Cash Controls

Cash is a company's most liquid asset, which means it can easily be used to acquire other assets, buy services, or satisfy obligations. For financial reporting purposes, cash includes currency and coin on hand, money orders and checks made payable to the company, and available balances in checking and savings accounts. Most companies report cash and cash equivalents together. Cash equivalents are highly liquid, short‐term investments that usually mature within three months of their purchase date. Examples of cash equivalents include U.S. treasury bills, money market funds, and commercial paper, which is short‐term corporate debt.

Cash is a liquid, portable, and desirable asset. Therefore, a company must have adequate controls to prevent theft or other misuses of cash. These control activities include segregation of duties, proper authorization, adequate documents and records, physical controls, and independent checks on performance.


Segregation of duties. Cash is generally received at cash registers or through the mail. The employee who receives cash should be different from the employee who records cash receipts, and a third employee should be responsible for making cash deposits at the bank. Having different employees perform these tasks helps minimize the potential for theft.


Proper authorization. Only certain people should be authorized to handle cash or make cash transactions on behalf of the company. In addition, all cash expenses should be authorized by responsible managers.


Adequate documents and records. Company managers and others who are responsible for safeguarding a company's cash assets must have confidence in the accuracy and legitimacy of source documents that involve cash. Important documents such as checks, are prenumbered in sequential order to help managers ascertain the disposition of each document. This helps prevent transactions from being recorded twice or from not being recorded at all. In addition, documents should be forwarded to the accounting department soon after their creation so that recordkeeping can be handled professionally and efficiently. Allowing documents that describe cash transactions to go unrecorded for an unnecessarily long period of time increases the likelihood that fraudulent or inaccurate records will pass undetected through the accounting department.


Physical controls. Cash on hand must be physically secure. This is accomplished in a variety of ways. Cash registers should contain only enough cash to handle customer transactions. When a cashier finishes a shift—or perhaps more frequently—excess cash should be moved from cash registers to a safe or another location that provides additional security. In addition, daily bank deposits are made so that excess cash does not remain on the premises. Blank checks, which can be used for forgery, are stored in locked, fireproof files.


Independent checks on performance. Employees who handle cash or who record cash transactions must be prepared for independent checks on their performance. These checks should be done periodically and may be done without fore-warning. Having a supervisor verify the accuracy of a cashier's drawer on a daily basis is an example of this type of control.


Other cash controls. Most companies bond individuals that handle cash. A company bonds an employee by paying a bonding company for insurance against theft by the employee. If the employee then steals, the bonding company reimburses the company. Companies may also rotate employees from one task to another. Embezzlement or serious mistakes may be uncovered when a new employee takes over a task. Although specific cash controls vary from one company to the next, all companies must implement effective cash controls.

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Capital, Loanable Funds, Interest Rate

The demand and supply for different types of capital take place in capital markets. In these capital markets, firms are typically demanders of capital, while households are typically suppliers of capital. Households supply capital goods indirectly, by choosing to save a portion of their incomes and lending these savings to banks. Banks, in turn, lend household savings to firms that use these funds to purchase capital goods.

Loanable funds. The term loanable funds is used to describe funds that are available for borrowing. Loanable funds consist of household savings and/or bank loans. Because investment in new capital goods is frequently made with loanable funds, the demand and supply of capital is often discussed in terms of the demand and supply of loanable funds.

Interest rate. The interest rate is the cost of demanding or borrowing loanable funds. Alternatively, the interest rate is the rate of return from supplying or lending loanable funds. The interest rate is typically measured as an annual percentage rate. For example, a firm that borrows $20,000 in funds for one year, at an annual interest rate of 5%, will have to repay the lender $21,000 at the end of the year; this amount includes the $20,000 borrowed plus $1,000 in interest ($20,000 × .05).

If the firm borrows $20,000 for two years at an annual interest rate of 5%, it will have to repay the lender $22,050 at the end of two years. After one year, the firm will owe the lender $21,000 as explained above; however, because the loan is for two years, the firm does not have to repay the lender until the end of the second year. During the second year, the firm is charged compound interest, which means it is charged interest on both the principal of $20,000 and the accumulated unpaid interest of $1,000. It is as though the firm receives a new loan at the beginning of the second year for $21,000. Thus, at the end of the second year, the firm repays the lender $21,000 + (21,000 × .05) = $22,050.

In general, the amount that has to be repaid on a loan of X dollars for t years at an annual interest rate of r is given by the formula 

For example, if X = $20,000, r = .05, and t = 2, the amount repaid is found to be $20,000 × (1.05) ² = $22,050.

Determination of the equilibrium interest rate. The equilibrium interest rate is determined in the loanable funds market. All lenders and borrowers of loanable funds are participants in the loanable funds market. The total amount of funds supplied by lenders makes up the supply of loanable funds, while the total amount of funds demanded by borrowers makes up the demand for loanable funds. The loanable funds market is illustrated in Figure . The demand curve for loanable funds is downward sloping, indicating that at lower interest rates borrowers will demand more funds for investment. The supply curve for loanable funds is upward sloping, indicating that at higher interest rates lenders are willing to lend more funds to investors. The equilibrium interest rate is determined by the intersection of the demand and supply curves for loanable funds, as indicated in Figure .

Rate of return on capital and the demand for loanable funds. The demand for loanable funds takes account of the rate of return on capital. The rate of return on capital is the additional revenue that a firm can earn from its employment of new capital. This additional revenue is usually measured as a percentage rate per unit of time, which is why it is called the rate of return on capital. Firms will demand loanable funds as long as the rate of return on capital is greater than or equal to the interest rate paid on funds borrowed. If capital becomes more productive—that is, if the rate of return on capital increases—the demand curve for loanable funds depicted in Figure will shift out and to the right, causing the equilibrium interest rate to rise, ceteris paribus.

Thriftiness and the supply of loanable funds. The supply of loanable funds reflects the thriftiness of households and other lenders. If households become more thrifty—that is, if households decide to save more—the supply of loanable funds increases. The increase in the supply of loanable funds shifts the supply curve for loanable funds depicted in Figure down and to the right, causing the equilibrium interest rate to fall, ceteris paribus.

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Labor Demand and Supply in a Perfectly Competitive Market

In addition to making output and pricing decisions, firms must also determine how much of each input to demand. Firms may choose to demand many different kinds of inputs. The two most common are labor and capital.

The demand and supply of labor are determined in the labor market. The participants in the labor market are workers and firms. Workers supply labor to firms in exchange for wages. Firms demand labor from workers in exchange for wages.

The firm's demand for labor. The firm's demand for labor is a derived demand; it is derived from the demand for the firm's output. If demand for the firm's output increases, the firm will demand more labor and will hire more workers. If demand for the firm's output falls, the firm will demand less labor and will reduce its work force.

Marginal revenue product of labor. When the firm knows the level of demand for its output, it determines how much labor to demand by looking at the marginal revenue product of labor. The marginal revenue product of labor (or any input) is the additional revenue the firm earns by employing one more unit of labor. The marginal revenue product of labor is related to the marginal product of labor. In a perfectly competitive market, the firm's marginal revenue product of labor is the value of the marginal product of labor.

For example, consider a perfectly competitive firm that uses labor as an input. The firm faces a market price of $10 for each unit of its output. The total product, marginal product, and marginal revenue product that the firm receives from hiring 1 to 5 workers are reported in Table .

The marginal revenue product of each additional worker is found by multiplying the marginal product of each additional worker by the market price of $10. The marginal revenue product of labor is the additional revenue that the firm earns from hiring an additional worker; it represents the wage that the firm is willing to pay for each additional worker. The wage that the firm actually pays is the market wage rate, which is determined by the market demand and market supply of labor. In a perfectly competitive labor market, the individual firm is a wage‐taker; it takes the market wage rate as given, just as the firm in a perfectly competitive product market takes the price for its output as given. The market wage rate in a perfectly competitive labor market represents the firm's marginal cost of labor, the amount the firm must pay for each additional worker that it hires.

The perfectly competitive firm's profit‐maximizing labor‐demand decision is to hire workers up to the point where the marginal revenue product of the last worker hired is just equal to the market wage rate, which is the marginal cost of this last worker. For example, if the market wage rate is $50 per worker per day, the firm—whose marginal revenue product of labor is given in Table —would choose to hire 3 workers each day.

The firm's labor demand curve. The firm's profit‐maximizing labor‐demand decision is depicted graphically in Figure .

This figure graphs the marginal revenue product of labor data from Table along with the market wage rate of $50. When the marginal revenue product of labor is graphed, it represents the firm's labor demand curve. The demand curve is downward sloping due to the law of diminishing returns; as more workers are hired, the marginal product of labor begins declining, causing the marginal revenue product of labor to fall as well. The intersection of the marginal revenue product curve with the market wage determines the number of workers that the firm hires, in this case 3 workers.

An individual's supply of labor. An individual's supply of labor depends on his or her preferences for two types of “goods”: consumption goods and leisure. Consumption goods include all the goods that can be purchased with the income that an individual earns from working. Leisure is the good that individuals consume when they are not working. By working more (supplying more labor), an individual reduces his or her consumption of leisure but is able to increase his or her purchases of consumption goods.

In choosing between leisure and consumption, the individual faces two constraints. First, the individual is limited to twenty‐four hours per day for work or leisure. Second, the individual's income from work is limited by the market wage rate that the individual receives for his or her labor skills. In a perfectly competitive labor market, workers—like firms—are wage‐takers; they take the market wage rate that they receive as given.

An individual's labor supply curve. An example of an individual's labor supply curve is given in Figure .

As wages increase, so does the opportunity cost of leisure. As leisure becomes more costly, workers tend to substitute more work hours for fewer leisure hours in order to consume the relatively cheaper consumption goods, which is the substitution effect of a higher wage.

An income effect is also associated with a higher wage. A higher wage leads to higher real incomes, provided that prices of consumption goods remain constant. As real incomes rise, individuals will demand more leisure, which is considered a normal good—the higher an individual's income, the easier it is for that individual to take more time off from work and still maintain a high standard of living in terms of consumption goods.

The substitution effect of higher wages tends to dominate the income effect at low wage levels, while the income effect of higher wages tends to dominate the substitution effect at high wage levels. The dominance of the income effect over the substitution effect at high wage levels is what accounts for the backward‐bending shape of the individual's labor supply curve.

Market demand and supply of labor. Many different markets for labor exist, one for every type and skill level of labor. For example, the labor market for entry level accountants is different from the labor market for tennis pros. The demand for labor in a particular market—called the market demand for labor—is the amount of labor that all the firms participating in that market will demand at different market wage levels. The market demand curve for a particular type of labor is the horizontal summation of the marginal revenue product of labor curves of every firm in the market for that type of labor. The market supply of labor is the number of workers of a particular type and skill level who are willing to supply their labor to firms at different wage levels. The market supply curve for a particular type of labor is the horizontal summation of the individuals' labor supply curves. Unlike an individual's supply curve, the market supply curve is not backward bending because there will always be some workers in the market who will be willing to supply more labor and take less leisure time, even at relatively high wage levels.

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Equilibrium in a Monopsony Market

In a monopsony market, the monopsonies firm—like any profit‐maximizing firm—determines the equilibrium number of workers to hire by equating its marginal revenue product of labor with its marginal cost of labor. Figure illustrates the monopsony labor market equilibrium, using the supply and cost data from Table .

The marginal revenue product of labor equals the marginal cost of labor when the firm employs 3 workers. The equilibrium market wage rate is determined by the market labor supply curve. In order to employ 3 workers, the firm will have to pay a wage of $20. Hence, the equilibrium wage is $20, and the equilibrium number of workers employed is 3.

Because the monopsonies is the only demander of labor in the market, it has the power to pay wages below the marginal revenue product of labor and to hire fewer workers than a perfectly competitive firm. In Figure , the perfectly competitive firm would face a market wage of $25 because that is the wage rate corresponding to the intersection of the market demand and supply curves. If the perfectly competitive firm had the same marginal revenue product as the monopsonies, the perfectly competitive firm would equate marginal revenue product with the market wage and choose to hire 4 workers at $25. The monopolist's decision to hire only 3 workers at a wage of $20 makes it clear that monopsony, like monopoly in a product market, reduces society's welfare.

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Labor Demand and Supply in a Monopsony

A labor market in which there is only one firm demanding labor is called a monopsony. The single firm in the market is referred to as the monopsonist. An example of a monopsony would be the only firm in a “company town,” where the workers all work for that single firm.

Wage‐searching behavior. Because the monopsonist is the sole de‐mander of labor in the market, the monopsonist's demand for labor is the market demand for labor. The supply of labor that the monopsonist faces is the market supply of labor. Unlike a firm operating in a perfectly competitive labor market, the monopsonist does not simply hire all the workers that it wants at the equilibrium market wage. The monopsonist faces the upward‐sloping market supply curve; it is a wage‐searcher rather than a wage‐taker. If the monopsonist wants to increase the number of workers that it hires, it must increase the wage that it pays to all of its workers, including those whom it currently employs. The monopsonist's marginal cost of hiring an additional worker, therefore, will not be equal to the wage paid to that worker because the monopsonist will have to increase the wage that it pays to all of its workers.

A numerical example of a monopsony market is provided in Table . The first two columns provide data on the market supply of labor that the monopsonist faces. The third column reports the total cost to the monopsonist of hiring each worker, which is just the wage times the number of workers. The fourth column reports the marginal cost of labor, which is the change in monopsonist's total cost of labor as it hires additional workers.

Suppose the monopsonist wants to increase the number of workers that it hires from 2 to 3. In order to attract the third worker, the monopsonist must offer an hourly wage of $20 instead of $15. However, because the monopsonist cannot discriminate among its workers (and risk alienating them), it must offer the higher $20 wage to its two current employees. Hence, the monopsonist's costs from hiring the third worker are $60 (3 × $20), and the marginal cost from hiring the third worker is $30 ($60 − $30). The marginal cost of $30 exceeds the new market wage of $20 because the monopsonist must also pay its two current employees an hourly wage that is $5 higher than before.

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Equilibrium in a Perfectly Competitive Market

While each labor market is different, the equilibrium market wage rate and the equilibrium number of workers employed in every perfectly competitive labor market is determined in the same manner: by equating the market demand for labor with the market supply of labor. The determination of equilibrium market wage and employment is illustrated in Figure .

The equilibrium market wage is W, and the equilibrium number of workers employed is Q. At wage rates greater than W, the demand for labor would be less than the supply of labor, implying that there would be a labor surplus. At wage rates belowW, the demand for labor would be greater than the supply of labor, implying that there would be a labor shortage. A labor surplus is eliminated when some workers agree to sell their labor for lower wages, thereby driving down the market wage rate to W. A labor shortage is eliminated when some firms agree to employ workers at higher wages, thereby driving the market wage rate up to W. At the equilibrium wage rate, there is no surplus or shortage of labor.

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Monopolists: Profit Maximization

An illustration of the monopolistically competitive firm's profit‐maximizing decision is provided in Figure .

The firm maximizes its profits by equating marginal cost with marginal revenue. The intersection of the marginal cost and marginal revenue curves determines the firm's equilibrium level of output, labeled Q in this figure. The firm finds the price that it can charge for this level of output by looking at the market demand curve; if it provides Q units of output, it can charge a price of $ P per unit of output. The firm is shown earning positive economic profits equal to the area of the rectangular box, abcd. Negative economic profits (losses) are also possible.

The monopolistically competitive firm's behavior appears to be no different from the behavior of a monopolist. In fact, in the short‐run, there is no difference between the behavior of a monopolistically competitive firm and a monopolist. However, in the long‐run, an important difference does emerge.

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Demand in a Monopolistic Market

 

Because the monopolistically competitive firm's product is differentiated from other products, the firm will face its own downward‐sloping “market” demand curve. This demand curve will be considerably more elastic than the demand curve that a monopolist faces because the monopolistically competitive firm has less control over the price that it can charge for its output. The firm's control over its price will depend on the degree to which its product is differentiated from competing firms' products. If the firm's product is not differentiated from other products, the firm will face a relatively elastic demand curve and will have less control over the price it can charge. If the firm's product is differentiated compared to a competing firm's products, the firm will face a relatively inelastic demand curve and will have more control over the price that it can charge.

Price‐searching behavior. The monopolistically competitive firm will be a price‐searcher rather than a price‐taker because it faces a downward‐sloping demand curve for its product. The firm searches for the price that it will charge in the same way that a monopolist does, by comparing marginal revenue with marginal cost at each possible price along the market demand curve.

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Conditions for Monopoly

 

Perfect competition and pure monopoly represent the two extreme possibilities for a market's structure. The structure of almost all markets, however, falls somewhere between these two extremes. This section considers two market structures, monopolistic competition and oligopoly, which lie between the extreme cases of perfect competition and monopoly. Monopolistic competition, as its name suggests, is a combination of monopoly and competition. However, monopolistic competition is more closely related to perfect competition than to monopoly. Oligopoly is also a combination of monopoly and competition, but it is more closely related to monopoly than to perfect competition.

Three conditions characterize a monopolistically competitive market. First, the market has many firms, none of which is large. Second, there is free entry and exit into the market; there are no barriers to entry or exit. Third, each firm in the market produces a differentiated product. This last condition is what distinguishes monopolistic competition from perfect competition. Examples of monopolistically competitive firms include restaurants, retail clothing stores, and gasoline service stations.

Differentiated products and monopolistic behavior. In many markets, competing firms sell products that can be differentiated from one another. A firm's product can be differentiated in a number of different ways: by its quality, its convenience, its size, its color, its look, its taste—even by its brand name! As a firm's product becomes more and more differentiated, the firm faces less and less competition and will be able to act more like a monopolist in its output and pricing decisions. Thus, in a monopolistically competitive industry, firms seek to differentiate their products as much as possible. Much of this differentiation is accomplished through advertising.

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Cartel Theory of Oligopoly

 

A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum‐exporting countries (OPEC) is perhaps the best‐known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.

Oligopolistic firms join a cartel to increase their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will charge. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oil‐producing firms form a cartel like OPEC to determine their output and price, they will jointly face a downward‐sloping market demand curve, just like a monopolist. In fact, the cartel's profit‐maximizing decision is the same as that of a monopolist, as Figure reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel's profits are equal to the area of the rectangular box labeled abcd in Figure . Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.

Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel's profits. Hence, there is a built‐in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist.

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Kinked-Demand Theory of Oligopoly

 

As mentioned above, there is no single theory of oligopoly. The two that are most frequently discussed, however, are the kinked‐demand theory and the cartel theory. The kinked‐demand theory is illustrated in Figure and applies to oligopolistic markets where each firm sells a differentiated product. According to the kinked‐demand theory, each firm will face two market demand curves for its product. At high prices, the firm faces the relatively elastic market demand curve, labeled MD ₁ in Figure .

Corresponding to MD ₁ is the marginal revenue curve labeled MR _1. At low prices, the firm faces the relatively inelastic market demand curve labeled MD _2. Corresponding to MD ₂ is the marginal revenue curve labeled MR _2.

The two market demand curves intersect at point b. Therefore, the market demand curve that the oligopolist actually faces is the kinked‐demand curve, labeled abc. Similarly, the marginal revenue that the oligopolist actually receives is represented by the marginal revenue curve labeled adef. The oligopolist maximizes profits by equating marginal revenue with marginal cost, which results in an equilibrium output of Q units and an equilibrium price of P.

The oligopolist faces a kinked‐demand curve because of competition from other oligopolists in the market. If the oligopolist increases its price above the equilibrium price P, it is assumed that the other oligopolists in the market will not follow with price increases of their own. The oligopolist will then face the more elastic market demand curve MD ₁.

The oligopolist's market demand curve becomes more elastic at prices above P because at these higher prices consumers are more likely to switch to the lower‐priced products provided by the other oligopolists in the market. Consequently, the demand for the oligopolist's output falls off more quickly at prices above P; in other words, the demand for the oligopolist's output becomes more elastic.

If the oligopolist reduces its price below P, it is assumed that its competitors will follow suit and reduce their prices as well. The oligopolistic will then face the relatively less elastic (or more inelastic) market demand curve MD ₂. The oligopolies' market demand curve becomes less elastic at prices below P because the other oligopolists in the market have also reduced their prices. When oligopolists follow each others pricing decisions, consumer demand for each oligopolist's product will become less elastic (or less sensitive) to changes in price because each oligopolist is matching the price changes of its competitors.

The kinked‐demand theory of oligopoly illustrates the high degree of interdependence that exists among the firms that make up an oligopoly. The market demand curve that each oligopolist faces is determined by the output and price decisions of the other firms in the oligopoly; this is the major contribution of the kinked‐demand theory.

The kinked‐demand theory, however, is considered an incomplete theory of oligopoly for several reasons. First, it does not explain how the oligopolist finds the kinked point in its market demand curve. Second, the kinked‐demand theory does not allow for the possibility that price increases by one oligopolist are matched by other oligopolists, a practice that has been frequently observed. Finally, the kinked‐demand theory does not consider the possibility that oligopolists collude in setting output and price. The possibility of collusive behavior is captured in the alternative theory known as the cartel theory of oligopoly.

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Conditions for an Oligopolistic Market

 

Oligopoly is the least understood market structure; consequently, it has no single, unified theory. Nevertheless, there is some agreement as to what constitutes an oligopolistic market. Three conditions for oligopoly have been identified. First, an oligopolistic market has only a few large firms. This condition distinguishes oligopoly from monopoly, in which there is just one firm. Second, an oligopolistic market has high barriers to entry. This condition distinguishes oligopoly from perfect competition and monopolistic competition in which there are no barriers to entry. Third, oligopolistic firms may produce either differentiated or homogeneous products. Examples of oligopolistic firms include automobile manufacturers, oil producers, steel manufacturers, and passenger airlines.

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Monopolistic Competition in the Long-run

The difference between the short‐run and the long‐run in a monopolistically competitive market is that in the long‐run new firms can enter the market, which is especially likely if firms are earning positive economic profits in the short‐run. New firms will be attracted to these profit opportunities and will choose to enter the market in the long‐run. In contrast to a monopolistic market, no barriers to entry exist in a monopolistically competitive market; hence, it is quite easy for new firms to enter the market in the long‐run.

The monopolistically competitive firm's long‐run equilibrium situation is illustrated in Figure .

The entry of new firms leads to an increase in the supply of differentiated products, which causes the firm's market demand curve to shift to the left. As entry into the market increases, the firm's demand curve will continue shifting to the left until it is just tangent to the average total cost curve at the profit maximizing level of output, as shown in Figure . At this point, the firm's economic profits are zero, and there is no longer any incentive for new firms to enter the market. Thus, in the long‐run, the competition brought about by the entry of new firms will cause each firm in a monopolistically competitive market to earn normal profits, just like a perfectly competitive firm.

Excess capacity. Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level of output that is below its minimum efficient scale, labeled as point b in Figure . When the firm produces below its minimum efficient scale, it is under‐utilizing its available resources. In this situation, the firm is said to have excess capacity because it can easily accommodate an increase in production. This excess capacity is the major social cost of a monopolistically competitive market structure.

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Profit Maximization

The monopolist's profit maximizing level of output is found by equating its marginal revenue with its marginal cost, which is the same profit maximizing condition that a perfectly competitive firm uses to determine its equilibrium level of output. Indeed, the condition that marginal revenue equal marginal cost is used to determine the profit maximizing level of output of every firm, regardless of the market structure in which the firm is operating.

In order to determine the profit maximizing level of output, the monopolist will need to supplement its information about market demand and prices with data on its costs of production for different levels of output. As an example of the costs that a monopolist might face, consider the data in Table . The first two columns of Table represent the market demand schedule that the monopolist faces. As the price falls, the market's demand for output increases. The third column reports the total revenue that the monopolist receives from each different level of output. The fourth column reports the monopolist's marginal revenue that is just the change in total revenue per 1 unit change of output. The fifth column reports the monopolist's total cost of providing 0 to 5 units of output. The sixth and seventh columns report the monopolist's average total costs and marginal costs per unit of output. The eighth column reports the monopolist's profits, which is the difference between total revenue and total cost at each level of output.

The monopolist will choose to produce 3 units of output because the marginal revenue that it receives from the third unit of output, $4, is equal to the marginal cost of producing the third unit of output, $4. The monopolist will earn $12 in profits from producing 3 units of output, the maximum possible.

Graphical illustration of monopoly profit maximization. Figure illustrates the monopolist's profit maximizing decision using the data given in Table . Note that the market demand curve, which represents the price the monopolist can expect to receive at every level of output, lies above the marginal revenue curve.

The result of the monopolist's price searching is a price of $8 per unit. This equilibrium price is determined by finding the profit maximizing level of output—where marginal revenue equals marginal cost (point c)—and then looking at the demand curve to find the price at which the profit maximizing level of output will be demanded.

Monopoly profits and losses. The monopoly in the preceding example made profits of $12. These profits are illustrated in Figure as the shaded rectangle labeled abcd. While you usually think of monopolists as earning positive economic profits, this is not always the case. Monopolists, like perfectly competitive firms, can also incur losses in the short‐run. Monopolists will experience short‐run losses whenever average total costs exceed the price that the monopolist can charge at the profit maximizing level of output.

Absence of a monopoly supply curve. In Figure , there is no representation of the monopolist's supply curve. In fact, the monopolist's supply schedule cannot be depicted as a supply curve that is independent of the market demand curve. Whereas a perfectly competitive firm's supply curve is equal to a portion of its marginal cost curve, the monopolist's supply decisions do not depend on marginal cost alone. The monopolist looks at both the marginal cost and the marginal revenue that it receives at each price level. In order to determine marginal revenue, the monopolist must know market demand. Therefore, the monopolist's market supply will not be independent of market demand.

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Demand in a Monopolistic Market

 

Because the monopolist is the market's only supplier, the demand curve the monopolist faces is the market demand curve. You will recall that the market demand curve is downward sloping, reflecting the law of demand. The fact that the monopolist faces a downward‐sloping demand curve implies that the price a monopolist can expect to receive for its output will not remain constant as the monopolist increases its output.

Price‐searching behavior. Unlike a perfectly competitive firm, the monopolist does not have to simply take the market price as given. Instead, the monopolist is a price searcher; it searches the market demand curve for the profit maximizing price. The monopolist's search for the profit maximizing price involves comparing the marginal revenue and marginal cost associated with each possible price‐output combination on the market demand curve.

Declining marginal revenue and price. The monopolist's marginal revenue from each unit sold does not remain constant as in the case of the perfectly competitive firm. The monopolist faces the downward‐sloping market demand curve, so the price that the monopolist can get for each additional unit of output must fall as the monopolist increases its output. Consequently, the monopolist's marginal revenue will also be falling as the monopolist increases its output. If it is assumed that the monopolist cannot price discriminate, that is, charge a different price for each unit of output it produces, then the monopolist's marginal revenue from each additional unit produced will not equal the price that the monopolist charges. In fact, the marginal revenue that the monopolist receives from producing an additional unit of output will always be less than the price that the monopolist can charge for the additional unit.

To understand why, consider a monopolist that is currently supplying N units of output. Suppose the monopolist decides to supply 1 more unit. It therefore increases its supply to N + 1 units of output. The downward‐sloping market demand curve indicates that the new market price will be lower than before. Because the monopolist cannot price discriminate, it will have to sell all N + 1 units of output at the new lower price. This new lower price reduces the total revenue that the monopolist receives from the first N units sold. At the same time, the monopolist will gain some revenue from the additional unit it supplies. The marginal revenue that the monopolist receives from supplying 1 additional unit is equal to the price that it receives for this unit minus its loss in revenue from having to sell N units of output at a lower market price. Thus, the price the monopolist receives from selling N + 1 units exceeds the marginal revenue that it receives from supplying the additional unit of output.

The relationship between marginal revenue and price in a monopolistic market is best understood by considering a numerical example, such as the one provided in Table .

The first two columns of Table , labeled “Output” and “Price,” represent the market demand schedule that the monopolist faces. As the price falls, the market's demand for output increases, in keeping with the law of demand. The third column reports the total revenue that the monopolist receives from each different level of output. The fourth column reports the monopolist's marginal revenue that is just the change in total revenue per 1 unit change of output. Note that the monopolist's marginal revenue is declining as output increases.

Suppose the monopolist is currently producing 2 units of output for which it is receiving a price of $10 per unit and a total revenue of $20 (2 × $10). Now, consider what happens when the monopolist increases its output to 3 units. The price that the monopolist can expect to receive falls to $8 per unit. At this new lower price, the total revenue the monopolist receives for the first two units of output it supplies falls from $20 to $16 (2 × $8), a loss of $4. The monopolist's marginal revenue is equal to the $8 that it receives from the third unit sold minus the loss in total revenue that it receives on the first two units due to the new lower price. Hence, the marginal revenue the monopolist receives from the third unit sold is $8 − $4 = $4, which is below the market price of $8.

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