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Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
1
Chapter 8-B
Pricing and Output Decisions:
Perfect Competition and Monopoly
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Overview
Competition and market typesPricing and output decisions in perfect competitionPricing and output decisions in monopoly marketsImplications for managerial decisions
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Learning objectivesunderstand the four market typescompare the degree of price competition among the four market typesexplain why the P=MC rule leads firms to the optimal level of productionexplain how the MR=MC rule helps a monopoly to determine its optimumexplain the relationship between the MR=MC rule and the P=MC ruledescribe what happens in the long run
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types 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
nonprice competition important
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types Examples: perfect competition
agricultural products
financial instruments
precious metals
petroleum
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types Examples: monopoly
pharmaceuticals
Microsoft
gas station on edge of desert
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types Examples: monopolistic competition
boutiques
restaurants
repair shops
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Four market types Examples: oligopoly
oil refining
processed foods
airlines
internet access
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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?
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 firm’s 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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 firm’s profits or minimizes its loss
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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*
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 firm’s ability to set price is limited by the demand curve for its product, and in particular, the price elasticity of demand
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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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 company’s monopolistic power
Chapter Eight Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall.
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Global application Example: Bluefin tuna
sushi restaurants operate in monopolistic competition
bluefin tuna price determined by perfect competition
low profit margin
