Managerial economics economic tools for todays decision makers 7th edtion by keat young and erfle chapter 08

Chapter 8
Pricing and Output
Decisions: Perfect
Competition and
Monopoly


Chapter Outline
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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

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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

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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
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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

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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
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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

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Competition and Market Types in
Economic Analysis

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Competition and Market Types in
Economic Analysis
• Examples: perfect competition
– agricultural products
– financial instruments
– commodities

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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

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Competition and Market Types in
Economic Analysis
• Examples: monopolistic competition
– boutiques
– restaurants
– repair shops

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

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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 (it must accept the
market price)
– The firm makes the distinction between the short
run and the long run

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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

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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
– 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

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Pricing and Output Decisions
in Perfect Competition
Perfectly Elastic Demand Curve

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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 firm’s 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 (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

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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
Q* =(P - AC) ·

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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 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.

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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

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