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Chapter 8 Chapter 8 Pricing and Output

Decisions: Perfect Competition and Monopoly

Managerial Economics: Economic

Tools for Today·s Decision Makers, 5/e

By Paul Keat and Philip Young

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2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

Pricing and Output Decisions:

Perfect Competition and Monopoly

Competition and Market Types in Economic

Analysis

Pricing and Output Decisions in Perfect

Competition

Pricing and Output Decisions in Monopoly

Markets

The Implications of Perfect Competition and

Monopoly for Managerial Decision Making

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Learning Objectives

Describe the key characteristics of the four basic

market types used in economic analysis.

Compare and contrast the degree of price

competition among the four market types.

Provide specific actual examples of the four

types of markets.

Explain why the P=MC rule leads firms to the

optimal level of production.

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Learning Objectives

Describe what happens in the long run in marketswhere firms that are either incurring economiclosses or are making economic profits. Explain

why this happens with particular attention to thekey assumptions used in this analysis.

Explain how and why the MR=MC rule helps amonopoly to determine the optimal level of price

and output.

Explain the relationship between the MR=MCrule and the P=MC rule.

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Four Basic 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

Monopoly (absolute market power subject togovernment 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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Monopolistic Competition (market power based on productdifferentiation) Large number of relatively small firms acting independently

Differentiated product

Market entry and exit relatively easy

Nonprice competition very important

Oligopoly (market power based on product differentiation and/or the firm¶s dominance of the market) Small number of relatively large firms that are mutually interdependent

Differentiated or standardized product

Market entry and exit difficult Nonprice competition very important among firms selling differentiated

products

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Pricing and Output Decisions

in Perfect Competition

The Basic Business Decision: entering a market

on the basis of 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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Key assumptions of the perfectly competitivemarket The firm operates in a perfectly competitive market

and therefore is a price taker.

The firm makes the distinction between the short runand the long run.

The firm¶s objective is to maximize its profit in theshort run. If it cannot earn a profit, then it seeks to

minimize its loss. The firm includes its opportunity cost of operating in

a particular market as part of its total cost of production.

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Perfectly Elastic demandcurve: consumers are willingto buy as much as the firm iswilling to sell at the going

market price. Firm receives the same

marginal revenue from thesale 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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Total Revenue-Total Cost approach:

Compare the total revenue and total cost schedules and findthe level of output that either maximizes the firm¶s profits or minimizes its loss.

Marginal Revenue ± Marginal Cost Approach A firm that wants to maximize its profit (or minimize its loss)

should produce a level of output at which the additionalrevenue received from the last unit is equal to the additional

cost of producing that unit. In short, MR=MC. For the perfectly competitive firm, the MR=MC rule may berestated as P=MC.

This is because P=MR in perfectly competitive markets.

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The point where

P=MR=MC is the

optimal output (Q*)

Profit = TR ± TC

=(P - AC) · Q*

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The firm incurs a loss.At the optimum outputlevel price is belowaverage cost.

However, since price isgreater than averagevariable cost, the firm is better off producing in

the short run, because itwill still incur fixed costsgreater than the loss.

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Contribution Margin(CM): the amount bywhich total revenueexceeds total variable

cost. CM = TR ± TVC

If the contribution marginis positive, the firmshould continue to produce in the short runin order to defray some of the fixed cost.

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Shutdown Point: the lowest price at which thefirm would still produce.

At the shutdown point, the price is equal to the

minimum point on the AVC. This is whereselling at the price results in zero contributionmargin.

If the price falls below the shutdown point,revenues fail to cover the fixed costs and thevariable costs. The firm would be better off if itshut down and just paid its fixed costs.

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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 which

shifts the supply curve to the right, puts downward

pressure on price and reduces profits.

Economic loss causes exit of firms which shifts thesupply curve to the left, puts upward pressure on

price and increases profits.

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Observations in perfectly competitive markets:

The earlier the firm enters a market, the better itschances of earning above-normal profit (assuming a

strong demand in the market). As new firms enter the market, firms that want to

survive and perhaps thrive must find ways to produceat 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 basisof product differentiation instead.

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Pricing and Output Decisions in

Monopoly Markets

A monopoly market consists of one firm.

The firm is the market.

Has the power to establish any price itwants.

However, the firm¶s ability to set price islimited by the demand curve for its product,and in particular, the price elasticity of demand.

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Monopoly Markets

Assume demand is

linear. It is downward

sloping because the

firm is a price setter.

Assume MC is

constant.

Choose output whereMR=MC, set price at

P*.

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Monopoly Markets

Demand is the same

as before, as is MR.

MC is upward

sloping, which shows

diminishing returns.

Set output where

MR=MC

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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 makemoney.

Must be as cost efficient as possible.

It might pay for a firm to move into a market before othersstart to enter.

Monopoly market

Most important lesson is not to be complacent or arrogant and

assume their ability to earn economic profit can never bediminished.

Changes in economics of a business eventually break down adominating company¶s monopolistic power.

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