CHAPTER 8

PRICING AND OUTPUT DECISIONS:

PERFECT COMPETITION AND MONOPOLY

PROBLEMS

1. a. FALSE Not if its loss is less than its fixed cost. See explanation of problem 1.

b. FALSE Even a pure monopoly has to consider the possibility of demand falling below
the level sufficient to earn a profit. (For example, even if Polaroid continues to
have a monopoly on cameras that use instant developing film, can they stop the
erosion in demand due to the one-hour photo developing machines and cameras
that record images electronically on discs?)

c. TRUE Other factors held constant, the entry or exit of firms will theoretically lead to
this condition.

d. TRUE In order to maximize revenue, a firm will price its product at the point where
MR=0. By implication, this must be a lower price than the point where MR=MC.

e. TRUE If P>AVC but P<AC, then the company will cover some of its fixed costs; thus,
loss will be less than fixed cost.

f. FALSE Price will be more than MR.

g. FALSE This depends on the demand for its product. The demand curve can shift to the
left. While a monopoly may earn profits in the short run, the long run monopoly
profits are often eroded as competition and changes in technology make
monopolies vulnerable.

2. Setting the derivative of the total cost function equal to the derivative of the total revenue function
and solving for Q yields the same result as setting the total profit function equal to 0 and solving for
Q.

TR = 170Q - 5Q2
MR = 170 - 10Q
TC = 40 + 50Q + 5Q2
MC = 50 + 10Q

MR = MC
170 - 10Q = 50 + 10Q
120 = 20Q
6 = Q*

π = 170Q - 5Q2 - 40 - 50Q - 5Q2

= - 40 + 120Q - 10Q2
dπ = 120 - 20Q = 0
dQ
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 Pricing and Output Decisions: Perfect Competition and Monopoly 76

120 = 20Q
6 = Q*

3. Given the market price and its cost structure, this firm will be incurring a loss. However, this loss
will not be as large as its fixed cost. In other words, this firm will have a positive contribution
margin. In the short run, it should remain in operation. In the long run, it may have to consider
dropping out of this market if the price does not rise above its average cost or if it cannot manage to
lower its average cost below the market price. However, other firms may decide to drop out before
it does and their actions may cause the market price to rise (i.e., a long run leftward shift in supply).
Furthermore, for some reason, demand may increase in the long run, thereby causing price to rise
(i.e., a long run rightward shift in demand).

4. a. To answer this question, we illustrate how Excel software can help to answer this question.
Using the online software provided for users of this text, we arrive at the following:

Total Total
Total Fixed Variable Total Total
Quantity Price Revenue Cost Cost Cost Profit
0 100 0 50 0 50.00 -50.00
1 92 92 50 71 120.60 -28.60
2 84 168 50 125 174.80 -6.80
3 76 228 50 166 216.20 11.80
4 68 272 50 198 248.40 23.60
5 60 300 50 225 275.00 25.00
6 52 312 50 250 299.60 12.40
7 44 308 50 276 325.80 -17.80
8 36 288 50 307 357.20 -69.20
9 28 252 50 347 397.40 -145.40
10 20 200 50 400 450.00 -250.00
Demand Coefficient 100 8 Fixed Cost 50.00
Cost coefficients 80 10 0.6

The optimal price is $60 and the optimal quantity is 5.

We can be more precise if we employ calculus to find the short run profit maximizing price.
Let us follow the procedure explained in detail in the appendix to Chapter 2. We simply state
the profit function as TR - TC. We then take the first derivative of this function, set it equal to
zero and solve for Q. We can then find the optimal price by inserting this value of Q into the
demand equation.

TR = 100Q - 8Q2

II = 100Q - 8Q2 - 50 - 80Q + 10Q2 - 0.6Q3

dII/dQ = 100 - 16Q - 80 + 20Q - 1.8Q2 = 0

Using the formula for finding the roots of a quadratic equation, we arrive at:

Q = -4 + or - 12.65

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 Pricing and Output Decisions: Perfect Competition and Monopoly 77

-3.6
Q* = 4.625 and P* = $63
b. In order to find the price that maximizes total revenue, we can use the spreadsheet above. We
see total revenue is maximized at a price of $52. Using calculus simply involves taking the first
derivative of the total revenue function (i.e., MR), setting it equal to zero and solving for Q.
Using this Q in the demand equation will give us the revenue maximizing price.
ÄTR/ÄQ = 100 - 16Q = 0
Q* = 6.25
P* = $50

(Notice that the spreadsheet will also indicate a price of $50 if the values of quantity were set
for small intervals.)

c. If the firm wanted to use a linear approximation of the cubic equation, it might simply derive
the linear equation in the manner shown in the figure below.

500

400

300
TC1
$
TC2
200

100

0
0 1 2 3 4 5 6 7 8 9 10
Q

Figure 8.3

5. A “good” firm
MC
S

AC

P1 P1

Q1 Q

Figure 8.5

Given market price P1, the firm is able to keep its cost structure low enough so that P = MC above AC.

A “lucky” firm

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 Pricing and Output Decisions: Perfect Competition and Monopoly 78

MC

P1

AC D
P1

Q1 Q

Figure 8.6

Given its cost structure, the firm is able to make an economic profit because the market price is so high.

6. If we assume that the firm uses the MR = MC rule to determine its optimal price, then it should not
raise its price because the increase in fixed cost does not change marginal cost. In fact, raising price
to cover the increase in fixed cost would actually move the firm away from its optimal price. Using
a spreadsheet or calculus, we would find that given the demand and cost functions in this problem,
the firm would be prompted to set its optimal price at $8.67. This is also shown in the figure below.

This figure shows that if the firm has AC1, it would make some profit. At AC2 (the cost that
assumes a fixed cost of 30 percent more), the firm would be losing money. However, by sticking
with the price, $8.67, it would at least be minimizing its losses. Furthermore, it can indeed survive
(at least for the short run) if it charges this price of less than $9.00 because it at least is covering its
per unit variable cost (i.e., it has a positive contribution margin).

14
13
12
11
10
9
P1* = 8.67 AC1
8
AC2
7
$ 6 D
5 MR
4 AVC=MC
3
2
1
0
-1
-2
0 10 20 30 40 50 60 70 80
Q

Figure 8.4

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 Pricing and Output Decisions: Perfect Competition and Monopoly 79

7. a.
60

55

50

45 AC
$ MC
40 AVC

35

30

25
8 9 10 11 12 13 14 15 16 17 18 19 20
Q (Thousands)

Figure 8.1

b. Yes. If P = $50, the firm should produce 18 units and earn an economic profit of $108.72.

c. If P = $35, then the best that the firm could do by operating would be to produce 14 units (i.e.,
by following the MR=MC rule). However, this would cause it to lose $136.36, a sum greater
than the implied fixed cost of $99.96 (rounded to $100). Thus the firm should shut down.

8. a. Because Kelson’s marginal cost function is linear, it implies that its total cost function is
quadratic. This indicates that the law of diminishing returns takes effect as soon as production
begins.

b. At Q = 1500, MC = $157.50
At Q = 2000, MC = $160.00
At Q = 3500, MC = $167.50

c. MC = $150 + 0.005Q = $175

Q* = 5000

d. The supply curve is essentially the portion of a firm’s marginal cost curve above its average
variable cost (i.e., the shut down point). Although fixed and variable cost is not provided, we
can assume that over a certain range, the firm is earning either a profit or is incurring a loss
greater than its fixed cost. Thus, the following is a suggested short run supply schedule:

P Q
$175 5000
180 6000
185 7000
190 8000
etc.

9. a. P* = $1090.

b. The above price would enable a firm to earn a maximum amount of total profit in the short run.
However, it may want to consider charging a higher price if it wanted to position its product as
a “premium” product. It might also want to set a higher price if it suspected that future
competition would eventually force all competitors to lower their price. Without more specific

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 Pricing and Output Decisions: Perfect Competition and Monopoly 80

data about these other considerations, it would be difficult to suggest a specific price that is
higher than $1090. As a generalization, we can only say that the firm would set a higher price if
it gives greater priority to goals mentioned above.

c. The firm would want to consider setting a price lower than $1090 if it wanted to increase its
revenue (i.e., market share). As can be seen in the numerical example, if the firm charged $850,
its total revenue would be $850,000 (as compared to $763,000 at the price of $1090). In fact, it
could continue lowering its price in order to increase its revenue up to the point at which MR=0
(not shown in the table).

There may be other reasons for lowering the price. For example, the firm may wish to use the
strategy of “learning curve pricing” (see Chapter 8). It may also choose to be an aggressive
price-cutter in an oligopolistic market.

10. a. To solve this problem, we find the MR and MC functions, set them equal to each other, and
solve for the optimal Q. Using this Q, we then find the optimal P.

P = 853.37 - 0.06Q
TR = 853.37Q - 0.06Q2
MR = 853.37 - 0.12Q
MC = 0.85 + 0.03Q

853.37 - 0.12Q = .85 + 0.03Q

Q* = 5683.466
P = 853.37 - 0.06(5683.466)
P* = $512.36

This price can then be rounded to a more even number (e.g., $500).

b.

$512.36 = P*

D
MR

$ AC
AVC
MC

Q* =
3000
0 4000 5000 5683.47 6000 7000
Q

Figure 8.2

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