Chapter 8

Pricing and Output

Decisions:
Perfect Competition
and Monopoly

Chapter Eight

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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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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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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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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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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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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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Four market types

Chapter Eight

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Four market types

Examples: perfect competition

agricultural products

financial instruments

precious metals

petroleum

Chapter Eight

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Four market types

Examples: monopoly

pharmaceuticals

Microsoft

gas station on edge of desert

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Four market types

Examples: monopolistic competition

boutiques

restaurants

repair shops

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Four market types

Examples: oligopoly

oil refining

processed foods

airlines

internet access

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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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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

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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

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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
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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
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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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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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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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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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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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Implications of perfect
competition and monopoly for
decision
making market
Perfectly competitive

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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Implications of perfect
competition and monopoly for
decision
Monopoly making
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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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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