1. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 1 Chapter 8-B Pricing and Output Decisions: Perfect Competition and Monopoly

2. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 2 Overview Competition and market types Pricing and output decisions in perfect competition Pricing and output decisions in monopoly markets Implications for managerial decisions

3. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

4. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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 nonprice competition not possible

5. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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 nonprice competition not necessary

6. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

7. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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 nonprice competition important

8. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 8 Four market types

9. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 9 Four market types  Examples: perfect competition agricultural products financial instruments precious metals petroleum

10. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 10 Four market types  Examples: monopoly pharmaceuticals Microsoft gas station on edge of desert

11. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 11 Four market types  Examples: monopolistic competition boutiques restaurants repair shops

12. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 12 Four market types  Examples: oligopoly oil refining processed foods airlines internet access

13. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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?

14. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

15. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

16. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

17. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

18. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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*

19. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

20. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

21. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

22. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

23. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

24. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

25. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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*

26. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

27. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

28. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 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

29. Chapter EightCopyright 2009 Pearson Education, Inc. Publishing as Prentice Hall. 29 Global application  Example: Bluefin tuna  sushi restaurants operate in monopolistic competition  bluefin tuna price determined by perfect competition  low profit margin