Karina Pricing Decision Summary

7/25/2019 Karina Pricing Decision Summary

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Name: Karina Permata Sari (29115447) Program: GM 2

Business Economics Summar

Pricing !ecision

"ntro#uction

The pricing and output decision will actually be answered within the framework of four basic

types of markets: perfect competition, monopoly, monopolistic competition, and oligopoly.

Perfect competition and monopoly can be considered the two extreme market environments in

which a firm competes in terms of market power. In terms of market power, monopolistic

competition and oligopoly are somewhere between the two extremes of perfect competition and

monopoly. From a pedagogical standpoint, it is easier to understand and appreciate theparticulars of monopolistic competition and oligopoly if there is first a thorough understanding

of perfect competition and monopoly.

$om%etition an# Mar&et '%es in Economic nasis

'*e Meaning o+ $om%etition

In economic analysis, the most important indicator of the degree of competition is the ability

of firms to control the price and use it as a competitive weapon. The extreme form of

competition is perfect competition. In this market, the competition is so intense and the

firms are so evenly divided that no one seller or group of sellers can exercise any control over

the price. That is, they are all price takers. ! second key measure of competition in economicanalysis is the ability of a firm to earn an "above normal# or "economic# profit in the long

run.

Figure 1 Comparison of Four Market Types by Characteristics AectingDegree of Competition


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The figure $ above shows the four market types according to the degree of competition as

indicated by the extent of market power and the ability of firms to earn long%run economic

profit. ! firm in monopolistic competition may have some market power because its product

can be differentiated from those sold by its competitors. ! firm operating in an oligopoly

derives its market power from its ability to differentiate its product, its relatively large si&e, or

both.

Figure 2 The Four Basic Market Types

Pricing an# ,ut%ut !ecisions in Per+ect $om%etition

'*e Basic Business !ecision

Imagine a firm that is considering entry into a market that is perfectly competitive. If it

decides to compete in this market, it will have no control over the price of the product.

Therefore, the firm's managers must make a business case for entering this market on the basis

of the following (uestions:

$. )ow 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*

The perfectly competitive firm must operate in a market in which it has no control over the

selling price, there may be times when the price does not fully cover the unit cost of

production -i.e., average cost. Thus, a firm must assess the extent of its losses in relation to


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the alternative of discontinuing production. In the long run, a firm that continues to incur

losses must eventually leave the market. /ut in the short run, it may be economically

0ustifiable to remain in the market, with the expectation of better times ahead. This is because

in the short run certain costs must be borne regardless of whether the firm operates. These

fixed costs must be weighed against the losses incurred by remaining in business. It is

reasonable to expect that a firm will remain in business if its losses are less than its fixedcosts%at least in the short run.

Ke ssum%tions o+ t*e Per+ect $om%etiti-e Mar&et

The key assumptions in analy&ing the firm1s output decision in perfect competition are:

$. The firm operates in a perfectly competitive market and therefore is a price taker.

+. The firm makes the distinction between the short run and the long run.

. The firm's ob0ective is to maximi&e is profit in the short run. If it cannot earn a profit, then

it seeks to minimi&e its loss.

2. The firm includes its opportunity cost of operating in a particular market as part of its total

cost of production

For the economic analysis of a firm's output and pricing decisions to have a uni(ue solution,

the firm must establish a single, clear%cut ob0ective. This ob0ective is the maximi&ation of

profit in the short run. If the firm has other ob0ectives, such as the maximi&ation of revenue in

the short run, the output that it would select would differ from the one based on this model.

The consideration of opportunity cost in the cost structure of the firm is vital to this decision%

making model. The firm must check whether the going market price enables it to earn a

revenue that covers not only its out%of%pocket costs, but also the costs incurred by forgoing

alternative activities.

'*e 'ota .e-enue/'ota $ost %%roac* to Seecting t*e ,%tima ,ut%ut 0e-eThe most logical approach to selecting the optimal level of output is to compare the total

revenue with the total cost schedules and find that level

of output that either maximi&es the firm's profit or

minimi&es its loss. 3raphically, this output level can be

seen as the one that maximi&es the distance between the

total revenue curve and the total cost curve. /y

convention, this point has been labeled Q*

Figure 3 Determining Optima Output from Cost an!

"e#enue Cur#es$$$%erfect Competition

'*e Margina .e-enue/Margina $ost %%roac* to in#ing t*e ,%tima ,ut%ut 0e-e

4arginal analysis is at the heart of the economic analysis of the firm. The marginal revenue

and marginal cost columns contain the key numbers the firm must use to decide on its optimal

level of output. 5sing the relationship between marginal revenue and marginal cost to decide


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on the optimal level of output is referred to in economics as the 46 7 48 rule. The rule is

stated as follows:

A firm that wants to maximize its profit (or minimize its loss) should 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. In short, MR M!.

The 46 7 48 rule applies to less any firm that wants to maximi&e its profit, regardless of

whether it has the power to set the price. )owever, in the particular case in which the firm has

no power to set the price -i.e., it is a price taker, the 46 7 48 rule can be restated as the P

M$rule. This is simply because when a firm is a price taker, its marginal revenue is in fact

the going market price. !lthough the optimal output level can be found 0ust as easily by using

the

T6 % T8 approach, economists rely much more on the 46 % 48 approach in analy&ing the

firm's output decision.

'*e $om%etiti-e Mar&et in t*e 0ong .un

6egardless of whether the market price in the short run results in economic profit, normal

profit, or a loss for competing firms, economic theory states that in the long run, the market

price will settle at the point where these firms earn a normal profit. This is because over a long

period of time, prices that enable firms to earn above normal profit would induce other firms

to enter the market, and prices below the normal level would cause firms to leave the market.

Figure 2a shows a hypothetical short%run situation in which the price -determined by supply

and demand is high enough to enable a typical firm competing in this market to earn

economic profit. -9iewed in another way, given the market price, the firm's cost structure is

low enough to enable it to earn economic profit. ver time, new firms would enter the

market, and the original firms would expand their fixed capacity in response to the incentive

of economic profit. This would have the effect of increasing the market supply -shifting the

supply curve to the right and reducing the market price. !t the point where firms earn only

normal profit, this ad0ustment process would cease. Figure 2b shows the opposite case, in

which a short%run loss incurred by firms in the market causes firms in the long run to leave the

market. This causes price to rise toward the level in which the remaining firms would earn a

normal profit. !n understanding of the conditions motivating market entry or exit over the

long run should lead the firms to consider the following points:

$. The earlier the firm enters a market, the better its chances of earning above%normal profit

-assuming a strong demand in this market.

+. !s new firms enter the market, firms that want to survive and perhaps thrive must findways 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, although this is extremely

difficult in this type of market.


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Figure & 'ong$"un (ect of Firm)s (ntering an! (*iting Market

Pricing an# ,ut%ut !ecisions in Mono%o Mar&ets

! monopoly market consists of one firm. The firm is the market. The key point is that a

monopoly firm's ability to set its price is limited by the demand curve for its product and, in

particular, the price elasticity of demand for its product. The price elasticity of demand indicates

how much more

or less people are willing to buy in relation to price decreases or increases. If we assume the

firm's downward%sloping demand curve is linear, we know that as the price of the product falls,

the marginal revenue from the sale of additional units falls, reaches &ero, and then becomes

negative. The ability of a monopoly to set its price is further limited by the possibility of risingmarginal costs of production. If this is the case, then surely at some point the increasing cost of

producing additional units of output will exceed the decreasing marginal revenue received from

the sale of additional units. In conclusion, the firm that exercises a monopoly power over its

price should not set its price at the highest possible level. Instead, it should set it at the right

level. !nd what is this 'right level* It is the level that results in 46 7 48.


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'*e "m%ications o+ Per+ect $om%etition an# Mono%o +or Manageria

!ecision Ma&ing

In the case of perfect competition, the market price is determined for the managers by the forces

of supply and demand. !ll that they have to do is to decide whether their cost structure will

enable their firm to at least earn a normal amount of profit. In the case of monopoly, the fact thatthe firm has no competition enables its managers simply to follow the 46 7 48 rule to

maximi&e its profit. The most important lesson that managers can learn by studying the perfectly

competitive market is that it is extremely difficult to make money in a highly competitive

market. Indeed, the only way for firms to survive in perfect competition is to be as cost efficient

as possible because there is absolutely no way to control the price. !nother lesson offered by the

perfectly competitive model is that it might pay for a firm to move into a market before others

start to enter. This might mean

entering a market even before the demand is high enough to support an above%normal price.

;potting these market opportunities and taking the risk of going into

these markets are key tasks of a good manager. f course, the demand may never materiali&e orthe long%run increase in supply might be so great that no one makes any money in this market.

/ut that is all part of the risk that a manager must sometimes take. The key lesson for managers

to learn from the many examples of once%powerful monopolies or near%monopolies that have

eventually been affected by changing economics is not to be complacent or arrogant and assume

their ability to earn economic profit can never be diminished.

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Karina Pricing Decision Summary