PRICING & OUTPUT DECISION

- Market Structure

Chapter Organization

• Introduction to Market Structure• Perfect Competition• Monopoly• Monopolistic Competition• Oligopoly

Market Structure

Determinants of market structure• Freedom of entry and exit• Nature of the product-

homogeneous, differentiated• Control over supply/output• Control over price• Barriers to entry

Classification of market based on nature of competition

MARKET

Perfect competition Imperfect Competition

Pure Perfect Monopoly Oligopoly Monopolistic

Perfect Competition

Assumptions• Large number of Buyers & Sellers.• Homogeneous product.• Free entry & exist to industry.• No govt. regulation.• Price takers• Perfect Knowledge of market conditions.• Perfect mobility of factors of production.

• A perfectly competitive market is where agents in the market (buyer&seller) are price taker.

• Price taking behaviors: agents believe that the market price is given and their actions do not influence the market price.

• Examples of Perfect Competition- Financial markets - (stock exchange,

currency market), agriculture

FIRM-PRICE TAKER

Equilibrium of firm in short run

(A) TR and TC approach TC

TRC

R

XAXXB

(B) MR and MC approach

MC

P=AR=MR

X

P

P0

0

e

Xe

Profit Maximization for a Perfectly Competitive Firm • All firms maximization for a Perfectly Competitive Firm

MR = MC•Since the perfectly competitive firm is a price taker, marginal revenue equals price.

MR = P•Therefore, profits will be maximized where

MR (= P) = MC or P = MC

Profit Maximization

All firms can maximize profits (or minimize losses) by comparing marginal revenue (MR) with marginal cost (MC)

• If MR > MC, profits are increasing• If MR < MC, profits are decreasing• Therefore, profits must be maximized where

MR=MC

• Since the perfectly competitive firm is price taker, marginal revenue equals price.

MR= P

• Therefore, profits will be maximized where

MR (=P) = MC or P = MC

Is the firm making a profit?

For a price taker, price is also equal to the average revenue and we need to compare average total cost with price in order to tell whether the firm is making a profit.

• If P > ATC , the firm is making a profit that is , it is selling its output at mere than its cost.

•If P < ATC, the firm is losing money

MC

ATC

LossD

C P=AR = MR

0Quantity

Pri

ce ,C

ost,

Rev

enue

E

F

•If P > ATC, the firm is having super normal profits

MC

ATC

Super Normal ProfitE P=AR = MR

0Quantity

Pri

ce ,C

ost,

Rev

enue

P0

A B

Xe

•If P = ATC, the firm is having normal profits.

MC ATC

CP=AR = MR

0Quantity

Pri

ce ,C

ost,

Rev

enue

B

Shut down point

What if the Firm is Losing Money?

• If a firm is losing money, it has to decide whether to operate at a loss or shut down.• If a firm shuts down, its loss will be equal to the amount of its total fixed costs.• But, if a firm can cover its variable costs, it should continue to operate even though it’s losing money.

The Shut-Down Condition

•If P < AVCmin , the firm should shut down. Why? Because it’s not covering its variable costs.

•If P > AVCmin , the firm should continue to operate at a loss.Why? Because it will cover its variable costs

•The minimum of average variable cost is called the shutdown price.

Short run equilibrium of industry

Long Run Equilibrium - Firm

Long Run Equilibrium- Industry