The marginal cost curve intersects the average total cost curve at:

The minimum point of average total cost

The minimum point of average fixed cost

The point where total cost is lowest

Every point, since the two curves coincide

In long-run equilibrium a firm in monopolistic competition earns only normal profit, yet it differs from a perfectly competitive firm because it produces:

At less than the output of minimum average cost, leaving excess capacity

At more than the output of minimum average cost

Exactly at minimum average cost, as does the competitive firm

At the output where average revenue is zero

In Sweezy's kinked demand curve model, price rigidity follows from the fact that:

Marginal revenue has a vertical gap, within which marginal cost may move without changing price

Marginal cost is constant at all levels of output

Firms are barred by law from changing their prices

Every firm faces a perfectly elastic demand curve

Falls continuously as output rises and never becomes zero

Is U-shaped like average variable cost

Rises with output because fixed cost rises

Is constant at every level of output

The long-run average cost curve is called an envelope curve because it:

Is tangent to every short-run average cost curve and lies below them elsewhere

Intersects every short-run average cost curve at its minimum

Lies above all short-run average cost curves

Is horizontal at the level of minimum cost

An electricity utility charges more per unit during evening hours when its capacity is strained. Strictly, this is:

Peak load pricing, because the price difference reflects a real difference in cost

First-degree price discrimination

Second-degree price discrimination

Business Economics II: Costs, Market Structure and Pricing

The second half of Unit 3 takes the firm from its production function to its price tag. The syllabus names short-run and long-run cost curves, price determination under perfect competition, monopolistic competition, oligopoly with the price leadership model, and monopoly with price discrimination, and finally three pricing strategies by name — skimming, penetration and peak load. The unit is examined mostly on boundaries: which cost curve passes through which minimum, which market form yields which long-run outcome, and which pricing strategy fits which situation.

1. Short-run costs, and the two intersections that are always asked

In the short run some costs do not vary with output. Total cost is fixed cost plus variable cost; average total cost is total cost per unit; and marginal cost is the addition to total cost from one more unit. Because fixed cost does not change with output, marginal cost is unaffected by it — a fact that decides several questions on its own.

🎯 Why MC cuts AVC and ATC at their minima

A marginal value pulls an average towards itself. While marginal cost is below average cost the average is being pulled down; once it is above, the average is pulled up. The average therefore stops falling and starts rising exactly where the two are equal, which is its minimum. The same reasoning is why the marginal product curve cuts the average product curve at its maximum, and knowing it means you never have to memorise either diagram.

Average fixed cost falls continuously as output rises and never reaches zero, because a constant is being divided by a growing number.
Average variable cost and average total cost are both U-shaped, and the vertical gap between them is average fixed cost, which narrows as output rises.
Marginal cost is U-shaped too and cuts both average curves at their lowest points, reaching AVC's minimum before ATC's.
Sunk cost is expenditure already incurred and unrecoverable, and it is irrelevant to any forward-looking decision — which is why a firm covering its variable cost keeps producing in the short run even at a loss.

2. The long run: an envelope, not a curve of its own

In the long run every factor is variable, so a firm may choose any plant size. The long-run average cost curve is the envelope of all the short-run average cost curves — for each output it takes the lowest cost achievable with the best plant for that output. It is often called the planning curve for exactly that reason.

⚠️ The envelope is tangent, not intersecting

The long-run curve touches each short-run curve at one point and lies below it everywhere else, so it can never cut a short-run curve. And only at the minimum of the long-run curve is the tangency at the short-run curve's own minimum; on the falling stretch the tangency is to the left of the short-run minimum, and on the rising stretch to the right.

The long-run curve is U-shaped because of economies and then diseconomies of scale. Internal economies come from specialisation of labour, indivisible machinery used more fully, bulk buying, cheaper finance and spreading research over more output; internal diseconomies come from the limits of managing a large organisation. External economies and diseconomies arise from the growth of the whole industry rather than the firm — a trained local labour pool is an external economy, congestion at a shared port an external diseconomy.

3. Market forms and the long-run outcome of each

Every market form sets output where marginal revenue equals marginal cost. What differs is the demand curve the firm faces, and from that everything else follows.

The four market forms compared
Form	Sellers and product	Demand curve for the firm	Long-run outcome
Perfect competition	Many sellers, identical product, free entry	Perfectly elastic, horizontal at the market price	Normal profit only; price equals minimum long-run average cost
Monopolistic competition	Many sellers, differentiated product, free entry	Downward sloping but highly elastic	Normal profit, but at less than minimum average cost — excess capacity
Oligopoly	Few sellers, interdependent decisions	Indeterminate; kinked under the Sweezy model	Prices sticky; profit may persist
Monopoly	One seller, no close substitute, blocked entry	The market demand curve itself	Supernormal profit can persist indefinitely

ℹ️ Excess capacity, in one line

A monopolistically competitive firm earns only normal profit in the long run, like a perfectly competitive one, but it reaches that position on the falling part of its average cost curve rather than at the bottom. The gap between the output it produces and the output at minimum average cost is excess capacity, and it is the price the market form pays for product variety.

4. Oligopoly and the price leadership model

What makes oligopoly different in kind is interdependence: a firm's best price depends on what its rivals will do about it, so there is no single determinate solution. The syllabus names price leadership, and the standard account distinguishes three forms.

Dominant firm leadership — one firm large enough to set the price, the rest supplying what they wish at it. The leader faces the market demand less what the followers supply, and maximises profit on that residual.
Barometric leadership — the leader is not the largest but the best at reading the market, and others follow because its judgement has proved sound.
Low-cost firm leadership — the firm with the lowest cost sets a price the others must match despite it being below their own optimum.

Alongside it sits Sweezy's kinked demand curve, which explains not the level of price but its stickiness. Each firm believes rivals will match a price cut and ignore a price rise, so its demand curve is more elastic above the going price and less elastic below it. The kink produces a vertical discontinuity in marginal revenue, and marginal cost can move anywhere within that gap without changing the profit-maximising price at all.

5. Monopoly and price discrimination

Price discrimination is charging different prices for the same good for reasons not attributable to differences in cost. Two conditions must hold: the seller must have some market power, and the markets must be separable so that the cheap buyer cannot resell to the dear one. Resale is what kills discrimination, which is why it is common in services and rare in commodities.

Pigou's three degrees
Degree	What is charged	Example
First degree	Each buyer's maximum willingness to pay, capturing the entire consumer surplus	An individually negotiated professional fee
Second degree	Different prices for different blocks of quantity, the buyer self-selecting	A slab tariff for electricity
Third degree	Different prices to identifiable groups with different elasticities	A student concession fare

🧠 Which market gets the higher price

Under third-degree discrimination the seller equates marginal revenue across markets, and the market with the less elastic demand is charged the higher price. Student and senior concessions look like generosity and are simply the elastic market being charged less, because the same formula that raises the price where demand is rigid lowers it where demand is responsive.

6. Skimming, penetration and peak load pricing

The syllabus names three strategies, and each answers a different question. Skimming and penetration both concern the launch of a new product and are opposites; peak load pricing concerns capacity and is not about launch at all.

Price skimming — launch high, then lower the price in steps. It suits an innovative product with inelastic early demand from buyers who want it first, and it recovers development cost quickly. It invites entry, because the high margin is visible to everyone.
Penetration pricing — launch low to win volume and share fast. It suits an elastic mass market with scale economies, and it deters entry; the cost is a low margin and a price that is hard to raise later.
Peak load pricing — charge more when demand presses against fixed capacity and less when it does not. Electricity tariffs by time of day, airline fares in season and surge fares are the standard examples, and the justification is that peak users are the reason the capacity had to be built.

⚠️ Peak load pricing is not third-degree discrimination

Price discrimination is by definition a price difference not attributable to cost. Peak load pricing reflects a real difference in the marginal cost of supplying at the peak, where extra capacity must be built or dearer plant brought on. The two look alike and are distinguished by whether cost differs, which is exactly what a question on this will turn on.

Key takeaways

Marginal cost cuts average variable and average total cost at their minima because a marginal value pulls an average towards itself — the same reason marginal product cuts average product at its maximum.
The long-run average cost curve is an envelope: tangent to each short-run curve, never cutting one, and tangent at a short-run minimum only at its own minimum.
Perfect and monopolistic competition both end at normal profit, but the second does so at less than minimum average cost — the excess capacity that pays for product variety.
Under third-degree price discrimination the less elastic market is charged the higher price, which is why concessions go to the group whose demand is most responsive.
Skimming and penetration are opposite launch strategies; peak load pricing is about capacity and is not price discrimination, because its price difference does reflect a difference in cost.

Practice questions (9)

Attempt each one before opening the answer. Every explanation names the tempting wrong option as well as the right one, because that is where marks are lost.

The marginal cost curve intersects the average total cost curve at:
1. The minimum point of average total cost
2. The minimum point of average fixed cost
3. The point where total cost is lowest
4. Every point, since the two curves coincide
Show answer
Answer: A — The minimum point of average total cost
A marginal value pulls an average towards itself: while marginal cost is below average total cost the average must be falling, and once marginal cost is above it the average must be rising. The average therefore turns at precisely the output where the two are equal, which is its minimum, and that is where the curves cross. Average fixed cost falls continuously and has no minimum, total cost is lowest at zero output, and the two curves are distinct for any firm with fixed costs.
In long-run equilibrium a firm in monopolistic competition earns only normal profit, yet it differs from a perfectly competitive firm because it produces:
1. At less than the output of minimum average cost, leaving excess capacity
2. At more than the output of minimum average cost
3. Exactly at minimum average cost, as does the competitive firm
4. At the output where average revenue is zero
Show answer
Answer: A — At less than the output of minimum average cost, leaving excess capacity
Free entry drives profit down to normal in both market forms, so long-run equilibrium requires the demand curve to be tangent to the average cost curve. For a perfectly competitive firm that demand curve is horizontal, so tangency occurs at the lowest point of average cost. For a monopolistically competitive firm the demand curve slopes downward, so tangency can only occur on the falling stretch of average cost, to the left of its minimum. The distance between that output and the minimum-cost output is excess capacity, the standard result for this market form.
A monopolist practising third-degree price discrimination between two separable markets will charge the higher price in the market where demand is:
1. Less elastic
2. More elastic
3. Perfectly elastic
4. Of unit elasticity
Show answer
Answer: A — Less elastic
The discriminating monopolist allocates output so that marginal revenue is equal in the two markets. Since marginal revenue equals price times the bracket (1 − 1/e), a market with a smaller elasticity needs a higher price to produce the same marginal revenue. So the rigid market pays more and the responsive market pays less, which is exactly why student and off-season concessions exist. A perfectly elastic market gives the seller no discretion at all, and unit elasticity is the point where marginal revenue is zero.
A firm launches a technically novel product at a high price and reduces it in stages as rivals appear. This is:
1. Price skimming
2. Penetration pricing
3. Peak load pricing
4. Predatory pricing
Show answer
Answer: A — Price skimming
Skimming takes advantage of the inelastic early demand of buyers who want a new product first, recovering development cost quickly, and then steps the price down to reach successively more price-sensitive segments. Penetration is its opposite: a low launch price to win volume and share, suited to an elastic mass market with scale economies. Peak load pricing varies price with the pressure of demand on fixed capacity and has nothing to do with a launch. Predatory pricing means pricing below cost to drive a rival out, which is not what is described here.
In Sweezy's kinked demand curve model, price rigidity follows from the fact that:
1. Marginal revenue has a vertical gap, within which marginal cost may move without changing price
2. Marginal cost is constant at all levels of output
3. Firms are barred by law from changing their prices
4. Every firm faces a perfectly elastic demand curve
Show answer
Answer: A — Marginal revenue has a vertical gap, within which marginal cost may move without changing price
The model assumes each oligopolist expects rivals to match a price cut but to ignore a price rise. Demand is therefore elastic above the prevailing price and inelastic below it, and the demand curve kinks at that price. A kink in demand produces a discontinuity in marginal revenue, a vertical stretch at the kink output, and a firm maximises profit where marginal cost crosses marginal revenue. So marginal cost can shift anywhere inside that vertical stretch and the profit-maximising price does not move. The model explains stickiness, not the level at which the price settles.
Average fixed cost:
1. Falls continuously as output rises and never becomes zero
2. Is U-shaped like average variable cost
3. Rises with output because fixed cost rises
4. Is constant at every level of output
Show answer
Answer: A — Falls continuously as output rises and never becomes zero
Average fixed cost is total fixed cost divided by output. The numerator does not change with output by definition, so dividing a constant by a rising number produces a curve that falls throughout and approaches the horizontal axis without ever touching it — a rectangular hyperbola. It has no minimum, which is why marginal cost never intersects it. Total fixed cost is what stays constant; the average of it does not, and confusing the two is the error this question tests.
The long-run average cost curve is called an envelope curve because it:
1. Is tangent to every short-run average cost curve and lies below them elsewhere
2. Intersects every short-run average cost curve at its minimum
3. Lies above all short-run average cost curves
4. Is horizontal at the level of minimum cost
Show answer
Answer: A — Is tangent to every short-run average cost curve and lies below them elsewhere
For each level of output the long-run curve records the lowest average cost achievable once plant size can be chosen freely, which is the cost on whichever short-run curve is best for that output. It therefore touches each short-run curve at exactly one point and lies below it at every other output, enveloping the whole family from beneath. It cannot intersect one, because that would mean some short-run arrangement is cheaper than the best long-run arrangement. Tangency at a short-run minimum occurs only at the minimum of the long-run curve itself.
An electricity utility charges more per unit during evening hours when its capacity is strained. Strictly, this is:
1. Peak load pricing, because the price difference reflects a real difference in cost
2. First-degree price discrimination
3. Second-degree price discrimination
4. Predatory pricing
Show answer
Answer: A — Peak load pricing, because the price difference reflects a real difference in cost
Price discrimination is defined as charging different prices for the same good for reasons not traceable to cost. Supplying at the peak is genuinely dearer, because it is the peak that obliges the utility to hold capacity and to run its costlier plant, so the higher evening tariff tracks a higher marginal cost and falls outside the definition. First-degree discrimination charges each buyer their maximum willingness to pay and second-degree charges by blocks of quantity, neither of which describes a time-of-day tariff. Predatory pricing means pricing below cost to eliminate a rival.
In long-run equilibrium under perfect competition, price equals:
1. Minimum long-run average cost
2. Average fixed cost
3. Maximum average revenue
4. Total cost divided by price
Show answer
Answer: A — Minimum long-run average cost
Free entry and exit drive economic profit to zero in the long run, so price must equal average cost. The firm also maximises profit where price equals marginal cost, and marginal cost equals average cost only at the minimum of the average cost curve. Both conditions can hold together only at that minimum, which is why the competitive long-run equilibrium is described as productively efficient. Average fixed cost is irrelevant in the long run because no cost is fixed, and the remaining options are not meaningful equilibrium conditions.