chapter 8 pricing and output decisions: perfect competition and monopoly

Chapter 8

Pricing and Output Decisions: Perfect Competition and

Monopoly

Chapter Outline

• Competition and market types in economic analysis• Pricing and output decisions in perfect competition• Pricing and output decisions in monopoly markets• Implications of perfect competition and monopoly

for managerial decisions

Learning Objectives

• Describe and provide examples of the four market structures

• Compare the degree of price competition among the four market types

• Explain why the P=MC rule leads firms to the optimal level of production in competitive markets

• Explain how the MR=MC rule helps a monopoly to determine its optimum quantity

• Contrast the relationship between the MR=MC rule and the P=MC rule

• Describe the shut down rule

Competition and Market Types in Economic Analysis

• Perfect competition (no market power)

– large number of relatively small buyers and sellers

– standardized product

– very easy market entry and exit

– non-price competition not possible

• Monopoly (absolute market power, subject to government regulation)

– one firm, firm is the industry

– unique product or no close substitutes

– market entry and exit difficult or legally impossible

– non-price competition not necessary

• Monopolistic competition (market power based on product differentiation)

– large number of small firms acting independently

– differentiated product

– market entry and exit relatively easy

– non-price competition very important

• Oligopoly (product differentiation and/or the firm’s dominance of the market)

– small number of large mutually interdependent firms

– differentiated or standardized product

– market entry and exit difficult

– non-price competition important

• Examples: perfect competition

– agricultural products

– financial instruments

– commodities

• Examples: monopoly

– pharmaceuticals with patents

– regulated utilities (although this is changing)

– last chance gas station on the edge of the desert

• Examples: monopolistic competition

– boutiques

– restaurants

– repair shops

• Examples: oligopoly

– oil refining

– processed foods

– airlines

– internet access and cell phone service

Pricing and Output Decisionsin Perfect Competition

• Basic business decision: entering a market using the following questions

– How much should we produce?– If we produce such an amount, how much profit

will we earn?– If a loss rather than a profit is incurred, will it be

worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit), or should we exit?

• Key assumptions of the perfectly competitive market:

– The firm is a price taker (it must accept the market price)

– The firm makes the distinction between the short run and the long run

• Additional key assumptions of the perfectly competitive market:

– The firm’s objective is to maximize its profit (or minimize loss) in the short run

– The firm includes its opportunity cost of operations in its total cost of production

• Perfectly elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price

– The firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product

– There is no limit to the total revenue that the firm can gain in a perfectly competitive market

Perfectly Elastic Demand Curve

• Total revenue/Total cost approach:

– Compare the total revenue and total cost schedules and find the level of output that either maximizes the firm’s profits or minimizes its loss

• Marginal revenue/Marginal cost approach– Produce a level of output at which the additional

revenue received from the last unit is equal to the additional cost of producing that unit (i.e. MR=MC)

– Both the TR/TC and MR=MC approach lead to the same price/output decision

– For the perfectly competitive firm, the MR=MC rule may be restated as P=MC because P=MR in perfectly competitive market

• Case A: economic profit

The point where P=MR=MC is the optimal output (Q*)

profit = TR – TC Q* =(P - AC) ·

Pricing and Output Decisions in Perfect Competition

• Case B: economic loss

The firm incurs a loss. At optimum output, price is below AC however, since P > AVC, the firm is better off producing in the short run, because it will still incur fixed costs greater than the loss

Pricing and Output Decisions in Perfect Competition

• Contribution margin: the amount by which total revenue exceeds total variable cost

CM = TR – TVC

if CM > 0, the firm should continue to produce in the short run in

order to defray some of the fixed cost

• Shutdown point: the lowest price at which the firm would still produce

– At the shutdown point, the price is equal to the minimum point on the AVC

– If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs.

• In the long run, the price in the competitive market will settle at the point where firms earn a normal profit over the long run.– Economic profit invites entry of new firms

• Shifts the supply curve to the right• Puts downward pressure on price • Reduces profits to normal levels

– Economic loss causes exit of firms • Shifts the supply curve to the left• Puts upward pressure on price• Increases profits to normal levels.

• Perfectly competitive markets in action:– the earlier the firm enters a market, the better its

chances of earning above-normal profit for a period of time

– as new firms enter the market, firms must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors

– firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation

Pricing and Output Decisions in Monopoly Markets

• A monopoly market consists of one firm (the firm is the market)

– The firm has the power to set the price which maximizes profit.

– The profit maximizing price is limited by the demand curve for the product, and in particular, the price elasticity of demand.

Pricing and Output Decisionsin Monopoly Markets

Assume demand is linear: it is downward sloping because the firm is a price setter

Assume MC is constant and choose output where MR=MC, set price at P*

Pricing and Output Decisionsin Monopoly Markets

Demand is the same as before, as is MR

MC is upward sloping, which shows diminishing returns

Set output where MR=MC

Implications of Perfect Competition and Monopoly for Decision Making

• Lessons on perfectly competitive markets

– It is extremely difficult to make money over the long run.

– The firm must be as cost efficient as possible to survive.

– It might pay for a firm to move into a market before others start to enter, but that is a risk--demand may not materialize.

Implications of Perfect Competition and Monopoly for Decision Making

• Monopoly market lessons– The most important lesson is not to be arrogant

or complacent and assume the firm’s ability to earn economic profit can never be diminished.

– Changes in the business environment eventually break down a dominating company’s monopolistic power

Global Application

• Example for discussion: Bluefin tunaWhat changes will occur in this market?

• sushi restaurants operate in monopolistic competition• Bluefin tuna price determined by perfect competition• low profit margin

Summary

• In the case of perfect competition, the firm has virtually no power to set the price--they are price takers and make normal profits.

• A monopoly has market power to set its price.

• All firms attempt to produce at a quantity where MR=MC to maximize profit or minimize loss.

chapter 8 pricing and output decisions: perfect competition and monopoly

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