Fundamental Questions

1.Why do economists and accountants measure profits differently?

2.How do firms decide how much to supply?

3.What is a market structure?

4.What are price takers?

5.What are price makers?

Teaching Objectives

The primary purpose of this chapter is to introduce the students to the concept of a market structure and to describe the characteristics and operations of perfect competition, monopoly, monopolistic competition, and oligopoly. Since profit maximization is an important concept in understanding market structure, this chapter also distinguishes between economic and accounting costs. The chapter also stresses the marginal-revenue and marginal-cost analysis of profit maximization.

A further purpose is to provide the students with a view of the forest before they begin to analyze the trees. You will find that covering this chapter saves valuable lecture time, as you need not continually tell students where you are headed, how the market structures compare, and so on. Our advice is to cover this chapter by emphasizing why economists need to examine the four market structure models.

Unique features of this chapter include a succinct comparison and contrast of the four market structures, complete with illustrations of existing firms. Also of note is the discussion of firm behavior and the price elasticity of demand and supply.

The features of each market-structure and profit-maximization analysis will link into the next four chapters as a basis of future discussion.

Key Term Review

accounting measure of costs
economic costs
direct costs
implicit costs
economic profit
accounting profit
zero economic profit (normal profit)
debt
equity
negative economic profit
positive economic profit (above-normal profit)
differentiated products
standardized or nondifferentiated products
price taker
natural monopoly
price maker (price setter, price searcher)

Lecture Outline and Teaching Strategies

1. Profit Maximization

A firm "adds value" to the resources it uses if it pays the resources for their use and still has something left over.

1.a. Economic profit: Accounting costs are direct costs. Economic costs are direct costs plus implicit costs. Economic profits are calculated using economic costs.

Teaching Strategy: Distinguish between economic profit and accounting profit. Stress that economic profit equals total revenues minus total costs including all opportunity costs, while accounting profit equals total revenues minus total costs except for the opportunity cost of capital.

1.a.1. Negative economic profit: Negative economic profit means that a firm's resources would have a higher value in another use.

1.a.2. Zero economic profit: A firm that neither adds value nor subtracts value is one with a zero economic profit, or a normal accounting profit..

1.a.3. Positive economic profit: If a firm is returning more to its owners than the owners' opportunity cost, the firm is said to be earning positive economic profit.

1.b. Accountants and economic profit: Accountants do not present economic profit in financial statements primarily because of the difficulty of calculating the cost of capital.

Teaching Strategy: Discuss how the cost of equity capital could vary from investor to investor.

2. Marginal Revenue and Marginal Cost

2.a. Demand and cost curves

Teaching Strategy: Carefully discuss Figure 1 in class, showing how the rectangle FECD represents total profits.

2.b. Profit maximum: Marginal revenue equals marginal cost. MR is the additional revenue obtained from selling one more unit. MC is the additional cost incurred from selling one more unit of output. If MR exceeds MC, expand production. If MC exceeds MR, decrease production. When MR = MC, profits are maximized.

Teaching Strategy: Carefully graph the data in Table 1 to show that profits are maximized at the output where MR = MC.

2.b.1. The marginal-revenue curve

Teaching Strategy: Relate MR to the price elasticity of demand. Since TR rises in the price-elastic region of the demand curve, MR is positive in that elastic region; also, since TR declines in the inelastic region of the demand curve, MR must be negative in that inelastic region. Refer carefully to Figure 2 when describing these relationships.

3. Selling Environments or Market Structure

A market structure is only a model of reality. Firms must sell their products in many different settings. Market-structure models are a way to classify these settings into four major groupings rather than trying to analyze the millions of settings that exist in the real world. Competition occurs in all market structures to varying degrees.

Teaching Strategy: Discuss the market structures of the example firms given in this section (Kyrene Scrap Metal, Burroughs-Wellcome, The Gap, and Southwest Airlines).

3.a. Characteristics of the market structures: Three characteristics define a market structure: the number of firms, the ease of entry of new firms into the market, and product differentiation.

Teaching Strategy: Center a discussion around different industries students are familiar with (for example, illegal drugs, postal service, and oil) in terms of the three market structure characteristics.

3.b. Market-structure models: Four market structures are discussed and summarized in Table 2.

3.b.1. Perfect competition: This market structure is characterized by a large number of firms, no price control by firms, standardized products, easy entry into the market, and long-run profits driven to zero.

Teaching Strategy: Describe perfect competition using the example of agriculture.

In perfect competition, firms sell their products at the prevailing market price. Changes in quantity by one firm have no effect on price. The demand curve is perfectly horizontal. Thus, the firm is a price taker.

Teaching Strategy: Show that a farmer faces a perfectly elastic demand curve.

3.b.2. Monopoly: This market structure is characterized by one firm, price control, a unique product (no substitutes), blocked entry, and the possibility of long-run positive economic profits.

Teaching Strategy: Describe monopoly using the example of a public utility, for example, a local cable company.

In monopoly the firm faces a downward-sloping demand curve that is inelastic. The firm selects the price to charge and thus is a price maker.

Teaching Strategy: Demonstrate how an unregulated public utility faces the market demand curve and how the utility can control market price.

3.b.3. Monopolistic competition: This market structure is characterized by a large number of firms, limited price control, differentiated product, easy entry, and the limitation on long-run economic profits (if not zero).

Teaching Strategy: Describe monopolistic competition using the beer industry as an example.

In monopolistic competition each firm is like a mini-monopoly because of product differentiation. Competition keeps the demand curve elastic for each firm, however. The greater the product differentiation, the less elastic the demand curve becomes.

Teaching Strategy: Demonstrate this concept using retail stores in a shopping mall.

3.b.4. Oligopoly: This market structure is characterized by few firms, price control limited by rivals' reactions, differentiated or standardized products (cars versus steel), blocked entry, and the possibility of long-run economic profits.

Teaching Strategy: Describe oligopoly using the steel and automobile industries as examples.

Because of the interdependence of firms, the demand curve each firm faces depends on how competitors respond to price changes.

Teaching Strategy: Demonstrate oligopoly by using the auto industry as an example. Talk about how this model hinges on the interdependent pricing policies of the three major car producers.

3.c. Comparisons of the market structures

Teaching Strategy: Stress to your students that the four market structures are models-simplifications of reality-and not true economic reality. Thus, real world examples, like the automobile or beer industries, are likely to have characteristics of more than one market structure.