut fares
Cut fares Don’t cut fares
$400 million $200 million
Cut fares
United $400 million $800 million

Airlines
Don’t cut
fares
Other Examples of
the Prisoners’ Dilemma
• Ad Wars
– Two firms spend millions on TV ads to steal
business from each other.
– Each firm’s ad cancels out the effects of the other,
and both firms’ profits fall by the cost of the ads.
• Organization of Petroleum Exporting Countries
– Member countries try to act like a cartel, agree to
limit oil production to boost prices and profits.
– But agreements sometimes break down when
individual countries renege.
Other Examples of
the Prisoners’ Dilemma
• Arms race between military superpowers
– Each country would be better off if both
disarm, but each has a dominant strategy of
arming.
• Common resources
– All would be better off if everyone conserved
common resources, but each person’s
dominant strategy is overusing the resources.
Welfare of Society
• Noncooperative oligopoly equilibrium
– May be bad for oligopolists
• Prevents them from achieving monopoly
profits
– May be bad for society
• Examples: Arms race game, Common
resource game
– May be good for society
• Quantity and price – closer to optimal level
Another Example:
Negative Campaign Ads
• Election with two candidates, “R” and “D.”
– If R runs a negative ad attacking D, 3000
fewer people will vote for D (1000 of these
people vote for R, the rest abstain).
– If D runs a negative ad attacking R, R loses
3000 votes, D gains 1000, 2000 abstain.
– R and D agree to refrain from running attack
ads. Will each of them stick to the
agreement?
Another Example: Negative Campaign Ads
Each candidate’s
dominant strategy: R’s decision
run attack ads.
Do not run attack Run attack ads
ads (cooperate) (defect)
Do not run no votes lost R gains 1000

attack ads or gained votes
(cooperate) no votes D loses
lost or gained 3000 votes
D’s decision
R loses 3000 R loses
Run votes 2000 votes
attack ads D gains D loses
(defect) 1000 votes 2000 votes
Another Example:
Negative Campaign Ads
• Nash equilibrium
– Both candidates run attack ads.
• Effects on election outcome: NONE
– Each side’s ads cancel out the effects of
the other side’s ads.
• Effects on society: NEGATIVE
– Lower voter turnout, higher apathy about
politics, less voter scrutiny of elected
officials’ actions.
Why People Sometimes Cooperate
– When the game is repeated many times,
cooperation may be possible
• Two strategies may lead to cooperation:
– If your rival reneges in one round, you
renege in all subsequent rounds.
– “Tit-for-tat”
Whatever your rival does in one round
(whether renege or cooperate), you do in
the following round.
Public Policy Toward Oligopolies
• Governments
– Can sometimes improve market outcomes
• Policymakers
– Try to induce firms in an oligopoly to
compete rather than cooperate
– Move the allocation of resources closer to
the social optimum
Public Policy Toward Oligopolies
• Antitrust laws
– The Sherman Antitrust Act, 1890
• Elevated agreements among oligopolists from
an unenforceable contract to a criminal
conspiracy
– The Clayton Act, 1914
• Further strengthened the antitrust laws
– Used to prevent mergers
– Used to prevent oligopolists from colluding
Controversies Over Antitrust Policy
– Most people agree that price-fixing
agreements among competitors should be
illegal.
– Some economists are concerned that
policymakers go too far when using
antitrust laws to stifle business practices
that are not necessarily harmful, and may
have legitimate objectives.
• We consider three such practices…
1. Resale Price Maintenance
(“Fair Trade”)
• A manufacturer imposes lower limits on the
prices retailers can charge
– Often opposed because it appears to reduce
competition at the retail level
– Yet, any market power the manufacturer has is
at the wholesale level
• No gains from restricting competition at the
retail level
– Legitimate objective: preventing discount
retailers from free-riding on the services
provided by full-service retailers
2. Predatory Pricing
• A firm cuts prices to prevent entry or drive a
competitor out of the market
– So that it can charge monopoly prices later
• Illegal under antitrust laws
– Difficult: when a price cut is predatory and when
it is competitive & beneficial to consumers?
• Many economists doubt that predatory pricing
is a rational strategy:
– It involves selling at a loss (costly for the firm)
– It can backfire
3. Tying
• A manufacturer bundles two products together
and sells them for one price
• Critics
– Tying gives firms more market power by
connecting weak products to strong ones
• Others: tying cannot change market power
– Buyers are not willing to pay more for two goods
together than for the goods separately
• Firms may use tying for price discrimination
– Sometimes increases economic efficiency
Summary
• Oligopolists can maximize profits if they form
a cartel and act like a monopolist.
• Yet, self-interest leads each oligopolist to a
higher quantity and lower price than under the
monopoly outcome.
• The larger the number of firms, the closer will
be the quantity and price to the levels that
would prevail under competition.
Summary
• The prisoners’ dilemma shows that self-
interest can prevent people from cooperating,
even when cooperation is in their mutual
interest. The logic of the prisoners’ dilemma
applies in many situations.
• Policymakers use the antitrust laws to prevent
oligopolies from engaging in anticompetitive
behavior such as price-fixing. But the
application of these laws is sometimes
controversial.
N. GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eighth Edition
CHAPTER The Markets for the

18 Factors of Production
• What determines a competitive firm’s
demand for labor?
• How does labor supply depend on the
wage? What other factors affect labor
supply?
• How do various events affect the equilibrium
wage and employment of labor?
• How are the equilibrium prices and
quantities of other inputs determined?
ASK THE EXPERTS
Immigration
“The average US citizen would be better off if a
larger number of highly educated foreign
workers were legally allowed to immigrate to
the US each year.”
Factors of Production
and Factor Markets
• Factors of production:
– Inputs used to produce goods and
services
• Labor
• Land
• Capital: the equipment and structures used
to produce goods and services
– Prices and quantities are determined by
supply & demand in factor markets.
Derived Demand
• Markets for the factors of production
– Are like markets for goods & services
– Except the demand for a factor of
production is a derived demand
• Derived from a firm’s decision to supply a
good in another market
Two Assumptions
1. All markets are competitive
– The typical firm is a price taker
• In the market for the product it produces
• In the labor market
2. Firms care only about maximizing profits

– Each firm’s supply of output and demand
for inputs are derived from this goal
Our Example: Farmer Jack
• Farmer Jack sells wheat in a perfectly
competitive market.
• He hires workers in a perfectly
competitive labor market.
When deciding how many workers to hire,
Farmer Jack maximizes profits by
thinking at the margin:
– If the benefit from hiring another worker
exceeds the cost, Jack will hire that
worker.
Our Example: Farmer Jack
• Cost of hiring another worker:
– The wage = the price of labor
• Benefit of hiring another worker:
– Jack can produce and sell more wheat,
increasing his revenue.
– The size of this benefit depends on Jack’s
production function: the relationship
between the quantity of inputs used to
make a good and the quantity of output of
that good
Farmer Jack’s Production Function
Q
L
(bushels
(no. of 3,000
of wheat
workers) per week)
2,500
Quantity of output
0 0
2,000
1 1000
1,500
2 1800
1,000
3 2400
500
4 2800
0
5 3000 0 1 2 3 4 5
No. of workers
Marginal Product of Labor (MPL)
• Marginal product of labor, MPL= ΔQ / ΔL
– The increase in the amount of output from
an additional unit of labor
– where
∆Q = change in output
∆L = change in labor
The Value of the Marginal Product
• Problem:
– Cost of hiring another worker (wage) is
measured in dollars
– Benefit of hiring another worker (MPL) is
measured in units of output
– Solution: convert MPL to dollars
• Value of the marginal product, VMPL=Px MPL
– The marginal product of an input times the
price of the output
Active Learning 1 Computing MPL and VMPL
• P = $5/bushel.
L Q
• Find MPL and (no. of (bushels MPL VMPL
VMPL, fill them workers) of wheat)
in the blank 0 0
spaces of the
1 1000
table.
• Then graph a 2 1800
curve with 3 2400

VMPL on the 4 2800
vertical axis, L 5 3000
on horizontal
axis.
• Farmer Jack’s
production L Q
function exhibits (no. of (bushels MPL = VMPL =
diminishing workers) of wheat) ∆Q/∆L P x MPL
marginal 0 0
product: 1000 $5000
1 1000
• MPL falls as 800 4000
L increases. 2 1800
600 3000
• This property is 3 2400
400 2000
very common. 4 2800
200 1000
5 3000
The VMPL curve
$6,000
Farmer Jack’s
5,000 VMPL curve is
downward sloping
4,000
due to diminishing
3,000 marginal product.
2,000
1,000
0
0 1 2 3 4 5
L (number of workers)
Farmer Jack’s Labor Demand
Suppose wage W = The VMPL curve
$6,000
$2500/week.
How many workers 5,000
should Jack hire?
4,000
Answer: L = 3
•At any smaller L: 3,000
$2,500
increase profit by 2,000
hiring another worker
•At any larger L: 1,000
increase profit by 0
hiring one fewer 0 1 2 3 4 5
worker. L (number of workers)
VMPL and Labor Demand
For any competitive,
W
profit-maximizing firm:
– To maximize profits,
hire workers up to
the point where W1
VMPL = W.
– The VMPL curve is
the labor demand VMPL
curve.
L
L1
Shifts in Labor Demand
Labor demand curve W

= VMPL curve.
VMPL = P x MPL
Anything that
increases P or MPL at
each L D2
will increase VMPL and
shift the labor demand D1
curve upward. L
Things that Shift the
Labor Demand Curve
• Changes in the output price, P
• Technological change (affects MPL)
• The supply of other factors (affects MPL)
– Example:
If firm gets more equipment (capital),
then workers will be more productive;
MPL and VMPL rise, labor demand shifts
upward.
Input Demand & Output Supply
• Marginal Cost (MC)
– Cost of producing an additional unit of
output
MC = ∆TC/∆Q, where TC = total cost
• Suppose W = $2500, MPL = 500 bushels
– If Farmer Jack hires another worker:
∆TC = $2500, ∆Q = 500 bushels
MC = $2500/500 = $5 per bushel
• In general: MC = W / MPL
MC = W / MPL
• To produce additional output
• Hire more labor.
• As L rises, MPL falls…
• causing W/MPL to rise…
• causing MC to rise.
• Hence:
• Diminishing marginal product and increasing
marginal cost are two sides
of the same coin
• The competitive firm’s rule for demanding
labor: P x MPL = W
– Divide both sides by MPL: P = W/MPL
– Substitute MC = W/MPL from previous
slide: P = MC
• This is the competitive firm’s rule for
supplying output.
• Hence
• Input demand and output supply are two
sides of the same coin.
Labor Supply
• Trade-off between work and leisure:
– The more time you spend working,
the less time you have for leisure.
• Wage
– Is the opportunity cost of leisure
The Labor Supply Curve
An increase in W W
is an increase in the S1
opp. cost of leisure.
W2
People respond by
taking less leisure W1
and by working
more.
L
L1 L2
Things that Shift the
Labor Supply Curve
• Changes in tastes or attitudes regarding
the labor–leisure trade-off
• Changes in alternative opportunities
• Immigration
– Movement of workers from region to
region, or country to country
Equilibrium in the Labor Market
The wage adjusts W

to balance supply S
and demand for
labor.
The wage always W1
equals VMPL.
D
L
L1
ASK THE EXPERTS
Immigration
“The average US citizen would be better off if a
larger number of low-skilled foreign workers
were legally allowed to enter the US each
year.”
Active Learning 2 Changes in labor-market
equilibrium
In each of the following scenarios, use a

diagram of the market for (domestic) auto
workers to find the effects on their wage and
employment.
A. Baby boomers who worked in the auto
industry retire.
B. Car buyers’ preferences shift toward
imported autos.
C. Technological progress boosts productivity
in the auto manufacturing industry.
Active Learning 2 Answers to A
The market for
The retirement autoworkers
W
of baby boomer S2
S1
auto workers
shifts supply W2
leftward. W1
• W rises, L
falls.
D1
L
L2 L1
Active Learning 2 Answers to B
The market for
A fall in the demand autoworkers
for U.S. autos W
S1
reduces P.
• At each L,
VMPL falls. W1
• Labor demand W2
curve shifts down.
D1
• W and L both fall. D2
L
L2 L1
Active Learning 2 Answers to C
The market for
At each L, autoworkers
MPL rises due to W
S1
tech. progress.
• VMPL rises and W2
labor demand W1
curve shifts D2
upward.
D1
• W and L
L
increase. L1 L2
Productivity and Wage Growth in the U.S.
Recall one of the Ten
growth growth
Principles:
time rate of rate
period produc- of real A country’s standard of
tivity wages living depends on its
ability to produce
1960–2015 2.0% 1.8%
goods and services.
1960–1973 2.7 2.7
Our theory implies wages
tied to labor productivity
1973–1995 1.4 1.2
(W = VMPL).
1995–2015 2.1 1.8 We see this in the data.
Monopsony
• Monopsony:
– A market with one buyer
– A monopsony employer can use its market
power to increase its profits by paying
lower wages
– As with monopoly, economic activity under
monopsony is below the socially optimal
level, causing a deadweight loss
• Monopsonies are rare in the real world
Land and Capital
• With land and capital, must distinguish
between:
– Purchase price: the price a person pays to
own that factor indefinitely
– Rental price: the price a person pays to
use that factor for a limited period of time
• The wage is the rental price of labor
• The determination of the rental prices
– Analogous to the determination of wages
How the Rental Price of Land Is Determined
Firms increase the The market
quantity of land to rent P for land
until the value of the
S
marginal product
(VMP) of land equals
the land’s rental price.
P
The rental price of land
adjusts to balance
supply and demand for D = VMP
land.
Q
Q
How the Rental Price of Capital Is Determined
Firms increase the The market
quantity of capital to P for capital
rent until the value of
S
the marginal product
(VMP) of capital equals
the capital’s rental price.
P
The rental price of

capital adjusts to D = VMP
balance supply and
Q
demand for capital. Q
Rental and Purchase Prices
• Buying a unit of capital or land
– Yields a stream of rental income.
• The rental income in any period
– Equals the value of the marginal product
(VMP)
• Hence, the equilibrium purchase price of
a factor
– Depends on both the current VMP and the
VMP expected to prevail in future periods.
Linkages Among the
Factors of Production
• Factors of production are used together
– In a way that makes each factor’s
productivity dependent on the quantities of
the other factors
– Example: an increase in the quantity of
capital
• The marginal product and rental price of
capital fall
• Having more capital makes workers more
productive, MPL and W rise
Conclusion
• Neoclassical theory of income distribution
– Theory developed in this chapter
– Factor prices are determined by supply
and demand
– Each factor is paid the value of its
marginal product
– Used by most economists as a starting
point for understanding the distribution of
income
ASK THE EXPERTS
Immigration
“Unless they were compensated by others,
many low-skilled American workers would be
substantially worse off if a larger number of
low-skilled foreign workers were legally
allowed to enter the US each year.”
Summary
• The economy’s income distribution is
determined in the markets for the factors of
production. The three most important factors of
production are labor, land, and capital.
• A firm’s demand for a factor is derived from its
supply of output.
• Competitive firms maximize profit by hiring
each factor up to the point where the value of
its marginal product equals its rental price.
Summary
• The supply of labor arises from the trade-off
between work and leisure; yields an upward-
sloping labor supply curve.
• The price paid to each factor adjusts to balance
supply and demand for that factor. In equilibrium,
each factor is compensated according to its
marginal contribution to production.
• Factors of production are used together. A
change in the quantity of one factor affects the
marginal products and equilibrium earnings of all
factors.

Microeconomics Mankiw Second Quarter

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N.

the amount a firm the market value of

The rent on office space increases $500/month.

Farmer Jack must pay $1000 per month for

1 1000 $1,000 $2,000 $3,000

2 1800 $1,000 $4,000 $5,000

3 2400 $1,000 $6,000 $7,000

Marginal Cost ($)

Q TC ATC AFC AVC

3 260 86.67 33.33 53.33

3 260 86.67 $75

When MC < ATC, $200 ATC

The MC curve $75

crosses the ATC $50

Q VC TC AFC AVC ATC MC

Firm can choose

The firm can change

In the real world,

Perfectly competitive market:

At Qa, MC < MR.

At Qb, MC > MR.

The MC curve P2 MR2

If P < AVC, then

Determine A competitive firm

Identify the area P = $10 MR

Identify the area ATC

One firm Market

10,000 20,000 30,000

• P falls, reducing profits and slowing entry

• Zero economic profit: when P = ATC

One firm Market

P One firm P Market

Fill in the missing 2 3.50

Here, the Consumer

1. Increasing competition with antitrust laws

The firm faces a Price

At each Q, MR < P. ATC

1. So far, we have studied three market

Confess 8 years 20 years

United $400 million $800 million

Do not run no votes lost R gains 1000

CHAPTER The Markets for the

2. Firms care only about maximizing profits

curve with 3 2400

Labor demand curve W

The wage adjusts W

In each of the following scenarios, use a

The rental price of

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