Lecture 9 & 10.pptvvvvvvvvvvvvvvvvvvvvvvv

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1. Chapter 8
Pricing and Output Decisions:
Perfect Competition
and Monopoly
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2. Overview
Competition and market types
Pricing and output decisions in perfect
competition
Pricing and output decisions in monopoly
markets
Implications for managerial decisions
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3. Learning objectives
understand the four market types
compare the degree of price competition among the
four market types
explain why the P=MC rule leads firms to the optimal
level of production
explain how the MR=MC rule helps a monopoly to
determine its optimum
explain the relationship between the MR=MC rule and
the P=MC rule
describe what happens in the long run
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4. Four market types
•Perfect competition (no market power)
–large number of relatively small buyers and sellers
–standardized product
–very easy market entry and exit
–Non-price competition not possible (No control
over price)
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5. 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
–Non-price competition not necessary
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6. 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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7. 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
–Non-price competition important
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8. Four market types
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9. Four market types
•Examples: perfect competition
–agricultural products
–financial instruments
–precious metals
–petroleum
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10. Four market types
•Examples: monopoly
–pharmaceuticals
–Microsoft
–gas station on edge of desert
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11. Four market types
•Examples: monopolistic competition
–boutiques
–restaurants
–repair shops
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12. Four market types
•Examples: oligopoly
–oil refining
–processed foods
–airlines
–internet access
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13. 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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14. 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
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15. 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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16. 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
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17. 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
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18. 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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19. 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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20. 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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21. 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
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22. 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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23. 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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24. 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
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25. 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*
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26. 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
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27. 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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28. 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
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29. Global application
•Example: Bluefin tuna
• sushi restaurants operate in monopolistic
competition
• bluefin tuna price determined by perfect
competition
• low profit margin
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