SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)

School of Distance Learning

SUBJECT :BUSINESS ECONOMICS Marks : 30

All questions are compulsory

1. Explain how profit maximizing output is determined in a

a. Perfect Competitive market
b. Monopoly
c. Monopolistic market

2. The estimated total cost function of firms is:

TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210

If the firms decides to produce 50 units of Q, what will be the estimated total,
average and marginal costs of production? Show all the components of economic
costs.

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Submitted By: Pardeep Kumar (GR No: D20101100127) Page 1 of 7

 SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning

Q1 Explain how profit maximizing output is determined in a

Perfect Competitive market

Monopoly

Monopolistic market

1. Perfect Competition

In competitive markets there are:

1. Many buyers and sellers - individual firms have little effect on the price.
2. Goods offered are very similar - demand is very elastic for individual firms.
3. Firms can freely enter or exit the industry - no substantial barriers to entry.

Competitive firms have no market power. Recall that businesses are trying to maximize
profits.

Profit = Total Revenue (TR) - Total Cost (TC).

Revenue in a Competitive Business

Businesses in competitive markets take the market price (P) as given (price takers). How
much does the business receive for a typical unit is known as the "average revenue" (AR)
and is equal to TR/Q = (P x Q)/Q = Price. So average revenue is equal to price, and is
constant.

How much additional revenue does the firm get if it sells one additional unit? To answer
this question, we take a look at "marginal revenue" (MR) which is equal to the change in
TR divided by the change in quantity. Note that this too is equal to price, so the marginal
revenue is constant as well, and is equal to average revenue.

Profit Maximization

To maximize profit, we need to know the revenue and costs of the business. Profit is
maximized when marginal revenue = marginal cost, and marginal cost is rising. To see
why, recall that marginal revenue is the additional revenue from 1 additional unit.
Marginal cost is the additional cost from 1 additional unit.

When MR > MC, revenue is increasing faster than costs and the firm should increase
production. When MR < MC, revenue from the additional unit is less than additional
cost, and the firm should decrease production. As such, A firm maximizes profits when
MR = MC.

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 SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning

So what happens to output at various prices? Since MC is upward sloping, as price

increases, quantity produced will increase too. As price falls, quantity produced falls. In
each case, the marginal cost curve determines how much the firm is willing to produce at
each price, so it translates into the supply curve.

Consider what results if marginal revenue is not equal to marginal cost:

• If marginal revenue is greater than marginal cost, as is the case for small
quantities of output, then the firm can increase profit by increasing production.
Extra production adds more to revenue than to cost, so profit increases.
• If marginal revenue is less than marginal cost, as is the case for large quantities of
output, then the firm can increase profit by decreasing production. Reducing
production reduces revenue less than to it reduces cost, so profit increases.
• If marginal revenue is equal to marginal cost, then the firm cannot increase profit
by producing more or less output. Profit is maximized.

2. MONOPOLY
A market structure characterized by a single seller of a unique product with no close
substitutes. This is one of four basic market structures. The other three are perfect
competition, oligopoly, and monopolistic competition. As the single seller of a unique
good with no close substitutes, a monopoly has no competition. The demand for output
produced by a monopoly is THE market demand, which gives monopoly extensive
market control. The inefficiency that results from market control also makes monopoly a
key type of market failure.

Monopoly is a market in which a single firm is the only supplier of the good. Anyone
seeking to buy the good must buy from the monopoly seller. This single-seller status
gives monopoly extensive market control. It is a price maker. The market demand for the
good sold by a monopoly is the demand facing the monopoly. Market control means that

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 SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning

monopoly does not equate price with marginal cost and thus does not efficiently allocate
resources.

Sources of a monopoly include:

• Ownership/Control of a Key Resource - rainforests, rare minerals (DeBeers

diamond monopoly).
• Exclusive Right Given by Government - patents, copyrights, franchises
(pharmaceutical companies, research, authors).
• Falling Average Total Cost - making one company more efficient than others
(also known as a natural monopoly), arising from economies of scale over the
relevant range of output.
• Public Utilities - electricity, cable television. and water provision.

The four key characteristics of monopoly are: (1) a single firm selling all output in a
market, (2) a unique product, (3) restrictions on entry into the industry, and (4)
specialized information about production techniques unavailable to other potential
producers.

Revenue for a Monopoly

A monopoly may raise its price, but it will lose sales. In order to sell more, it must lower
its price. There are two effects on total revenue (profit x quantity):

1. Output effect - gains more revenue because it sells more.

2. Price effect - gains less revenue because it gets less from each unit sold because
of the lower price.

Marginal revenue (MR) can even turn negative if price falls enough to reduce total
revenue, even though the company sells more. What determines value of MR? It depends
on whether the fall in price is larger than the increase in quantity. In other words, it
depends on the elasticity of demand. Note that MR = P [1-1/abs. E].

When E > 1, MR > 0 because output effect > price effect

When E < 1, MR < 0 because price effect > output effect
When E = 1, MR = 0 because price effect = output effect

Profit Maximization

The profit-maximizing level of output is a production level that achieves the greatest
level of economic profit given existing market conditions and production cost. For a
monopoly, this entails adjusting the price and corresponding production level to achieved
the desired match between total revenue and total cost.

profit maximization can be identified by a comparison of marginal revenue and marginal

cost. If marginal revenue is equal to marginal cost, then profit cannot be increased by

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 SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning

changing the level of production. Increasing production adds more to cost than revenue,
meaning profit declines. Decreasing production subtracts more from revenue than from
cost, meaning profit also declines. In the bottom panel, the marginal revenue and
marginal cost curves intersect at 6 ounces of Amblathan-Plus. At larger or smaller output
levels, marginal cost exceeds marginal revenue or marginal revenue exceeds marginal
cost.

3. Monopolistic Competition

Monopolistic competition is a market structure with a large number of relatively small

firms that sell similar but not identical products. Each firm is small relative to the overall
size of the market such that it has some market control, but not much. In other words, it
can sell a wide range of output at a narrow range of prices. This translates into a
relatively elastic demand curve. If a monopolistically competitive firm wants to sell a
larger quantity, then it must lower the price.

Monopolistic competition has characteristics of both competition and monopoly. Similar

to competition, it has many firms, and free exit and entry. Similar to monopoly, the
products are differentiated and each company faces a downward sloping demand curve.
Since the company has a differentiated product, it is like a monopolist and faces a
negatively-sloped demand curve. In the short-run,

• marginal revenue is always less than demand

• profit is maximized where MR = MC
• profit = (price - average total cost) x quantity

Profit Maximization

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 SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning

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.
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 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.

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 SVKM’s Narsee Monjee Institute of Management Studies (NMIMS)
School of Distance Learning

Q2 The estimated total cost function of firms is:

TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210

If the firms decides to produce 50 units of Q, what will be the estimated total, average and
marginal costs of production? Show all the components of economic costs.

Total Cost Function:

TC = Q0 + 2Q1 + 3Q2 + 4Q3 + 43210

Total Cost

TFC = 43210

TVC = Q0 + 2Q1 + 3Q2 + 4Q3

For Q=50, TVC = 1+ 2*50 + 3*50*50 + 4*50*50*50 = 1+100+7500+500000 = 507601

TC = TFC + TVC = 43210 + 507601 = 550811

Average Cost

AC = TC/Q = (Q0 + 2Q1 + 3Q2 + 4Q3 + 43210)/Q

AC = 1/Q + 2 + 3Q + 4Q2 + 43210/Q

Therefore, Average Cost for Q=50 is

AC = 1/50 + 2 + 3*50 + 4*50*50 + 43210/50 = 0.02 + 2 + 150 + 10000 + 864.20

AC = 11016.22

AFC = 43210/Q = 864.20

AVC = 1/Q + 2 + 3Q + 4Q2 = 1/50 + 2 + 3*50 + 4*50*50 = 10152.02

Marginal Cost

MC = d TC/dQ = 0 + 2 + 6Q + 12Q2

Therefore, Marginal cost for Q=50 is

MC = 2 + 6*50 + 12*50*50 = 30302

Submitted By: Pardeep Kumar (GR No: D20101100127) Page 7 of 7