PRICING

AND
OUTPUT
DECISIONS:
COMPETITION AND MONOPOLY

PERFECT

Competition and Market Types in Economic Analysis: - there are four

types

of

markets

perfect

competition,

monopoly,

monopolistic

competition, oligoply

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

Monopoly

(absolute

market

power,

subject

to

based

on

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

Monopolistic

competition

(market

power

product differentiation)

Large number of small firms acting independently

differentiated product
market entry and exit relatively easy
non-price competition very important

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
non-price competition important

Examples: perfect competition

agricultural products
financial instruments
commodities

Examples: monopoly

pharmaceuticals with patents

regulated utilities (although this is changing)
last chance gas station on the edge of the desert

Examples: monopolistic competition

boutiques
restaurants
repair shops

Examples: oligopoly

oil refining
processed foods
airlines
internet access and cell phone service

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?

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

Additional key assumptions of the perfectly competitive market:

The firms 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

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

Perfectly Elastic Demand Curve

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

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

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.

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

o Shifts the supply curve to the right
o Puts downward pressure on price
o Reduces profits to normal levels
Economic loss causes exit of firms
o Shifts the supply curve to the left
o Puts upward pressure on price
o Increases profits to normal levels.

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
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.

Implications of Perfect Competition and Monopoly for

Decision Making

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.

Monopoly market lessons

The most important lesson is not to be arrogant or complacent and

assume the firms ability to earn economic profit can never be
diminished. Changes in the business environment eventually break
down a dominating companys monopolistic power

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.