1. Chapter 8 Pricing and Output Decisions: Perfect Competition and Monopoly

2. Chapter Outline Competition and market types in economic analysis
Pricing and output decisions in perfect competition
Pricing and output decisions in monopoly markets
Implications of perfect competition and monopoly for managerial decisions
Although most products are sold markets of imperfect competition, the models of monopoly and perfect competition provide the bounds on the pricing flexibility of firms.

3. Learning Objectives
Describe and provide examples of the four market structures
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 in competitive markets
Explain how the MR=MC rule helps a monopoly to determine its optimum quantity
Contrast the relationship between the MR=MC rule and the P=MC rule
Describe the shut down rule

4. Competition and Market Types in Economic Analysis
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
Although no market fits all of these criteria, the agricultural market and some other commodity markets are close to perfect competition.

5. Competition and Market Types in Economic Analysis
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
Most people have experienced monopoly prices-when consumers feel they are a captive audience.

6. Competition and Market Types in Economic Analysis
Monopolistic competition (market power based on product differentiation)
large number of small firms acting independently
differentiated product
market entry and exit relatively easy
non-price competition very important

7. Competition and Market Types in Economic Analysis
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

8. Competition and Market Types in Economic Analysis
When we say that non-price competition is “impossible” in a perfectly competitive market-it means that it just does not provide any benefits.

9. Competition and Market Types in Economic Analysis
Examples: perfect competition
agricultural products
financial instruments
commodities
Each of these next few slides are good for discussion to provide actual examples of each market structure.

10. Competition and Market Types in Economic Analysis
Examples: monopoly
pharmaceuticals with patents
regulated utilities (although this is changing)
last chance gas station on the edge of the desert

11. Competition and Market Types in Economic Analysis
Examples: monopolistic competition
boutiques
restaurants
repair shops

12. Competition and Market Types in Economic Analysis
Examples: oligopoly
oil refining
processed foods
airlines
internet access and cell phone service

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. Pricing and Output Decisions in Perfect Competition
Key assumptions of the perfectly competitive market:
The firm is a price taker (it must accept the market price)
The firm makes the distinction between the short run and the long run

15. Pricing and Output Decisions in Perfect Competition
Additional key assumptions of the perfectly competitive market:
The firm’s objective is to maximize its profit (or minimize loss) in the short run
The firm includes its opportunity cost of operations in its total cost of production

16. 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
The firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product
There is no limit to the total revenue that the firm can gain in a perfectly competitive market

17. Pricing and Output Decisions in Perfect Competition
Perfectly Elastic Demand Curve
Note that this is the demand curve for the individual producer-it comes about from the equilibrium of the market demand and supply curves.

18. 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

19. 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 (i.e. MR=MC)
Both the TR/TC and MR=MC approach lead to the same price/output decision
For the perfectly competitive firm, the MR=MC rule may be restated as P=MC because P=MR in perfectly competitive market
In the case of the perfectly competitive market-competition will force the price to be equal to marginal costs. Note that the marginal cost includes all opportunity costs.

20. 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
Q* =(P - AC) ·
Point out that this is a unstable situation in a competitive market.

21. 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

22. 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
This general rule is applicable to all market structures.

23. 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.

24. 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 over the long run.
Economic profit invites entry of new firms
Shifts the supply curve to the right
Puts downward pressure on price
Reduces profits to normal levels
Economic loss causes exit of firms
Shifts the supply curve to the left
Puts upward pressure on price
Increases profits to normal levels.

25. Pricing and Output Decisions in Perfect Competition
Perfectly competitive markets in action:
the earlier the firm enters a market, the better its chances of earning above-normal profit for a period of time
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

26. Pricing and Output Decisions in Monopoly Markets
A monopoly market consists of one firm (the firm is the market)
The firm has the power to set the price which maximizes profit.
The profit maximizing price is limited by the demand curve for the product, and in particular, the price elasticity of demand.

27. 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 and choose output where MR=MC, set price at P*

28. 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

29. Implications of Perfect Competition and Monopoly for Decision Making
Lessons on perfectly competitive markets
It is extremely difficult to make money over the long run.
The firm must be as cost efficient as possible to survive.
It might pay for a firm to move into a market before others start to enter, but that is a risk--demand may not materialize.
Just a clarification-only normal profits will be made by firms in perfectly competitive markets.

30. Implications of Perfect Competition and Monopoly for Decision Making
Monopoly market lessons
The most important lesson is not to be arrogant or complacent and assume the firm’s ability to earn economic profit can never be diminished.
Changes in the business environment eventually break down a dominating company’s monopolistic power

31. Global Application Example for discussion: Bluefin tuna
What changes will occur in this market?
sushi restaurants operate in monopolistic competition
Bluefin tuna price determined by perfect competition
low profit margin
For discussion

32. Summary
In the case of perfect competition, the firm has virtually no power to set the price--they are price takers and make normal profits.
A monopoly has market power to set its price.
All firms attempt to produce at a quantity where MR=MC to maximize profit or minimize loss.