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7
© Alan Schein/Corbis
Market Structures and Price Determination
Learning Objectives
A�er reading this chapter, you should be able to:
Dis�nguish among the four main types of markets (or market
structures).
Explain how markets work and how they determine the market-
clearing prices.
Dis�nguish between price-taking and price-making situa�ons
for individuals and firms.

Discuss how the extent of product differen�a�on is cri�cally
important for price-making.
Iden�fy how the firm selects the price and output levels that
maximize profit under various market
structures.
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A market is a tangible place or an intangible situa�on in
which
buyers and sellers communicate for the purpose of
exchanging
value. Purchasing items at a grocery store is an example
of a
tangible market.
© Jupiterimages/Thinkstock
Introduction
In this chapter, we are primarily concerned with the
manager's problem of choosing the appropriate price and
output level in order to maximize the firm's
profits. As you know, profits are the excess of revenues
over costs. In the preceding four chapters we have been
concerned with the demand and revenue
side (Chapters 3 and 4) and the produc�on and cost sides
(Chapters 5 and 6). In this chapter, we bring together the

cost and demand sec�ons of this course
to help the manager make be�er pricing and output
decisions.
Business firms operate in markets; they sell their outputs
of products or services in markets, and they buy their
fixed and variable inputs in markets. Their
inputs are in turn the outputs of other firms and
individuals that supply products and services (such as
direct materials, direct labor, buildings and
equipment) to these input markets. Before proceeding with
the firm's pricing and output decisions, it seems prudent
to clarify what we mean by "markets."
What Is a Market?
A market can be defined as a tangible place or an
intangible situa�on in which buyers and
sellers communicate for the purpose of exchanging things
of value. Buyers exchange money
for goods or services, and sellers exchange goods or
services for money. In barter markets,
buyers and sellers exchange goods or services that they
own for other goods or services that
they want. Since the earliest �mes, people would gather
in the village marketplace to buy and
sell (or exchange by barter) food, clothing, animals, tools,
weapons, and so on. Such physical
market loca�ons s�ll exist, of course; even in modern
ci�es you will find vegetable markets,
fish markets, and so on. Other market loca�ons are
visited only by those directly engaged in
the transac�on, such as a person ge�ng a haircut at the
hairdresser's shop, or a farm laborer
going out to a farm looking for work. Market transac�ons
can take place without the buyer or

the seller physically mee�ng: For example, you can use a
telephone to call a roofer to fix your
roof while you are at work, and later pay his invoice. To
do this you (metaphorically) enter the
market for roof repairs and choose one or more roof
repairers who give you a price quota�on
(or assurance that the price for the repair job will be
fair), a verbal or wri�en contract is then
entered into, and the transac�on is subsequently
completed.
The Internet has provided buyers and sellers with quick
and effec�ve online access to millions
of markets. Prospec�ve buyers can easily find out who
sells the item they wish to purchase,
what price and quality features are associated with the
offer made by each seller, when and how delivery and
payment will take place, and so on. Buyers
and sellers can nego�ate the transac�on price online
without mee�ng, or mul�ple and anonymous buyers can
compete for the sale of a specific item via
online auc�ons (on sites such as eBay). Similarly, buyers
and sellers rou�nely enter into contracts to purchase and
sell items, or to provide services for
remunera�on, using text messaging or email
correspondence.
The extent of a market is limited by �me, space, and
informa�on. First, markets take place at certain �mes,
and it is too late tomorrow to enter today's
market expec�ng to get yesterday's prices—prices (and
perhaps also quali�es) may have changed considerably
compared to yesterday's market outcomes.
For example, if we hear on the news that Facebook stock
prices fell today, trying to buy Facebook stock tomorrow
we might find that its stock prices have

risen considerably. Second, markets take place at
par�cular loca�ons, real or virtual, which in many cases
limits the number of par�cipants if buyers and
sellers have to be physically present to buy or sell the
product or service, or if buyers need to follow specific
processes to access a virtual market
environment. For example, ge�ng a haircut requires the
buyer to travel to a hairdresser, and there may be only
three or four service providers within a
convenient distance for the buyer, notwithstanding that
there may be hundreds of barbers and hairdressers spread
around the city and across the state.
Similarly, a mobile mechanic may consider taking
automobile repair jobs only within a radius of 20 miles,
despite there being thousands more poten�al
buyers of auto repairs outside that radius. Thirdly, markets
are limited by the availability of informa�on to poten�al
buyers and sellers. For example,
poten�al home buyers may not know that their dream
home has been put up for sale, and thus they do not
a�end the auc�on at which it is sold. Similarly,
poten�al sellers may not know that someone would be
willing to offer them thousands of dollars for their
an�que furniture, if only both par�es knew about
the other's willingness to buy or sell. Markets require that
par�cipants be informed about the market's existence and
be able to enter (personally or by
proxy) the marketplace (real or virtual) at the �me that
the market transac�on is to occur.
Thus, a market is a means by which buyers and sellers
can get together in some sense to allow them to enter
into and complete a transac�on. In any
market, a transac�on can occur if a price can be agreed
upon between the buyer and the seller. Our major concern
in this chapter is how the structure of

the market influences the ability of the selling firm to set
the price level for its output.
The Four Basic Market Structures
Economists iden�fy four basic market structures as
follows:
pure compe��on markets in which there are many sellers
supplying iden�cal products, such as farmers selling milk,
eggs, or corn, or individuals selling
shares on the Stock Exchange;
monopolis�c compe��on markets in which there are many
sellers each supplying differen�ated products, such as coffee
shops in the central business
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Market Structures
oligopoly markets in which rela�vely few sellers each supply
iden�cal or differen�ated products, such as automobiles,
aircra�, steel, and other building
materials; and
monopoly markets in which there is only one seller of the
product or service which has no direct subs�tutes, such as your
local gas or electricity u�lity.
The number of compe�ng sellers and the degree of

product differen�a�on interact to give rise to an
expecta�on, by the focal firm, of what rivals will do in
reac�on to its price changes. When there are many firms
(i.e., in pure compe��on and in monopolis�c
compe��on), we expect that firms will not expect
rival firms to react to their pricing decisions. Note that
by "many firms" we mean a number sufficiently large that
the produc�ve capacity of any one firm is
a very small propor�on of the total produc�on capacity
of the firms opera�ng in the market. Because of this
rela�ve insignificance of any one supplier in
pure compe��on and monopolis�c compe��on, none of
these firms expects its ac�ons to be reacted to (or
perhaps even no�ced) by other firms.
Conversely, by "few firms" we mean a number small
enough such that any one firm can produce a rela�vely
large propor�on of market demand and
consequently can influence the market price upwards (by
withholding supply) or downwards (by flooding the
market). Being a significant en�ty in such
markets, the firm must expect reac�on from those affected
by its compe��ve moves; we shall expand upon the
expecta�ons of oligopolists regarding their
rivals' reac�ons to their compe��ve moves later in this
chapter. Monopolists do not have to worry about rivals'
reac�ons because they have no direct rivals,
but they do have to be concerned with the reac�ons of
public regulatory bodies to their pricing and other
compe��ve moves. Many public u�li�es that
provide ci�es and communi�es with water, electric power,
and household gas supplies are regulated monopolies that
are subject to con�nual scru�ny by
their regulators. Monopoly suppliers of services based on
new technologies, such as Microso� and Google, must
also heed the monopoliza�on sec�ons of

the Federal An�-Combines Act. The dis�nguishing
differences of the four basic market structures are
summarized in Table 7.1, along with examples of each
type.
Table 7.1: The four market structures
Pure
compe��on
Monopolis�c
compe��on
Oligopoly Monopoly
Number of
compe�ng
firms
Many, due to no
barriers to entry
of new rivals
Many, due to no
barriers to entry
of new rivals
Few, due to high barriers to entry of new rivals One, due
to an
absolute
barrier to
entry for
poten�al rivals
Degree of
product

differen�a�on
Zero (iden�cal
products)
Small (slightly
differen�ated
products)
Zero to substan�al (ranges from iden�cal to highly
differen�ated
products)
Extreme
(unique
product with
no direct
subs�tutes,
due to entry
barrier)
Expecta�on
of rivals'
reac�ons
No reac�on
expected due to
very small share
of total supply
of the product
No reac�on
expected due to
very small share
of total supply of
the product

Rivals are generally expected to match price increase but
to ignore
price reduc�ons1
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
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No rivals, but
does expect
government
regula�on if
behaving
"badly"
Examples Agricultural
commodi�es;
stock markets;
financial
markets; foreign
exchange
markets
Personal services;
clothes retailers;
foodservice
providers (e.g.,
Coffee shops and
restaurants)
Steel, aluminum, cement, and glass building materials; car
and airplane
manufacturers; local oligopolies
Pharmaceu�cal
firm with
patents;

electricity and
gas u�li�es;
unique items;
labor unions;
cartels
The degree of product differen�a�on refers to the extent
to which compe�ng suppliers' products contain the same
or different product a�ributes, or more
or less of these a�ributes, as discussed in Chapter 3.
Product differen�a�on is as perceived by the customer
and implies a preference ranking between and
among compe�ng suppliers, that is, the customer would
expect to gain more u�lity from some product variants
than from others offered in the same
market. In pure compe��on, the compe�ng sellers provide
iden�cal products, meaning that their products are
completely undifferen�ated, such as the
shares in a company that might be offered for sale in the
stock market by many small stockholders. In monopolis�c
compe��on, the sellers compete in the
same product category providing basically similar products
which are more or less differen�ated in terms of their
loca�on or the other product a�ributes
offered. For example, the various coffee shops and fast-
food stores that are sca�ered around a big city all offer
food, snacks, and beverages but in slightly
different formats and combina�ons, with be�er or worse
service quality, and in more or less convenient loca�ons.
In oligopoly markets, the degree of product differen�a�on
can range from none to quite
substan�al. It will be quite low in markets where a few
sellers provide iden�cal products (such as
tendering to buyer specifica�on for steel, aluminum, and
other building materials) and the only

elements of differen�a�on might be the firms' more-or-
less convenient loca�ons, proposed
delivery �mes, reputa�on for service quality, or personal
rela�onships between the buyer (or
purchasing agent) and the seller. Taking the a�ribute view
of product quality, as we did in Chapter
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3, we can see that these loca�on, �ming, and service
differences among compe�ng suppliers
cause the buyer to differen�ate the quality of one seller
from another when the basic product
(e.g., steel supplied to exac�ng specifica�ons) is
otherwise iden�cal. Conversely, product
differen�a�on in oligopoly markets may be quite
substan�al because the sellers' products or
services are quite different or would be delivered in
different ways by firms that are equally
convenient or pleasant to deal with. Examples include the
markets for automobiles, passenger
flights, university degrees, suburban houses, and so on. In
these examples, the different brands
and models of cars, different classes of air travel,
different subject ma�er to study, and different
design features and loca�ons of homes cause the poten�al

buyer to restrict their choice to a
subset of the suppliers or service providers in the broader
market.
In monopoly markets, the products of the monopolist are
totally differen�ated from those
available in other markets—by defini�on, a monopoly is
the single supplier of a par�cular product
category. Monopolies usually occur due to barriers to
entry—meaning there are obstacles to the
entry of compe�ng firms. These barriers include legal
restric�ons preven�ng new entrants (such as
for the post office and for gas and electricity u�li�es);
restricted access to the technology necessary to compete
effec�vely (such as trade secrets or
patents); or control of necessary raw materials or human
skills (such as control of all the bauxite deposits for
making aluminum, or employment of the only
person with a unique talent). Barriers to entry also
operate to prevent entry of new firms into oligopoly
markets, thus preserving the fewness of firms in
those markets. For example, the barriers to entry
preserving the fewness of firms in the automobile industry
are due to the huge cost of establishing an
automobile manufacturing plant and the associated network
of distributors and service facili�es; the strong and
established reputa�ons for quality of the
exis�ng sellers; and the limited access to the latest and
patented technology held by the incumbent firms.2
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/ch07introduc�on#Ch7footNote2)
1. This refers to one par�cular oligopoly situa�on. During a

"price war" for example, price reduc�ons by one firm should be
expected to be matched or exceeded by rival firms.
Alterna�vely, with price leadership, the price leader expects
the price followers to match both price increases and price
reduc�ons—we discuss these oligopoly situa�ons later in this
chapter. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/ch07introduc�on#return1) ]
2. Another reason for the preserva�on of monopolies is that
some markets are natural monopolies, meaning that they are
rela�vely small markets and are most efficiently served by only
one firm, due to the economies of plant size (introduced in
Chapter 5). They are "natural" in the sense that although there
are not insurmountable barriers to entry, if a new entrant
did enter it would soon realize that it would be more profitable
to sell out to, or merge with, the exis�ng firm and thus revert to
the monopoly structure of the market. We consider
natural monopoly later in this chapter. Similarly, some would
argue that the automobile industry and the airplane
manufacturing industry (for example) are natural oligopolies
due to
the massive economies of scale and economies of scope
available to exis�ng firms, such that new entrants would
ul�mately sell out to or merge with exis�ng firms (or perish
due to
price compe��on). [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/ch07introduc�on#return2) ]
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Due to the fact that excess demand drives
prices upward and excess supply drives
prices downward, profit-maximizing sellers
of undifferen�ated products must be
price-takers.
© Ryan McVay/Thinkstock
7.1 Short-Run Price and Output Decisions in Pure Competition
In iden�cal–products markets, prices are determined by
what we call market forces. These market forces are the
pressure exerted by buyers and sellers to
move the market price level upward or downward, and
occur due to either excess supply or excess demand.
Excess supply at the market price means that
the quan�ty supplied exceeds the quan�ty demanded at
that price, and thus sellers are unable to sell all that they
want to sell at the exis�ng price. Because
products are iden�cal in undifferen�ated product markets,
a very slight reduc�on in price would allow the firm to
offer a be�er value proposi�on to
poten�al buyers. When products are undifferen�ated, price
is necessarily the only difference between the various
sellers' products, so all poten�al buyers
would flock to any seller offering a lower price. That

firm would soon sell out, and other sellers would be
similarly mo�vated to also reduce their price
slightly, so that they too would sell more output (and
make more profit). When all firms have slightly reduced
their prices, the market price will have moved
to the new slightly lower level. If there remains excess
supply at this price level, the process would con�nue:
Each firm is again mo�vated to reduce price
slightly to sell all their output (rather than a lesser
amount) at a price just below the market price. This
process con�nues un�l the excess supply disappears,
and it disappears when the quan�ty supplied by the
sellers (at the market price) is just equal to the quan�ty
demanded by all the buyers at that same
price.
Excess demand occurs when the quan�ty demanded by
buyers at the market price exceeds the quan�ty that
suppliers wish to provide at that price. Excess demand
causes upward pressure on the market price level, and this
occurs because any firm will see that it could sell all it
wants to at a slightly higher price and will be mo�vated
to
raise its price to maximize its profits. Since all firms are
similarly mo�vated to gain more revenue for the same
quan�ty of output, the market price is pushed upwards
slightly. If there remains excess demand at this higher
price, it means that some buyers are s�ll seeking to buy
the product but are unable to do so, so the profit-
maximizing firm will see the opportunity to again raise
price slightly and sell all it wants to at a slightly higher
price. This process will be repeated un�l the excess
market demand (and the upward pressure on market price)
disappears and market quan�ty demanded equals market
quan�ty supplied.

This principle—that excess demand drives the market price
upward, and conversely, excess supply drives the
market price downward—is the fundamental reason why
profit-maximizing sellers of undifferen�ated products
must be price-takers; that is, they simply accept the
market-determined price (see Chapter 1). If a firm sets
price
above the market price, it would sell no product at all
(and that will not be profit-maximizing). Conversely, if it
sets price below the market price, buyers would want to
buy all the firm could produce, but the rising marginal
cost of the la�er units (due to the law of diminishing
returns; see Chapter 5) would exceed the price and it
would
not be profit-maximizing to serve all the demand at the
lower price. Although the seller opera�ng in pure
compe��on can change its own price upward or
downward, the profit-maximizing thing for the individual
seller to
do is to accept the market price level (unless there is
evidence of excess demand or excess supply).
There are many markets with many sellers of
undifferen�ated products that fulfill the characteris�cs of
pure compe��on. Examples are:
the (stock) market for ownership shares in listed public
companies, which determines the price of one unit of stock in a
par�cular company at any
par�cular �me;
the loanable funds market, which determines the interest rate
(borrowing price) for loans of any specific period and risk
profile, issued in any specific
currency;
the bond market which determines bond prices for the bonds of

a specific company with a specific dura�on remaining before
those bonds are redeemed;
the foreign exchange market, which determines the exchange
rate for a par�cular na�onal currency (i.e., price of that
currency in terms of other
currencies); and
the market for undifferen�ated agricultural products such as
milk, eggs, corn, and co�on.3
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.1#Ch7footNote3)
In all these markets, price determina�on takes place all
day every day, and prices move upwards or downwards
many �mes each day according to whether
there is temporarily excess demand or temporarily excess
supply in the market at the prevailing price level.
In Figure 7.1, we show the market demand and supply
curves for a par�cular iden�cal products market. The
market demand curve is the summa�on of the
demand curves of individuals, as we saw in Chapters 3
and 4. Note that it slopes downward to the right so more
will be demanded at lower prices than at
higher prices. This follows from the u�lity-maximizing
behavior of individuals who, as we saw in Chapter 3, will
a�empt to equalize the ra�o of marginal
u�lity to price (MU/P) for all products and services they
consume. If the price of product X has fallen, other
things being equal, the MUx/Px ra�o
for the last unit purchased of product X must have
increased, so consumers will buy more of X to restore the
u�lity-maximizing balance of MU/P across all
goods and services purchased. This subs�tu�on in favor

of product X does not go on forever because the MU of
any par�cular product or service declines
(due to the law of diminishing marginal u�lity) as the
individual consumes more of that item. So MUx falls as
more of product X is consumed un�l a new
u�lity-maximizing combina�on of products and services is
found (for each consumer) that necessarily includes more
of product X than it did at the higher
price. Thus, the market demand curve slopes downward to
the right because more units are demanded at lower prices
than at higher prices.
Conversely, the market supply curve slopes upward and to
the right so more is supplied to the market when the
price is higher than when it is lower. The
market supply curve reflects the summa�on of the supply
of all the firms opera�ng in the market for a par�cular
product or service. It slopes upward to the
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right because of the profit-maximizing behavior of
suppliers who are subject to the law of diminishing
returns in their produc�on processes. This law, you
will recall from Chapter 5, reflects the declining marginal

product (MP) of the variable input factors as these are
applied progressively and more intensively
to the fixed factors of produc�on. We saw in Chapter 5
that diminishing marginal produc�vity causes the marginal
cost (MC) of produc�on to rise
progressively as the output rate increases.4
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.1#Ch7footNote4) The profit-maximizing firm will
not want to
supply output at levels where the MC (which equals
incremental cost in this case) is higher than the price
(which equals incremental revenue in this case).
But at a higher market price the profit-maximizing firm
would willingly supply more units of output, since the
incremental revenue would exceed MC for at
least one more unit of output. When all sellers act in this
same way, it is clear that the aggregate amount they
supply to the market must increase when
the market price is higher and decrease when the market
price is lower—thus the market supply curve slopes
upward and to the right.
In Figure 7.1, we demonstrate the existence of excess
demand at price P1, where Q2 is demanded but only Q1
is supplied. This excess demand will leave a
quantum of demand (equal to Q2–Q1) unsa�sfied and you
can see that all of those poten�al buyers would be
willing to pay P1 or more to purchase the
product.5
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.1#Ch7footNote5) These unsa�sfied buyers will offer
to purchase at prices higher than P1 and the

price will dri� upwards toward the price (P*) at which
there is no excess demand le�. For example, suppose that
in the egg market there is an automated
auc�on system to determine the market price. The
auc�oneer would first propose an ini�al price, such as P2
(per dozen of a par�cular quality, such as
extra-large free-range eggs) and the poten�al buyers (i.e.,
food stores) enter their bids to buy various quan��es at
that price, and the poten�al sellers enter
their bids to supply various quan��es at that price.
Suppose the automated system then calculates that quan�ty
demanded (Q2) exceeds quan�ty supplied
(Q1). The auc�oneer (or the automated system) then
proposes a somewhat higher price and the poten�al buyers
and sellers adjust their offers accordingly.
We expect the buyers to want to buy somewhat less at
the higher price as they will be ac�ng to maximize their
profits and know that they face a
downward-sloping demand curve for this product in their
retail stores. Conversely, we expect the sellers to offer
somewhat more eggs to the market at a
higher price because, although they face increasing
marginal costs of produc�on, the higher price will cover
the incremental costs of addi�onal supply.6
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.1#Ch7footNote6) If there is s�ll excess demand at
the higher price, the auc�oneer again proposes a s�ll
higher price, and this process con�nues un�l the quan�ty
demanded just equals the quan�ty supplied (i.e., Q*) at
the equilibrium market price (P*).

Figure 7.1: Market supply and demand curves and the
equilibrium market price
Oppositely, if the price is ini�ally at the higher level,
P2, the quan�ty supplied will greatly exceed the quan�ty
demanded by the amount shown in Figure 7.1
as "Excess supply." Suppliers will find that there is
insufficient demand for their products and they will have
unplanned accumula�on of inventory (if the
product is tangible) or underemployed workers and
facili�es (if the product is a service). This will induce
suppliers to reduce their quan�ty supplied (or
output levels if supplied in real �me) while offering
excess inventory of the product for sale at lesser prices.7
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.1#Ch7footNote7) Because (in pure compe��on) the
firms' products are perceived to be iden�cal, the buyers
will buy from any seller asking a lower price causing
sellers who maintain the higher price to sell nothing at
all. Thus, prices will fall un�l the excess supply
situa�on is removed, and this occurs at price P*. At
price P* there is neither excess demand nor excess
supply, and thus there are no longer any market
forces opera�ng to either raise or lower the price, and
thus we say that P* is the equilibrium price. As noted in
Chapter 1, the equilibrium price is also
known as the market-clearing price, as its clears the
market of all products to be sold.
The Profit-Maximizing Output for Firms in Pure Competition
We have argued above that the profit-maximizing firm will

want to raise its output rate if the market price is higher
and reduce its output rate when the
market price is lower. We will now explain more fully
how the price-taking firm, opera�ng in an undifferen�ated
market where price is determined by
market forces, makes its output-rate decision. In Figure
7.2, we show the market price determina�on in the le�-
hand graph and the firm's output rate
decision in the right-hand graph. We extend a line across
from the market graph to the firm's graph to signify the
price level that the firm must set; in
effect, that line becomes the demand curve for the purely
compe��ve firm. A demand curve shows how much a
firm can sell at various price levels—in this
case the purely compe��ve firm can only use one price
level, but it can sell any amount (i.e., all that it wants
to) at the market price level. Thus, we showProcessing
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The foreign exchange market is an

example of pure compe��on. Price
determina�on occurs daily, and prices
shi� several �mes each day according to
whether there is temporarily excess
demand or supply in the market at the
prevailing price level.
© TongRo Image Stock/Thinkstock
the firm's demand curve as the horizontal line labeled d.
Since the firm can sell any number of output units at the
market price, its marginal revenue, which
is defined as the change in total revenue (TR) due to a
one-unit change in the output rate, or MR = ΔTR/Δq,
must be equal to price, and thus the MR curve,
shown as mr, is depicted by the same line as the demand
curve for firms opera�ng in pure compe��on.
Now, to maximize profit at the market-determined price
the firm must choose its output level such that marginal
costs (MC) are equal to marginal revenue
(MR). To understand why profits are maximized when MC
= MR, consider a situa�on where MC > MR; this would
mean that the last unit of output adds
more to total cost (TC) than it adds to total revenue (TR)
and thus it must reduce profit. Conversely if MR > MC
this would mean that the last unit of output
adds more to TR than it adds to TC, and thus its
produc�on and sale must increase profit. It follows that
produc�on should be increased to the output level
where MC = MR (but not beyond this output level) if the
firm wishes to maximize profit. In Figure 7.2, we can see
this occurs at the output rate depicted as
q*. Note that if the firm produced even one extra unit
beyond q*, the point on the MC curve would lie above
the mr curve, and thus profits would be

reduced. Conversely, if the firm produced one less unit
than q* the relevant point on the MC curve would be
less than the MR and the firm would have
foregone an opportunity to make a small addi�onal
contribu�on (since incremental revenue would be higher
than incremental costs) to the firm's profit.
Thus, the profit-maximizing rule is to set output level such
that MC = MR, which in the case of the firm in pure
compe��on is the same as se�ng output
such that MC = P.
Figure 7.2: The firm's choice of output rate in pure compe��on
No�ce that the area of the shaded rectangle in Figure 7.2
represents the firm's profits. The area of a rectangle
equals height by width, of course. The height
of the shaded box is equal to the difference between price
and the short-run average cost at output level q*, that is
P*–SACʹ, which is the (average) profit
per unit at output level q*. The width of the box is
equal to the number of units produced. Thus, total profits
are equal to average profit per unit �mes the
number of units, shown as the area of the shaded
rectangle. The difference between price and SAC (i.e., P*
– SACʹ) is also known as the price–cost margin
or simply the profit margin.
Also no�ce that in Figure 7.2 we have used lowercase
le�ers to depict the firm's demand, marginal revenue, and
output levels to avoid confusion with the market-level
demand and output variables. The rela�onship between big
Q* and li�le q* is interes�ng, however. Since we have
shown a representa�ve or average firm, we can say that
Q* =
nq* where n is the number of firms in the industry—the

profit-maximizing outputs of the many small firms must
add up to the total amount supplied to the market at
price P*, namely Q*. (Obviously the scales on the
horizontal
axes in Figure 7.2 are different for the market graph and
the firm's graph.)
Shifts of Market Demand and Supply Curves
The equilibrium market price is temporary, however, since
any shi� of either the market supply curve or the market
demand curve will cause a situa�on of either excess
demand or supply to arise, and thus price will move
towards a
new equilibrium level. Such price adjustments happen
con�nually in the stock markets, funds markets, bond
markets, foreign exchange markets, and in agricultural
commodity markets. So, firms that operate in purely
compe��on markets should expect market price to change
from �me to �me, and will need to respond quickly to
adjust their output levels so that they can maximize
profits under the new market condi�ons.
In Figure 7.3, we show a shi� in the market demand
curve due to a change that has happened in the
consumers'
world. Perhaps their incomes have increased, or they have
had a change in tastes towards this product. Or, perhaps
the price of another product complementary in
consump�on has fallen, or for some other reason (as
discussed in
Chapters 3 and 4), individual demands for this product
have increased and thus the aggregate or market demand
has shi�ed to the right. Since this demand shi� will
cause excess demand at the former equilibrium market
price P*, the price will be quickly adjusted

upwards towards a new equilibrium price P**.
Figure 7.3: Output adjustments by firms due to a shi� in market
demand curve
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Law of Demand and Supply
The individual firm's response to the higher market price
will be to increase its output up to the point where MC
equals the new marginal revenue level,
which is shown as mrʹ in Figure 7.3. You can observe
that the firm's profit has increased substan�ally, being
equal to the much larger rectangle (in darker
shading) defined by its height (the ver�cal distance
between the new price level P** and the somewhat higher
SAC level at output level q**) and its width
(the number of units at the new profit-maximizing output
level q**).
Also, note that the increase in the equilibrium market
supply (from Q* to Q**) must be equal to n
�mes the increase in supply of the individual firm (from
q* to q**), where n is again the number
of firms in the industry. Note that we have now explained
both the ini�al (Q*) and the subsequent

(Q**) market equilibrium quan��es supplied as the
aggregate of the amounts supplied by the
many firms in the industry in each situa�on. What is true
for two aggregate output levels can be
shown for other output levels as well. Thus, you will
appreciate that the market supply curve S is
actually the horizontal summa�on of the MC curves of
the many firms in the industry.8
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.1#Ch7footNote8) Indeed, the MC curve (for firms
in
pure compe��on) is effec�vely the individual firm's
supply curve, since it shows what output level
the individual will supply at various price levels. We saw
in Chapter 3 that the market demand
curve D is the horizontal summa�on of the individual
consumers' demands at various price levels.
Thus, individual suppliers and individual consumers jointly
determine the market price in markets
for undifferen�ated products. These market forces that
cause price to rise when there is excess
demand and to fall when there is excess supply are
simply the result of individual consumers and
suppliers trying to maximize their u�li�es and their
profits, respec�vely.
3. Just as in the stock market example where we view the
market for one company's stock (e.g., Google) to be a separate
market from the market for another company's stock (e.g.,
Facebook), in these other markets, we view different quali�es
of product (e.g., eggs from hens in cages versus eggs from free-
range hens) as separate markets. In the market for free-
range eggs, for example, most consumers will regard the various

suppliers of free-range eggs to be supplying iden�cal products
(in the absence of significant brand name recogni�on
that would differen�ate these products of compe�ng suppliers).
So, although buyers will compare the products offered across a
product category as differen�ated subs�tutes (e.g.,
bonds with different maturi�es issued by different firms) they
will choose the bond that offers the superior value proposi�on
from their point of view, and in that bond market (e.g.,
for a bond issued by a par�cular organiza�on with a par�cular
maturity) they will expect to pay the market-determined price.
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4. The output rate refers to the number of units of output
produced per period of �me, shown as Q/t in the figures, to
refer to output levels in any one produc�on period. An
increased
rate of output necessarily requires increased input of the
variable inputs and involves the law of variable propor�ons (or
the law of diminishing returns to the variable inputs). For the
most part, we will simply say increases or decreases in output,
or in output levels, but keep in mind that in the short-run
context we mean the output rate per period of �me. [return
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5. The demand curve not only shows the maximum quan�ty
buyers will demand at any price, but simultaneously shows the
maximum price they will pay for any quan�ty. Note that all of
the buyers between Q1 and Q2 are willing to pay a price higher
than P1 (except for the very last buyer who is prepared to pay
only P1). [return
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6. Note that eggs can be held in cold storage for weeks and that
the sellers can decide to supply more eggs from storage if the
price is high enough or conversely, take some or all their
eggs back into storage if the price is not high enough. [return
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7. The upward-sloping supply curve reflects the rising MC
levels of individual suppliers. For those firms, MC (incremental
costs) should not exceed price (incremental revenue) if they are
to maximize profit. When the market price is lower, MC > P for
the later units of produc�on. So the firm must reduce its output
rate to reduce its MC and avoid making losses on
output units produced when MC is higher than the market price.
Price will tumble down from P2 to P* because at least some
firms will sell their build-up of excess inventories at prices
below P2 and no buyer will be willing to pay a higher price for
an undifferen�ated product if a lower price is available
somewhere in the market. [return
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8. The industry supply curve should be drawn as somewhat
curved, as in Figure 7.4, to reflect it being the horizontal
summa�on of the firms' MC curves which are typically curved.
[return
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The entry of new firms can only occur in
the long run. When the barrier to entry is
low, new firms will con�nue to sprout up
in the industry as long as its profits are
superior to those obtainable in other
industries.
© Peter Beck/Corbis
7.2 Long-Run Adjustments in Pure Competition
In Table 7.1, we noted that there are many firms in
purely compe��ve industries because there are no barriers
to
entry, which means that other firms can enter the industry
if they want to. Of course, they will want to in the

case we have just seen—the healthy profits being earned
by the representa�ve firm in the above situa�on will
surely a�ract the entry of new firms keen to share in the
profitability of this industry. Entry of new firms can only
happen in the long run which, as we saw in Chapter 5,
is the hypothe�cal situa�on in which a firm can change
the fixed inputs necessary for produc�on. Some of these
new entrant firms will be new firms started by
individuals keen to be self-employed rather than work in
another firm as an employee, while other new entrant
firms will be exis�ng firms star�ng to produce the focal
product as a product-line extension or exis�ng firms
leaving industries that are unprofitable or less profitable
and moving their resources into this more-profitable
industry. In the case of entry by start-up firms, these
firms must change their fixed resources from zero to some
finite plant size, while firms switching into produc�on of
this product must acquire at least some new industry-
specific fixed resources in order to produce the product
that is characteris�c of the industry.
Because the market supply curve is the horizontal
summa�on of the individual firms' MC curves, it is
evident that
the entry of new firms must shi� the industry supply
curve to the right, and we know that this will cause
excess
supply (assuming market demand is unchanged) and, thus,
the market price will fall to a new equilibrium level.
This will cause each firm to reduce its output level in
order to maximize profits under the new condi�ons and
the
level of profit for the firms will be smaller than before
as a direct result of the entry of the new firms. Indeed,
if
there are no barriers to entry, new firms will con�nue to

enter this industry as long as its profits are superior to
those obtainable in other industries, such that eventually
all profit will be squeezed out of this industry, as we
shall see.
Choice of Plant Size in the Long Run
In Chapter 5, we noted that in the long run the firm can
switch to any other size of plant and that, in so doing, it
might experience economies of plant size,
constant returns to plant size, or diseconomies of plant
size. That is, a larger plant size might cause the SAC
curve to sit lower, or at the same level, or at a
higher level than the current plant size. So, if the entry
of new firms reduces the profits of exis�ng firms, the
exis�ng firms should inves�gate whether a
different (larger or smaller) plant size would allow them
to be more profitable.
But, in fact, the situa�on facing the firm producing
undifferen�ated products in an industry with no barriers
to entry is worse than that—there is generally
only one plant size that will allow them to even survive,
and that is the one we called (in Chapter 5) the op�mum
size of plant, which is the SAC that is
nested at the lowest point of the long-run average cost
curve (LAC). In Figure 7.4, we show an LAC curve and
the op�mum size of plant is denoted as SAC*.
Imagine that the representa�ve firm is ini�ally opera�ng
the smaller plant size shown as SACʹ and the equilibrium
market price is ini�ally P* reflec�ng the
intersec�on of the ini�al market demand and supply
curves D and S. The representa�ve firm's profit-
maximizing output level is ini�ally q* where MC = mr
under the ini�al market and industry condi�ons.

Figure 7.4: Movement to the op�mum plant size in the long run
At the ini�al market demand (D) and supply (S)
situa�on, the representa�ve firm is making a healthy
profit, since the market price P* is higher than its
average costs (on the SAC' curve) at the profit-maximizing
output level q*. But the existence of this profit will
a�ract the entry of new firms in the long run.
The poten�al for exis�ng firms to make even larger
profits by building the op�mum size of plant will result
in addi�onal supply of product from these firms,
which must shi� the market supply curve to the right, as
shown by Sʹ in the le�-hand side of Figure 7.4. If just
the right number of new firms enter the
market, and all firms adopt the op�mum size of plant,
the supply curve will be shi�ed across to Sʹ, which will
force the equilibrium price down to P** just
equal to the minimum level of the LAC curve. You can
see that the only way that the representa�ve firm can
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SAC* since it is inevitable that the market price will fall
to the long-run equilibrium price level P**, which just
covers average costs at the minimum point of
LAC* (where MC* = mr*). If it fails to move to the
op�mum plant size before too many new firms enter the

industry it will be le� stranded with a higher
cost structure, will take losses, and may be unable to
afford to build the op�mum plant size that will allow it
to remain in the industry.9
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Normal Profit in the Long Run
But why would a firm want to stay in an industry if the
price is just equal to the level of average costs? Does
this mean the firm is making no profit at all?
Well, no, it does not, because we are speaking in terms
of economic costs (see Chapter 5) meaning that the costs
include the opportunity costs of being in
this par�cular industry—that is, the cost curves include,
as a foregone opportunity cost, the return on investment
that could have been obtained in the
next-best-alterna�ve investment opportunity. That means
there is no incen�ve to shi� from this industry to the
next-best-alterna�ve industry because the
firm is already earning what it could earn in that
alterna�ve industry. When price is just equal to SAC,
economists say that the firm is earning normal profit,
meaning the profit level is as good as the firm could earn
elsewhere. So, suppose the firm could alterna�vely have
earned 5% return on investment (ROI) in
the next-best-alterna�ve use of its resources (in a
different industry); normal profit in the chosen industry
represents a 5% rate of return on investment.
Conversely, when price exceeds SAC, like in the shaded
box in Figure 7.2, economists say the firm is earning pure
profit, or excess profit, also known as
economic profit, which is a be�er profit rate than it

could earn elsewhere (i.e., > 5% ROI in this example).
If the firms in a purely compe��ve market are making
losses in the short run, due to too many firms in the
industry, they will want to sell up their fixed
resources and invest in a different industry as soon as
they can—that is, in the long run. Some of these firms
will have smaller financial reserves and will be
forced to close, or will find a buyer sooner than others,
and as they do stop supplying output, the market supply
curve will move back to the le�, li�le by
li�le, un�l a new market equilibrium is a�ained and all
remaining firms can earn normal profit again. Examples of
this kind of adjustment are seen in small-
farm agriculture and also in the coastal fishing industry:
when prices are "bad," some firms cease supplying the
market and sell their farm or their fishing
boat, reducing total supply. When prices rise again, others
buy the assets (farms or boats) and enter the industry,
forcing prices down again, and this
process con�nues with profits oscilla�ng around the
normal profit level.
What we have seen here, in the context of an industry
with no barriers to the entry of new firms and where the
firms produce undifferen�ated products, is
that while firms may make pure profits in the short run,
they can only expect to make normal profits in the long
run.10
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.2#Ch7footNote10) In the next sec�on we look at
firms producing differen�ated products in other market
forms where they are protected by barriers to the entry of
new firms, and we will see that such firms can make

pure profits in the long run.
9. Note that a late move to the op�mum size plant by an
exis�ng firm would shi� the market supply curve to the right
and depress market price below the LAC curve. Thus, all firms
would take losses and would wish to exit the industry. Some
would be able to liquidate their fixed assets sooner than others
and would leave, thus causing the market price to rise,
such that all remaining firms would no longer be taking losses
and would no longer want to exit the industry. Note also that
short-run profits may induce a flood of new entrants
(ac�ng independently) such that the market price might be
forced down below minimum LAC. This would cause some
firms to exit the industry un�l exactly the right number of firms
remain in the industry, such that market supply and demand
intersect at an equilibrium price level that is just equal to the
minimum level of the LAC curve. [return
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10. The pure compe��on long-run equilibrium assumes that all
pure-profit opportuni�es elsewhere have already been taken;
that is, in the absence of barriers to entry, new firms keep
being established to exploit pure-profit opportuni�es un�l
there are none le�. The long-run equilibrium situa�on (where
all firms make only normal profits) is never likely to be
observed in prac�ce because market demand and supply curve
are con�nually shi�ing back and forth due to exogenous
shocks, causing the firms to be con�nually adjus�ng to those
changes. [return
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A farmer's market is an example of
monopolis�c compe��on because there
are many vendors offering slightly
differen�ated products. Some vendors
might have friendlier service or be�er
looking produce than the compe��on.
© iStockphoto/Thinkstock
7.3 Monopolies and Oligopolies
As we saw in Table 7.1, there are three market forms in
which the firms' products are differen�ated, namely
monopolis�c compe��on, oligopoly, and
monopoly. In the following subsec�ons we shall examine
the firm's pricing and output decision for profit
maximiza�on in each of these market structures.
The common theme is that these firms are price-makers
and face downward-sloping demand curves (at the firm
level), which means that they can sell more

output at lower prices and less at higher prices. Thus,
they have a combined price and output decision to make.
Monopolis�c compe��on is characterized by many firms
producing slightly differen�ated products in an industry
that has no barriers to entry. Thus, it is different from
pure compe��on in only one way: the firms' products are
differen�ated rather than iden�cal. Because the products
are differen�ated, raising price slightly above the price of
rivals will not cause sales to fall to zero (as it would in
the iden�cal products case). While some customers will
switch to another product when the firm raises its price
slightly, most customers will remain with the firm,
because
they believe the firm s�ll offers them the best value
proposi�on even at a slightly higher price. You will
recall from
Chapter 3 that the value proposi�on can be characterized
as "quality over price." Different percep�ons of quality
underlie the percep�on of product differen�a�on. In
monopolis�c compe��on different customers look at the
compe�ng products from their own individual perspec�ves
and perceive qualita�ve differences that either do appeal
to them (or do not), thus inducing them to pay more (or
less) for the different products.
An example of monopolis�c compe��on would be a
farmer's market, where some of the vendors have more
friendly
personali�es, and some of the vendor's apples are shinier
and less marked than others. You might willingly pay five
cents more per apple if the seller was friendlier and the
apple was perfect compared with another nearby seller
who was grumpy and had blotchy apples. But, if the
former seller raised his price by another 10 cents you
might

change your mind and buy the cheaper less-perfect apple
from the less-perfect vendor. Others might s�ck with the
friendly seller at the higher price even when the price is
raised by an addi�onal 10 cents because in their minds it
is
s�ll the best value proposi�on. Another example of
monopolis�c compe��on might be coffee shops in large
ci�es;
people will see them as differen�ated on one or more
criteria that are important to them (e.g., coffee taste,
convenience of loca�on, cheerful vendor) and will prefer
one over the others. However, this preference will not be
sustained if their preferred seller raises its price by too
much—another seller's product then becomes a be�er value
proposi�on. A third example might be clothing retailers in
large shopping malls. O�en there are dozens of compe�ng
clothing stores in a large mall, and the clothes for sale
typically differ between the stores, the quality of service
may
differ, and some stores are closer to the parking lot. Even
when two or more stores sell exactly the same dress, the
"product" (which includes the a�ributes of service quality,
shopping ambiance, and convenience of loca�on) is likely
to be seen as slightly differen�ated.
Accordingly, some of these firms will have slightly higher
prices and others slightly lower prices for their similar
but differen�ated products, and all firms
could raise their prices slightly without losing all their
customers. On the other hand, if they reduced prices
slightly, they would gain a significant number of
customers, but many others would ignore the price
reduc�ons and s�ck to their current supplier.11
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote11)

The demand curve for a monopolis�c compe�tor will be
downward sloping but rela�vely flat. That is, there will
be a rela�vely price–elas�c demand
reac�on to price increases or price decreases, meaning
that the percentage change in quan�ty demanded would be
significantly larger than the percentage
change in the firm's price level, as we learned in Chapter
4. Also in Chapter 4 we learned that when the firm's
demand curve is downward sloping, total
revenue (TR) will rise at first and later fall as price is
varied from rela�vely high levels to rela�vely low levels,
such that the TR is represented by an inverse
U-shaped curve, sloping upwards at first, reaching a
maximum, and sloping downwards therea�er as price is
reduced s�ll further (see Figure 4.2 in Chapter
4). Since marginal revenue (MR) is the rate of change of
TR, we saw that it falls progressively, reaches zero at the
midpoint of the demand curve, and is
nega�ve therea�er. This rela�onship between the demand
curve and the MR curve for a monopolis�c compe�tor is
shown in Figure 7.5, but note that
because the firm's demand curve is highly elas�c the MR
curve does not become nega�ve (i.e., cut the horizontal
axis) within the range of outputs relevant
to the firm's SAC and MC curves in Figure 7.5. The
profit-maximizing rule remains the same: The firm should
set price and output such that marginal costs
equal marginal revenue, in this case MC = mr. Thus, the
firm sets price P and output level q and consequently
maximizes profit, which is shown as the
rectangle equal to the average profit (i.e., P – SAC)
�mes q units.
Figure 7.5: Price and output determina�on for the firm in
monopolis�c compe��on

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Long-Run Adjustment in Monopolistic Competition
Because this firm is making pure profit and there are no
barriers to entry in monopolis�c compe��on, other firms
will be mo�vated to enter this industry
producing similar but differen�ated products un�l all the
pure profit is squeezed out. As in purely compe��on
markets, the exis�ng firms must adjust their
plant sizes to ensure that they can make normal profits
rather than losses (which would force them to exit the
industry). In Figure 7.6 we show the long-run
equilibrium outcome for firms opera�ng in a
monopolis�cally compe��on market. Their demand curve
has shi�ed to the le� as new rivals con�nue to enter
and "steal" some of their sales. They can only survive if
they build the size of plant (SAC*) that is tangent to the
LAC at the point where the LAC is tangent
to their demand curve, such that P = SAC = LAC, and
separately MC = mr, of course.
Figure 7.6: Long-run equilibrium for the firm in monopolis�c
compe��on

Thus, the firm in monopolis�c compe��on faces the
same fate as the firm in pure compe��on; that is, other
profit-seeking firms will enter the industry and
squeeze out all the excess profits. The firms will
nonetheless con�nue in business in their chosen industry
because their economic cost of produc�on
includes the opportunity cost of using their resources in
the next-best-alterna�ve industry. The lesson to be learned
is that absence of barriers to entry
means that while these firms may earn pure profits in the
short run they cannot expect to earn pure profits in the
long run. We turn now to the remaining
market forms that are characterized by barriers to the
entry of new firms, and consequently examine situa�ons
where the firms can make pure profits in
the long run.
Oligopoly
An oligopoly is a market in which there are only a few
sellers; the word is derived from the Greek word oligos,
meaning few and the La�n word polis,
meaning seller. "Few" in this context means a number
small enough so that the ac�ons of any one firm have a
no�ceable impact on the demand for each of
the other firms in the market. Few also means that the
firms will each have a significant share of the total sales
in the market, and this market share
becomes an important yards�ck by which they measure
their success in the market. In the real world, the great
majority of markets are oligopolies—
prominent examples are the aircra�, automobile, steel,
chemical, and pharmaceu�cal industries. These are na�onal
and in some cases interna�onal

oligopolies. In other industries, where there are hundreds
or even thousands of firms na�onally or globally, firms
will cons�tute oligopolies in the local or
regional area due to transporta�on costs or consumer
ignorance. For example, your bread would come from one
of a few local bakeries, your car would be
bought from one of a few local dealerships, ready-mixed
cement would be sourced from a few local cement
companies, and so on. Looking at this from the
customer's viewpoint, an oligopoly exists when a typical
customer considers only a few sellers when making a
purchase decision, such that the sale made by
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The aircra� industry is an example of an oligopoly
because it is a
market in which there are only a few sellers.
© iStockphoto/Thinkstock
one seller is in effect a sale missed by another. If one
seller conducts a promo�onal campaign or reduces its
price, its sales increase substan�ally and the
sales of the other firms decrease significantly, unlike
monopolis�c compe��on where the gain of sales to one
firm were spread as insignificantly small

reduc�ons of demand across many rivals.12
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote12)
Thus, oligopolists suffer from mutual dependence, meaning
the ac�ons of one firm
impact upon the others, and vice versa. Restric�ng our
discussion to price and output
changes for the moment, the focal firm opera�ng in an
oligopoly will soon learn that
when another firm makes a price reduc�on and gains a
substan�al increase in sales, the
focal firm suffers a significant decrease in sales. This also
works the other way around
when the focal firm reduces its price. The firm will also
learn that when it increases its
price, it loses a substan�al propor�on of its sales while
other firms gain significantly, and
vice versa. Recogni�on of this mutual dependence will
cause oligopolists to predict the
reac�ons of rivals to their compe��ve ac�ons. If a firm
expects that its rivals will react to
its price reduc�on by also reducing price (to avoid loss
of market share), the firm may
decide that it is not worthwhile cu�ng price. Sales
volume would increase only slightly,
but there would be a reduced price for all units of output
that would have been sold at
the original (higher) price. Similarly, if the firm expects
that other firms will ignore its
price increase (since their sales volumes would increase
significantly) it may decide that a
price increase is not worthwhile. In the following
sec�ons, we shall discuss two scenarios
o�en experienced by oligopolists that are based on the
firm's predic�on of how rivals

will react to its price changes. The first is the kinked
demand curve, which results in prices not being adjusted
very frequently despite changes in cost or
demand condi�ons, and the second is conscious parallelism,
which results in prices being adjusted every �me there is
a significant change in cost or demand
condi�ons.13
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote13)
The Kinked Demand Curve of Oligopoly
Oligopolists face a kinked demand curve when they expect
rivals to ignore a price increase (to gain market share)
but to match a price decrease (to protect
their market share) and this arises because the demand
curve for a price increase is highly price elas�c while the
demand curve applicable for price
reduc�ons is highly price inelas�c.14
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote14) That is, for price increases above
the current price,
quan�ty demand would decrease along a rela�vely flat
demand curve, while for price decreases the quan�ty
demanded would increase along a rela�vely
steep demand curve. Thus, the demand curve faced by the
firm is made up of two segments of different slopes that
join at the current price level, and thus
the firm's demand curve has a kink at the current price
level, as shown in Figure 7.7.
Figure 7.7: Price rigidity with a kinked demand curve

Although this figure looks complex, you already have the
knowledge to interpret it. The kinked demand curve
(shown as the kinked line dadʹ, or the line
connec�ng the points d, a, and dʹ) is made up of sec�ons
of two different demand curves. The upper sec�on of the
kinked demand curve (i.e., the sec�on
da) is the demand curve that is appropriate for independent
price increases, and the lower sec�on (i.e., adʹ) is the
demand curve appropriate for joint price
reduc�ons. Similarly, the marginal revenue curve (the
disjointed line db-cmr) is made up of two parts of the
marginal revenue curves that are associated
with the relevant sec�ons of the demand curve, with a
gap (b-c) between the two tangible sec�ons.15
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote15) Note that each of the marginal
revenue curves is located such that it has the same
ver�cal
intercept and twice the slope of its "parent" demand
curve, as we learned in Chapter 4. Now note that I have
shown the MC curve passing through the gap
in the marginal revenue curve. Thus, if the price were to
be raised above price P, the price-quan�ty coordinate
would move back along the independent-
ac�on demand curve (i.e., sec�on da) and MR would
exceed MC, indica�ng that the firm should increase its
output rate to maximize profit. Conversely, if
the price were to be reduced below P along the joint-
ac�on demand curve (i.e., sec�on adʹ), output would
increase, MC would exceed MR at any higherProcessing
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When the cost of avia�on fuel increases, airlines respond
by raising
airfares. This is an example of conscious parallelism.
© Comstock/Thinkstock
output rate, so profit would be increased by raising price
back to where it was. Thus, the current price level P is
indeed the profit-maximizing price, with the
magnitude of profit depicted by the rectangle defined by
the price–cost margin (P-SACʹ) �mes the number of units
sold, q.
Since the MC curve passes through the gap in the
marginal revenue curve, costs condi�ons could change
substan�ally without causing the price to change.
For example, the MC curve could shi� ver�cally up or
down a considerable distance yet s�ll remain within the
gap in the MR curve. Similarly, with the MC
curve unchanged, changes in the customers' incomes or
preferences that cause the demand curves to move either

to the right or to the le� would shi� the
gap in the MR curve (to the right or the le�, within
limits) without causing the MC curve to intersect a solid
sec�on (either db or cmr) of the MR curve.
Thus, the current price would remain the profit-maximizing
price (although the magnitude of profit would rise or fall
due to the shi�s in the cost or demand
curves) and we would see the characteris�c price rigidity
of kinked demand curve oligopoly. That is, price levels
remain fixed at the current level despite
changes in cost or demand condi�ons because of the
firms' expecta�ons that price increases would be ignored
and price reduc�ons would be followed.
Conscious Parallelism in Oligopoly Markets
In many oligopoly markets the recogni�on of their mutual
dependence leads rival firms to adopt an implicit price
leadership model, whereby one firm (the
price leader) ini�ates a price increase and the other firms
(price followers) independently raise price by the same
amount or by a similar percentage. Note
that an explicit agreement to jointly adjust prices would be
quite illegal under collusive pricing provisions of the
An�-Combines Act in the United States (or
under similar laws against price fixing in other countries).
It is not illegal, however, for one firm to raise price
independently and take the risk that others
will not follow. If rival firms subsequently also raise their
prices to a similar extent, all firms will avoid the kink,
since quan�ty demanded would move
upwards along an extension of the more inelas�c (joint-
ac�on) part of the oligopolist's demand curve.
In prac�ce, we o�en see firms in oligopoly markets
independently but more or less

simultaneously adjus�ng their prices upward (or downward)
in response to cost or demand
increases (or decreases) that are common to them all.
Typically commercial banks all raise (or
lower) their interest rates on consumer loans, home
mortgages, and business loans over the
few days following the central bank (the Federal Reserve
in the United States) raising (or
lowering) the rate at which it lends money to the banks.
Airlines might independently adjust
airfares upwards by a similar propor�on when the cost of
fuel rises for all airlines.
Manufacturers in a par�cular industry might all raise their
prices at about the same �me due
to the government's implementa�on of a carbon tax
applicable to that industry, and so on.
This has been called conscious parallelism, defined as
firms independently ac�ng in a parallel
fashion while conscious that their rivals have the same
incen�ves to act in the same way at
about the same �me. Given an�-collusion laws it is
impera�ve that rival firms do not
communicate with each other at all about prices or costs,
since evidence of that
communica�on might be held as prima facie evidence of
collusive price fixing.
In Figure 7.8 we show a firm raising its price in
conscious parallelism due to a cost increase
that applies more or less equally to all firms in an
oligopoly. The firm's ini�al price is P and its demand
curve is kinked at point a, causing a ver�cal gap in
the marginal revenue curve through which the ini�al
marginal cost curve (shown as MC) passes.16

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote16) The cost curves then shi�
upwards from MC to MCʹ and from SAC and SACʹ. This
firm,
ac�ng as a price leader, then raises its price from P to
Pʹ in the expecta�on that rival firms will do likewise,
and if this indeed happens the firm effec�vely
moves up the joint-ac�on sec�on of the demand curve
from point a to point aʹ where a new kink would be
expected, since the firm does not expect rivals
to raise their prices by any higher amount.
Figure 7.8: Price leadership through conscious parallelism in
oligopoly markets
In Figure 7.8, you will see that we have also shown the
market demand curve, D, for the industry, and it is drawn
such that the total market demand for the
product is four �mes larger than the quan�ty demanded
of the focal firm at each of the price levels indicated.
This would mean that the focal firm has a
25% share of the market at each price level, and
demonstrates that the joint-ac�on sec�on of the demand
curve is the firm's constant-share-of-the-market
demand curve. In this par�cular case there might be three
other firms each also having 25% of the market, or there
might be more than, or fewer than,
three other firms whose shares of the market sum to the
remaining 75% of the market demand at any par�cular
price. As men�oned previously, oligopolists
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Due to government prohibi�on, the United States Postal
Service has
a monopoly on le�er carrying. Monopolies occur when
there is
only one seller of a par�cular product in a specific
market.
© iStockphoto/Thinkstock
are typically very concerned with maintaining their share
of the market and will tend to achieve this by ac�ng in
conscious parallelism when costs or
demand condi�ons change.
Before we leave oligopoly, note that compe�ng firms do
not need to set exactly the same price levels, as might
seem to be implied by Figures 7.7 and 7.8.
Price differen�als between and among firms are common
in oligopoly markets and reflect both the differences in
the a�ributes contained in the products
(i.e., differences in the firms' costs) and differences in
customer preferences for those a�ributes (i.e., differences
in demand) across compe�ng firms. For
example, a par�cular Mercedes Benz model is typically
sold at a price that is higher than a similar sized and
equipped Ford or Toyota. Such rela�ve prices
tend to be the historical outcome of prior profit-
maximizing adjustments to price by each firm and tend to

be maintained over �me by the prac�ce of
conscious parallelism.17
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote17)
Monopoly
Monopolies are defined as the only seller of a par�cular
product in a par�cular market. This
may be because they are the first firm to supply that
product to that market (such as an
entrepreneurial new venture introducing a new product to
a previously unserved market, or
an exis�ng firm entering a previously unserved
geographical market) or because the entry of
other firms into the market is prevented by barriers to
entry. As discussed earlier in this
chapter, barriers to entry are insurmountable problems that
prevent poten�al entrants from
assembling the necessary resources to begin producing and
selling a compe��ve product. The
inability to gain access to the necessary technology (e.g.,
the monopoly may have a patent on
the technology) or to acquire another indispensable
resource (e.g., there is only one deep
water harbor near a major city and that is controlled by
the port authority) will prevent
another firm from entering the monopolist's market.
Perhaps the major reason for monopoly
markets is government prohibi�on of a second supplier.
For example, the United States Postal
Service is allowed a na�onal monopoly on le�er carrying,
and electricity and gas companies
are o�en granted regional monopoly status for the
provision of these u�lity services.

Since the monopolist firm is the only firm in the market,
the market demand curve becomes
the firm's demand curve, and the monopolist must choose
the profit-maximizing price and
output combina�on on that demand curve. The profit-
maximizing rule is the same, of course, namely MC =
MR. We saw in Chapter 4 that a linear demand
curve has an associated marginal revenue curve that shares
the same ver�cal intercept with the demand curve and has
twice the slope of the demand
curve, as we have shown in Figure 7.9. Superimposing the
firm's short-run cost curves SAC and MC on the demand
and marginal revenue curves, we see
that the monopolist should choose price P and sell output
level Q to maximize its profit in the short run. Its short-
run profit is indicated by the rectangle of
height P – SACʹ (the profit margin per unit) and width Q
(the number of units of output).
Now considering the long-run average cost curve, LAC,
and the associated long-run marginal cost curve, LMC, the
monopolist can increase profit in the long
run by choosing the output level where LMC = MR,
which is shown as Q*, and set the corresponding price
P*. The resultant magnitude of profit in the long
run is shown by the considerably larger rectangle of
height equal to the price–cost margin at output level Q*
(i.e., P* – SAC*) and of width equal to Q*
units of output. Figure 7.9 is already quite busy, so it
does not show the SAC* curve or its related SMC* curve
of the plant size that the monopolist would
choose in the long run—that is your task! To prove that
you understand the analysis, look carefully at Figure 7.9
and tell yourself where in that figure you

would place the SAC* and SMC* curves of the plant that
the profit-maximizing monopolist would want to build and
operate in the long run.18
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#Ch7footNote18)
Figure 7.9: Monopoly price and output choice in the short and
long run
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Natural Monopolies
As men�oned earlier, another reason for the existence and
persistence of monopolies is that they may be natural
monopolies, meaning that even if another
firm did enter the market there would subsequently be a
takeover or merger of the two firms and the market
would revert to a monopoly again. The
inevitable merger of compe�ng firms in a natural
monopoly situa�on is due to the rela�onship between the
limited size of the market and the economies of
plant size available in the industry. If the market demand

curve crosses the LAC curve before the lowest point on
that curve, the two firms opera�ng smaller
plant sizes could make greater profit as a single firm
opera�ng a larger but lower-cost plant size. This is
illustrated in Figure 7.10, where we show the market
demand curve (D) crossing the LAC before its minimum
point.
For simplicity of exposi�on, we assume that there are
ini�ally two firms, each separately opera�ng a rela�vely
small plant size, which we will depict by
lowercase le�ers sac and mc for exposi�onal clarity. For
further simplicity, we assume the two firms share the
market equally, that is, 50% each, and always
match the other's price. Accordingly their joint-ac�on or
share-of-market demand curve (shown as d) will be
coextensive with the MR curve, since both d
and MR lie halfway between the ver�cal axis and the
market demand curve. The joint-ac�on demand curve, d,
will have a marginal revenue curve, shown as
mr, associated with it. To maximize profits, each firm
would set mc = mr, produce output level qʹ and sell at
price Pʹ. The profit of each firm would amount
to the rectangle shown by the profit margin (Pʹ – sacʹ)
mul�plied by the number of units sold, qʹ.
Figure 7.10: Natural monopoly
Now, the owners/shareholders of these two firms will
pre�y soon figure out that if they merged they could
make more profit than they could separately as
compe�tors in a market that is rela�vely small compared
to the available economies of plant size. Opera�ng
independently as compe�ng duopolists (i.e.,
two sellers) they can only make total profit of twice the

profit rectangle shown as (Pʹ – sacʹ) �mes qʹ in Figure
7.10. Merging to become a monopolist would
allow them to build the plant size SAC* and operate it at
the output rate Q* where SMC* = MR = LMC. The
profit of the resultant monopoly firm would
then be the average profit margin (P* – SACʹ) �mes the
output level Q*, which is clearly much larger than the
sum of their previous profits opera�ng as
compe�ng duopolists.
If you understand Figure 7.10, you should be proud of
yourself because it was ge�ng pre�y heavy, wasn't it?
Figure 7.10 incorporated a variety of concepts
newly introduced in this chapter and also called upon
other concepts from earlier chapters, and is probably the
most complex figure in this book. Good for
you if you understood it all the first �me through. If
not, go through the chapter again, maybe when you are
not so �red, and I'm sure it will s�ck the next
�me through.
Regulated Monopoly
Now for something rela�vely simple to finish the
chapter—the situa�on of regulated monopoly. Government
regula�ons o�en are imposed on so-called
public u�lity "monopolists" to prevent them from making
huge profits, o�en from a natural monopoly posi�on, by
charging rela�vely high prices for
electricity (for example) to ci�zens who have no
alterna�ve source of supply. In Figure 7.11, we assume
that the regulators have imposed a ceiling price, or
maximum allowable price, of Preg on the monopolist (who
would prefer set price P* to maximize profits).
Figure 7.11: Price regula�on of monopoly

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If prices above Preg are prohibited, then the demand
curve facing the firm is effec�vely the kinked line that is
horizontal at the level Preg out to point a and
then con�nuing down the market demand curve, D. As we
know, from the oligopoly discussion, a kinked demand
curve means that the marginal revenue
curve must be the discon�nuous line Preg a– bMR, in this
case coextensive with the horizontal sec�on of demand
curve (from Preg out to point a), then
falling abruptly to point b and then con�nuing down the
MR curve. To maximize profit subject to the regulated
price, the monopolist will choose the output
level Qreg (where LMC passes equals marginal revenue at
point a) and build the size of plant that has its SAC
curve (not shown) tangent to the LAC curve at
output level Qreg. The regulators are not likely to be
happy with that, however, since the monopolist is s�ll
making excess profits, because the regulated
price is above the firm's LAC curve. The regulators are
likely to set the regulated price at the lower level Pʹ,

where the LAC curve cuts the demand curve, D,
such that the supply of the u�lity is increased to Qʹ and
the monopoly makes only normal profit where price equals
average costs. Note that marginal
revenue will not equal marginal costs in this situa�on;
the monopolist is prevented from maximizing profits by
the regulator who is ac�ng in the public
interest to facilitate a lower price and a higher output
level for consumers of this product. This form of price
regula�on is known as average-cost pricing.
11. No�ce that lack of informa�on, causing the buyer to be
unaware of the price difference (or price change), is another
reason why some customers do not switch to the lower-priced
supplier. Unless customers know all the prices in all the stores
all of the �me, they may unwi�ngly pay more on some
occasions, being unable to verify if the same or similar item is
available elsewhere as a be�er value proposi�on. If buyers
must incur search costs of �me and money to find out firms'
prices, they might be be�er off simply paying a li�le more for
a
product when its price is raised and thereby avoid those search
costs. [return
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ns/sec7.3#return11) ]
12. Industries with many firms that look like monopolis�c
compe��on when considered na�onally or globally, typically
operate as a series of interlinked oligopolies at the local level
due to
the shopping convenience and informa�on advantages of the
local firms, causing poten�al customers to not consider more-
distant suppliers. But note that Internet shopping, which
offers informa�on, convenience, and lower prices in many
cases, tends to offset these advantages of local firms and may

make such "many firm" industries operate more like
monopolis�c compe��on. [return
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ns/sec7.3#return12) ]
13. There are many other oligopoly scenarios that might be
examined, such as cartel pricing, where the firms act collusively
(and illegally) to set the same price, or raise prices by the same
percentage to preserve their price differen�als. There are also
several price-leadership models of oligopoly, such as low-cost
firm price leadership and dominant-firm price leadership.
These operate in essen�ally the same manner as conscious
parallelism, whereby all firms tend to adjust their prices upward
or downward at about the same �mes, following a price
adjustment by any one firm, and thus preserve their market
shares. [return
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ns/sec7.3#return13) ]
14. Recall from Chapter 4 that price elas�c means that the
percentage change in quan�ty demanded will be higher than the
percentage change in price, while price inelas�c means that
the percentage change in quan�ty demanded will be less than
the percentage change in price. For example, sales might
decrease 20% for a 10% price increase, but increase only 2%
for a 10% price reduc�on. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�o
ns/sec7.3#return14) ]
15. We are calling it a "curve" to follow conven�on, even
though the MR is not curved when it is derived from a linear
demand "curve" and in the case of the kinked demand curve the
MR
is a series of straight line segments! [return
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ns/sec7.3#return15) ]

16. The lower parts of the discon�nuous MR curves are not
shown in Fig 7.8, since they would lie below the horizontal axis
in this case. [return
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ns/sec7.3#return16) ]
17. Marketers speak of "price posi�oning" whereby they choose
strategically to set price at a premium to (above) or at a
discount to (below) the prices of rival firms. Note that unless
the
quality of the product is simultaneously set at a commensurately
higher (or lower) level rela�ve to rivals' quali�es, the price
differen�al will not hold up in the market since customers
will scru�nize compe�ng products looking for the best value
proposi�on, where value equals quality divided by price, as we
saw in Chapter 3. [return
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ns/sec7.3#return17) ]
18. Note that the SAC level at output level Q* must equal the
LAC at that output level, and that the short-run marginal cost
(SMC*) curve needs to equal the MR at output level Q*. Try to
work it out before you look at Figure 7.10! [return
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ns/sec7.3#return18) ]
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Summary
In this chapter, we have been concerned with the
opera�on of business firms in markets, and specifically
with their choice of price and output levels that
will maximize their profits. A�er defining a market as a
situa�on in which buyers and sellers communicate for the
purpose of exchanging value, the four
basic market structures were introduced. These are
categorized on the basis of (a) iden�cal or differen�ated
products; (b) barriers to entry of new firms, or
not; (c) number of compe�ng firms; and (d) expecta�on
of rivals' reac�on to strategic changes.
Pure compe��on is characterized by many firms producing
iden�cal products, no entry barriers, and no expecta�on
of rival reac�ons. Firms in such markets
must take the market-determined price as given and simply
adjust output to maximize profit in the short run, but can

also adjust their plant size to the
op�mum plant size in the long run. While they can make
excess profits in the short run, they will be reduced to
making only normal profit in the long run.
Monopolis�c compe��on is characterized by many firms
producing slightly differen�ated products, no entry
barriers, and no expecta�on of rival reac�ons.
Firms opera�ng in such markets are able to choose their
own price and output levels and can also adjust their
plant size in the long run but will not adopt
the op�mum size of plant because they face a downward-
sloping demand curve. While they can make excess profits
in the short run, they will be reduced
to making only normal profit in the long run, where their
demand curve is forced into tangency with the LAC curve
on the downward-sloping sec�on of that
curve.
Oligopolis�c compe��on is characterized by few firms,
due to barriers to entry of new firms. These firms
produce differen�ated products, and the firms
recognize their mutual dependence and form expecta�ons
about whether or not rivals will follow their price
increases or price reduc�ons. We considered
the kinked demand curve and price leadership via
conscious parallelism whereby firms change prices
independently but expect rivals to act in the same
manner. Oligopolists can make excess profits in both the
short and long run, assuming sufficient market demand.
A monopoly market is characterized by a single seller and
is typically due to insurmountable barriers to entry.
Although a natural monopoly market may
allow entry of new firms, they are des�ned to merge
with, or be taken over by, the monopoly firm due to the

profit incen�ve facing shareholders to
consolidate produc�ve capacity within a single business
en�ty due to the economies of plant size available to a
monopoly firm. Because monopolies can
make excess profits in both the short run and the long
run, governments o�en regulate a maximum price that the
monopoly may charge, and the monopoly
then selects the output level that is profit maximizing,
given this constraint.
In the following chapter, we will u�lize the conceptual
material from this and from preceding chapters to address
pricing by business firms in real-world
situa�ons when the managers do not have the data they
need to simply draw the cost and demand curves and find
the intersec�on of the MC and MR
curves. Instead they must u�lize es�mated demand and
cost func�ons or u�lize rules-of-thumb pricing procedures
that avoid or minimize data search costs
and provide acceptably correct solu�ons to their profit-
maximizing problem.
Ques�ons for Review and Discussion
Click on each ques�on to reveal the answer.
1. Define "market." Explain how people can enter a market
without actually being there.
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A market is a place or a situa�on where poten�al buyers
and sellers can meet in person or by proxy to exchange
items of value (including money).
People can enter markets without being there by using a

purchasing or sales agent, by using an electronic
intermediary (e.g., buying and selling online)
or paper-based statement of willingness to buy or sell at
a par�cular price.
2. What are "barriers to entry"? Does a monopoly or oligopoly
market necessarily have insurmountable barriers to entry?
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Barriers to entry are reasons why new firms cannot enter
some markets. They are either legislated by governments
or are due to the prospec�ve
entrants' inability to purchase or gain control of resources
that are necessary to become established and to compete
in the market. A monopoly or
oligopoly market may not have insurmountable barriers to
entry, but could be a "natural" monopoly or oligopoly in
the sense that although other firms
can enter the market they would soon be absorbed by
merger or takeover. This would occur because shareholder
value would be maximized by a
smaller number of firms in markets that are small rela�ve
to the scale of plant at which diseconomies of plant size
begin.
3. Define product differen�a�on in terms of the a�ributes of
the firm's products or services.
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Product differen�a�on can be defined as the design of
products within a product category such that the products
contain different product a�ributes,

and/or different combina�ons of product a�ributes, and/or
different quan��es of the same product a�ributes.
4. In what way(s) does a monopolis�cally compe��ve market
differ from a purely compe��ve market?
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Monopolis�cally-compe��ve markets differ from purely-
compe��ve markets in that the former supply
differen�ated products whereas the la�er supply
iden�cal or undifferen�ated products. They share the
characteris�cs of many firms, due to no barriers to entry,
and firms having no expecta�on of rival
reac�ons.
5. Under what circumstances would an industry that has many
firms opera�ng na�onally be perceived by customers to be an
oligopoly?
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