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Micro Unit 5: Monopolies

GRAPH: Monopoly

I. Key characteristics
a. Sole provider of a unique product 8
i. E.g. local monopolies such as a the sole movie theater in a small town
b. Absolute monopolies are rare at the national and international level
c. Barriers to entry allow economic profits in the long run
i. Patents
ii. Control of resources
1. E.g. diamond mines
iii. Exclusive licenses
1. E.g. gov. grants only one company the right to produce electricity
II. Demand curve is downward sloping

8
Just because they are the sole provider of the product, it doesn’t mean that monopolies can charge whatever price they
want. Consumers will not buy a product if the price is higher than the demand curve.

AP Microeconomics Full Review Page 39 of 56

 a. Lower price must be charged on all previous units to sell additional units
b. Price ≠ marginal revenue at output levels greater than zero
i. MR falls as Q increases
III. Always produces in the elastic portion of the demand curve when maximizing profits
a. Find where MR = MC to find the quantity of output
b. Trace your finger upwards until you hit the demand curve to find price
IV. Monopolies produce less and at a higher price than firms in perfect competition

Price Discrimination
I. E.g. airlines, car dealers, Uber
II. Key characteristics
a. Firm must have market power: downward sloping demand curve
b. Buyers with differing demand elasticities must be separable
c. Firm must be able to prevent the resale of its goods
i. Block those paying the lower price to resell to those willing to pay the higher price
III. Want to charge customers the most they are willing to pay

GRAPH: Monopoly – Perfect Price Discrimination

I. All consumer surplus is transformed into profit

II. MR = D
a. No need to lower the price of all units to sell one additional unit
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GRAPH: Monopoly – Perfect Price Discrimination w/Differing Demand Elasticities

I. The more inelastic the demand, the more consumers pay

EXAMPLE: Government Policy towards Imperfect Competition

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 I. Firms with market power can challenge the efficiency of the market if left unchecked
II. Monopolies produce less and at a higher price than firms in perfect competition
III. Monopolies and their corresponding profits have the potential to motivate research and
development expenditures that result in important drug and technology innovation

GRAPH: Natural Monopoly

I. E.g. power generation

II. Industries where competition isn’t possible due to extremely high fixed costs
III. ATC decreases throughout the relevant range of production
IV. At the socially optimal price (𝑃𝑃𝑆𝑆𝑆𝑆 = MC), the monopoly is incurring economic losses
V. At the monopoly price (MR = MC → 𝑃𝑃𝑀𝑀 ), the monopoly is making economic profit but charging
too high of a price and producing too low of an output
VI. Gov. needs to intervene as competition can’t influence prices in this situation
a. Fair return price = 𝑃𝑃𝐹𝐹𝐹𝐹
i. Firm will make zero economic profit
ii. Middle ground between severe resource misallocation and economic losses
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Micro Unit 6: Monopolistic Competition and Oligopolies

GRAPH: Monopolistic Competition

I. Key characteristics
a. Faces more competition than monopolies or oligopolies
b. Maintains some market power due to product differentiation
i. E.g. restaurants, clothing stores
c. Zero economic profits in long run
i. Firms will enter the market to compete away existing profits
ii. Firms will leave the market to eliminate any losses
II. Demand curve is downward sloping
a. Lower price must be charged to sell additional units
b. Price ≠ marginal revenue at output levels greater than zero
i. MR falls as Q increases
III. Always produces in the elastic portion of the demand curve when maximizing profits
a. Find where MR = MC to find the quantity of output
IV. Trace your finger upwards until you hit the demand curve to find price

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 Oligopoly
I. E.g. airlines, Coca-Cola vs. Pepsi
II. Key characteristics
a. Small number of firms selling a homogeneous or differentiated product
b. High barriers to entry and high market power
c. Mutualistic interdependence
i. Decision of one firm will highly impact the decisions of other firms

Game Theory
I. Considers the strategic decision of players (e.g. interdependent ogopolistic firms) in anticipation of
their competitors’ reactions
II. Payoff matrix: two by two square
a. Details the possible results of varying pricing choices by two entities
b. Isolate one player and one strategy and circle the best choice for the other player
i. It can be helpful to cover up the other side of the square
ii. E.g. use circles for player 1 and rectangles for player 2 for their best choices
III. Dominant strategy
a. Choosing one pricing strategy regardless of what the competitor chooses
IV. Nash equilibrium 9
a. Occurs when two choices appear in the same square of a payoff matrix
b. Dominant strategy equilibrium
i. Both sides have a dominant strategy, so neither party will deviate from its strategy
given the strategy of the other side
ii. All dominant strategy equilibriums are Nash equilibriums, but not vice versa
V. Prisoner’s dilemma
a. When competing parties forgo an option more beneficial for both parties e.g. Party A and B
choose to make $100 and $200 instead of $300 and $500, respectively
b. E.g. arms races
i. Both parties are better off with peace

9
Rest in peace, John Nash.
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EXAMPLE: Payoff Matrix – Dominant Strategy Equilibrium

I. Bob chooses high priced strategy

a. Liz makes 300 going high or makes 500 going low
II. Bob chooses low priced strategy
a. Liz loses 800 going high or loses 500 going low
III. Liz chooses high priced strategy
a. Bob makes 400 going high or makes 600 going low
IV. Liz chooses low priced strategy
a. Bob loses 800 going high or loses 500 going low
V. Nash equilibrium
a. Both players have a dominant strategy of going low
b. Bob ends up losing 500 and Liz ends up losing 500
i. This illustrates the prisoner’s dilemma
1. Both players would have been better off going high

AP Microeconomics Full Review Page 45 of 56

 EXAMPLE: Payoff Matrix – Non-Dominant Strategy Equilibrium

I. Bob chooses high priced strategy

a. Liz makes 500 going high or makes 300 going low
II. Bob chooses low priced strategy
a. Liz makes 150 going high or makes 200 going low
III. Liz chooses high priced strategy
a. Bob makes 400 going high or makes 600 going low
IV. Liz chooses low priced strategy
a. Bob makes 50 going high or makes 100 going low
V. Nash equilibrium
a. Bob has a dominant strategy of going low
b. Liz goes high when Bob goes high and goes low when Bob goes low

Bilateral Monopoly (less common)

I. Only one buyer and one seller exist in the same market
II. Cannot theoretically predict what the final wage of workers will be
a. Depends on the relative bargaining skills of both parties
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SUMMARY: Market Structures

I. Maximizing profits (without price discrimination) for all market structures

a. Find where MR = MC
b. Go straight down to the x-axis to determine the quantity produced
c. Go straight up to the demand curve to determine the price
i. If the D = MR, this step is easy
d. If price is less than AVC, the firm will shut down
e. Otherwise, the firm will produce at Q and at a price of P
f. Profit = total revenue – total costs = (𝑃𝑃 − 𝐴𝐴𝐴𝐴𝐴𝐴) × 𝑄𝑄

AP Microeconomics Full Review Page 47 of 56

 Micro Unit 7: Factor Markets 10

Instead of working with demand for products, we are now working with demand for the factors of
production e.g. land, labor, capital. 11

EXAMPLE: Factor Markets – Ice Cream Machines

I. If the demand for ice cream increase, the demand for ice cream machines will also increase

GRAPH: Marginal Revenue Product of Labor

10
This is one of the hardest units in microeconomics. It is easy to confuse product markets with labor markets and vice
versa, but you need an adept understanding of both to score well on the AP Test.
11
Most graphs and examples will use labor in the explanation of factor markets. The determination of other factor prices is
analogous to the material in this section.
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I. 𝑀𝑀𝑀𝑀𝑀𝑀𝐿𝐿 = 𝑀𝑀𝑀𝑀𝐿𝐿 × 𝑃𝑃𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜

II. Assuming firms can’t price discriminate, those facing downward sloping demand curves must
lower the price of all output in order to sell more output produced by additional units of an input
a. The most a firm would be willing to pay for another worker (or other factor of production)
in the short run is that factor of production’s marginal revenue product
III. Want to hire at the intersection of wage and MRP
a. If less workers are hired, there is still the opportunity to hire more workers and pay them
less than the value of their contribution to revenues
b. If more workers are hired, those excess workers are paid more than the value of their
contributions to revenues
IV. If MRP shifts outward, demand for labor will increase and vice versa
V. Demand for labor is a derived demand
a. i.e. firms demand labor b/c consumers demand their products

GRAPH: Perfectly Competition – Labor Market

I. Each firm is a wage taker, just as firms are price takers in a perfectly competitive output market
II. Market demand for labor is the horizontal summation of individual firm demand curves
III. Market demand shifters to the right (opposite will shift 𝐷𝐷𝐿𝐿 in)
a. Increase in the number of firms in the market

AP Microeconomics Full Review Page 49 of 56

 b. Increase in the 𝑀𝑀𝑀𝑀𝑀𝑀𝐿𝐿 in the individual firms
IV. Equilibrium wage
a. Intersection of 𝑆𝑆𝐿𝐿 and 𝐷𝐷𝐿𝐿
b. Zero unemployment 12
i. Everyone who would like to work has the opportunity to do so

GRAPH: Monopsony

I. E.g. mining company in a small mining town

12
Unemployment is discussed further in macroeconomics.
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II. Key characteristics

a. Like a monopoly, but for factors of production
III. Supply curve is upward sloping
a. Must raise wages of all workers to hire an additional worker
b. Price ≠ marginal factor cost (MFC) at output levels greater than zero
i. MRC rises as Q increases
IV. Find where MFC = MRP = D to find the quantity of output
a. Trace your finger downwards until you hit the supply curve to find wage
V. In contrast to a perfectly competitive labor market
a. Price = MFC as firms can hire all of the workers they want at the same market wage
b. Firms hire more workers (𝐿𝐿𝐶𝐶 ) and pay them more (𝑊𝑊𝑐𝑐 )

Unions (less common)

I. Workers form unions to increase their collective bargaining and lobbying strengths
II. Goals
a. Increase the demand for labor
b. Decrease the supply of labor
i. Unions comprised of skilled workers do this
c. Negotiate higher wages
i. Unions comprised of unskilled workers tend to use their size to their advantage

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 Micro Unit 8: Market Failures and the Role of Government

Market Failures
I. Occurs when resources are not allocated efficiency (P = MC)
a. Imperfect competition
b. Externalities
c. Public goods
d. Imperfect information
i. Buyers and sellers don’t have full knowledge about available markets, prices,
products, customers, suppliers, and so forth
ii. E.g. consumers pay too much for a product b/c they aren’t aware of a cheaper
alternative

Externalities
I. Costs and benefits felt beyond those causing the effects: spillover effects
II. Lead to inefficient allocation of resources as those making decisions fail to consider all of the
repercussions of their behavior
III. Negative externalities
a. Lead to overconsumption of a good
b. Solutions
i. Can be taxed by the amount of the MEC
1. E.g. taxing cigarettes
2. Internalize the externality
ii. Restricting output to eh socially optimal quantity
iii. Imposing a price floor at the socially optimal price
IV. Positive externalities
a. Lead to underconsumption of a good
b. Solution
i. Can be subsidized by the amount of the MEB
1. E.g. subsidizing higher education
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EXAMPLE: Negative Externality13

I. MPC = marginal private cost

a. Additional cost Mary pays for each additional dog
II. MEC = marginal external cost
a. Additional cost imposed Mary’s neighbors due to biting, barking etc.
III. MSC = marginal social cost = MPC + MEC
IV. MB = marginal benefit = Mary’s demand curve for dogs
V. Mary will own 𝑄𝑄𝑝𝑝 dogs if we ignore the negative externality
VI. Mary will own 𝑄𝑄𝑠𝑠 dogs if we account for the negative externality

EXAMPLE: Positive Externality 14

13
Notice the similarities to the cost curves in perfect competition. MSC is to ATC as MEC is to AVC and MPC is to AFC.
14
Marginal private benefit (MPB) is equivalent to MB.

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 I. MPB = marginal benefit = Mary’s demand curve for flowers
II. MPC = marginal private cost
a. Additional cost Mary pays for each additional flower
III. MEC = marginal external benefit
a. Additional benefit Mary provides to her neighbors for each additional flower planted
IV. MSB = marginal social benefit = MPB + MEB
V. Mary will own 𝑄𝑄𝑝𝑝 flowers if we ignore the positive externality
VI. Mary will own 𝑄𝑄𝑠𝑠 flowers if we account for positive externality

Public Goods
I. Those that many individuals benefit from at the same time
II. Key characteristics
a. Nonrival in consumption
i. One person’s consumption doesn’t affect its consumption by others
ii. E.g. Mrs. Keats’ use of the park doesn’t affect Mr. T’s use of the same park
b. Nonexcludable
i. Goods cannot be held back from those who desire access
ii. E.g. the police cannot choose who they protect
III. Free rider problem
a. Consumer attempts to benefit from a public good without paying for it
b. Consumers know they can enjoy the provision of these goods without paying for them
c. Thus, the gov. oftentimes provides these goods and pays for them through taxes

Antitrust Legislation (less common)

I. Sherman Act (1890)
a. Declared attempts to monopolize commerce or restrain trade among the states illegal
II. Clayton Act (1914)
a. Strengthened the Sherman Act
b. Specified that monopolistic behavior such as price discrimination was illegal
III. Robinson-Patman Act (1936)
a. Allows price discrimination in certain circumstances
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i. E.g. differences in marketability of product

IV. Celler-Kefauver Act (1950)
a. Banned select vertical mergers
i. Merger of firms in the various steps in the production process
b. Banned select horizontal mergers
i. Merger of firms who are direct competitors

Measures of Market Power (less common)

I. Herfindahl-Harschman Index (HHI)
2
a. 𝐻𝐻𝐻𝐻𝐻𝐻 = ∑𝑚𝑚
𝑖𝑖=1 𝑆𝑆𝑖𝑖

i. Takes the market share of each firm in an industry as a percentage, squares each
percentage, and adds them up
b. Increases as the number of firms in the industry decreases and/or as the firms become less
uniform in size
II. N-firm concentration ratio
a. Sum of the market shares of the largest n firms in an industry, where n is an integer

GRAPH: Lorenz Curve

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 I. Measure of income inequality
II. Horizontal axis starts with the poorest families on the left and ends with the richest families
𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎
III. Gini coefficient = 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑜𝑜𝑜𝑜 ∆𝐴𝐴𝐴𝐴𝐴𝐴

a. If the Lorenz curve was the line of perfect equality, the poorest 𝑛𝑛% of people would own
𝑛𝑛% of the wealth in their nation: Gini coefficient = 0
b. United States Gini coefficient: 0.45

Poverty and Taxes

I. Poverty line
a. Official benchmark of poverty
II. Progressive tax
a. Gov. receives a larger percentage of revenue from families with larger incomes
III. Regressive tax 15
a. Gov. receives a larger percentage of revenue from families with smaller incomes
IV. Proportional tax
a. Gov. receives the same percentage of income from all families
V. Social Security
a. Provides cash benefits and health insurance to retired and disabled works and their families

15
For example, Mrs. Keats employs a regressive curve in her class: the curve helps you more the worse you do.