Chapter 8

Pricing and Output Decisions: Perfect Competition and Monopoly

Chapter Eight

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Four market types

Perfect competition (no market power)

large number of relatively small buyers and sellers standardized product very easy market entry and exit nonprice competition not possible
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Chapter Eight

Four market types

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 nonprice competition not necessary
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Chapter Eight

Four market types

Monopolistic competition (market power based on product differentiation)

large number of small firms acting independently differentiated product

market entry and exit relatively easy

nonprice competition very important
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Chapter Eight

Four market types

Oligopoly (product differentiation and/or the firms dominance of the market)

small number of large mutually interdependent firms differentiated or standardized product

market entry and exit difficult

nonprice competition important
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Chapter Eight

Four market types

Chapter Eight

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Four market types

Examples: perfect competition

agricultural products financial instruments precious metals

petroleum

Chapter Eight

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Four market types

Examples: monopoly

pharmaceuticals Microsoft gas station on edge of desert

Chapter Eight

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Four market types

Examples: monopolistic competition

boutiques restaurants repair shops

Chapter Eight

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

Four market types

Examples: oligopoly

oil refining processed foods airlines

internet access

Chapter Eight

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Pricing and output decisions in 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?
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Chapter Eight

Pricing and output decisions in perfect competition

Key assumptions of the perfectly competitive market: the firm is a price taker the firm makes the distinction between the short run and the long run the firms objective is to maximize its profit (or minimize loss) in the short run the firm includes its opportunity cost of operating in a particular market as part of its total cost of production

Chapter Eight

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Pricing and output decisions in perfect competition

Perfectly elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product no limit to the total revenue that the firm can gain in a perfectly competitive market
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Pricing and output decisions in perfect competition

Total revenue/Total cost approach:

compare the total revenue and total cost schedules and find the level of output that either maximizes the firms profits or minimizes its loss

Chapter Eight

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Pricing and output decisions in perfect competition

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 (ie. MR=MC) Note: for the perfectly competitive firm, the MR=MC rule may be restated as P=MC because P=MR in perfectly competitive market

Chapter Eight

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Pricing and output decisions in perfect competition

Case A: economic profit The point where P=MR=MC is the optimal output (Q*) profit = TR TC =(P - AC) Q*
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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

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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
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Pricing and output decisions in perfect competition

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

Chapter Eight

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Pricing and output decisions in perfect competition

In the long run, the price in the competitive market will settle at the point where firms earn a normal profit

economic profit invites entry of new firms shifts the supply curve to the right puts downward pressure on price and reduces profits economic loss causes exit of firms shifts the supply curve to the left puts upward pressure on price and increases profits
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Chapter Eight

Pricing and output decisions in perfect competition

Observations in perfectly competitive markets: the earlier the firm enters a market, the better its chances of earning above-normal profit

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 instead
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Chapter Eight

Pricing and output decisions in monopoly markets

A monopoly market consists of one firm (the firm is the market) firm has the power to set any price it wants however, the firms ability to set price is limited by the demand curve for its product, and in particular, the price elasticity of demand
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Chapter Eight

Pricing and output decisions in monopoly markets

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

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

Chapter Eight

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Pricing and output decisions in monopoly markets

Demand is the same as before, as is MR MC is upward sloping, which shows diminishing returns set output where MR=MC

Chapter Eight

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Implications of perfect competition and monopoly for decision making

Perfectly competitive market

most important lesson is that it is extremely difficult to make money must be as cost efficient as possible it might pay for a firm to move into a market before others start to enter
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Chapter Eight

Implications of perfect competition and monopoly for decision making

Monopoly market

most important lesson is not to be arrogant and assume their ability to earn economic profit can never be diminished changes in economics of a business eventually break down a dominating companys monopolistic power
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Chapter Eight

Global application

Example: Bluefin tuna sushi restaurants operate in monopolistic competition bluefin tuna price determined by perfect competition low profit margin

Chapter Eight

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.

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