Robert Malthus (1766–1834) applied the logic of diminishing returns to population and food production.
He argued that population grows exponentially while food production grows arithmeticallyleading inevitably to famine and misery.
Diminishing returns to labor applied to fixed land: as more labor is added, each additional worker adds less and less output.
Thomas Carlyle (1795–1881) famously called economics the “Dismal Science” in part because of Malthusian pessimism.
Why Does the AC Curve Have a U-Shape?
Average Cost (AC) = TC / Q
At low output: Fixed costs spread over few units ︎→︎ AC is high.
As output rises: Fixed costs spread over more units ︎→︎ AC falls.
At high output: Diminishing returns push variable costs up faster ︎→︎ AC rises again.
The MC curve crosses the AC curve at its minimum.
Profit Maximization Does Not Guarantee Profits
The firm produces where MR = MC. But whether it makes a profit depends on the relationship between P and AC.
If P > AC: the firm earns positive economic profit.
If P = AC: the firm earns zero economic profit (normal profit).
If P < AC: the firm earns negative economic profit (a loss).
Example: If P = $10 and AC = $20, the firm loses $10 per unit.
Short-Run vs. Long-Run
Short-Run: the time frame before entry or exit can occur.
Fixed costs are sunk costsalready incurred and cannot be recovered.
The firm will continue to operate as long as TR ≥ VC (i.e., it covers variable costs).
Long-Run: the time frame after which all entry or exit can occur.
All costs become variable in the long run.
Firms can enter or exit freely.
Entry and Exit in the Long-Run
Firms will enter the industry when P > AC (positive profits).
Entry pushes P downward.
Firms will exit the industry when P < AC (losses).
Exit pushes P upward.
The long-run equilibrium: P = AC (zero economic profits).
When P = AC, there is no incentive for existing firms to exit or potential firms to enter.
Long-Run Equilibrium in Perfect Competition
Entry when P > AC ︎→︎ P falls.
Exit when P < AC ︎→︎ P rises.
Long-run result: P = AC = MC at minimum AC ︎→︎ zero economic profits.
Consumer surplus is maximized, no deadweight loss.
Basic Insights from a Perfectly Competitive Market
If firms are making economic profits, entry (competition) leads to falling prices.
In the long-run, profits will be competed away…
…while consumer surplus will increase.
A perfectly competitive firm produces where MR = P = MC.
The demand curve faced by the competitive firm is perfectly elastic, a horizontal line equal to MR.
It can’t charge more than P, and it makes no sense to charge less.
What if there is only one firm in a market?
Monopolies, Some Examples
First-class mail in the US?
Yes, USPS holds a legal monopoly.
Windows OS?
Historically close to monopoly.
Diamonds? (De Beers)
Yes, historically.
But: shipping services, operating systems broadly, precious stones, fantasy novels?
No, substitutes exist, market power is partial.
The Monopoly Is a Price-Maker
A monopolist’s choice of Q and P are dependent on one another.
The monopolist faces a downward-sloping demand curve for its good.
To sell more, it must lower its price.
It can choose any (P, Q) combination on the demand curve.
For a monopolist, MR is always below D.
Why is MR always below D for a monopolist?
The Whazzagizmo™ Example
Q
Price (P)
Total Revenue
Marginal Revenue
5
$4.00
$20
7
$3.00
$21
$0.50 per unit
Selling 2 additional units at P = $3 generates only MR = $0.50 per unit. Why?
The Whazzagizmo™, Why MR < P
Selling 2 additional units at P = $3 generates 2 × $3 = $6 of additional revenue…
…but the initial 5 units are now sold at $3 rather than $4, losing 5 × ($4 − $3) = $5 of revenue.
Net MR = $6 − $5 = $1 total, or $0.50 per unit, well below the $3 price.
This is why MR < D for a price-maker: to sell more, the monopolist must lower the price on all units, not just the marginal unit.
The Monopolist’s Diagram
There is a downward-sloping demand curve (D). The MR curve always lies below D.
The monopolist still maximizes profit by setting MC = MR…
…then reads the price from the D curve at that quantity.
Monopoly Deadweight Loss
The monopolist produces less than the competitive quantity and charges a higher price.
Total surplus would be higher if output expanded to where MC = D (the competitive outcome).
The difference is the deadweight losssurplus from mutually beneficial trades that do not occur.
Monopolies increase producer surplus (profits) at the cost of larger decreases in consumer surplus.
Joseph Schumpeter (1883–1950), The Case for Monopoly Profits
“If one wants to induce firms to undertake R&D one must accept the creation of monopolies as a necessary evil.”
Joseph Schumpeter, 1943
The incentive to innovate: Monopoly profits are the reward for successful innovation. Without the prospect of those profits, firms have weaker incentives to invest in costly research and development. Example: pharmaceutical patent protection grants temporary monopoly rights to encourage drug development. The deadweight loss of monopoly pricing must be weighed against the dynamic benefit of new products and technologies.
Perfect competition and monopoly are both extreme caseswhat lies between them?
The Spectrum of Market Power
Neither perfect competition nor monopoly exists in pure form in the real world.
The extreme cases help us think about markets depending on:
Whether firms face more or less competition.
Whether their goods are more or less differentiable from those of other firms.
Whether firms have relatively great market power or somewhat lesser market power is captured by the slopes of the D and MR curves.
Steeper D and MR ︎→︎ more market power.
Flatter D and MR ︎→︎ less market power (closer to competitive).
Varying Degrees of Market Power
The slope of the demand curve reflects market power.
Competitive firm: horizontal D = MR (price-taker).