Pricing and Output Decisions: Perfect Competition and Monopoly

Chapter 8
Pricing and Output

Decisions: Perfect
Competition and
Monopoly
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
Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-2

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

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

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

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

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

Economic Analysis

Economic Analysis
• Examples: perfect competition
– agricultural products
– financial instruments
– commodities

Economic Analysis
• Examples: monopoly
– pharmaceuticals with patents
– regulated utilities (although this is changing)
– last chance gas station on the edge of the desert

Economic Analysis
• Examples: monopolistic competition
– boutiques
– restaurants
– repair shops

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

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?

• 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 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

• 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 firm’s 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

• Case A: economic profit
The point where

P=MR=MC
is the optimal output
(Q*)
 profit = TR – TC
Q* =(P - AC) ·

• 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

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

• 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
• 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.

• 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

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.

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*

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

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.

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

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

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.

Pricing and Output Decisions: Perfect Competition and Monopoly

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Chapter 8

Pricing and Output

• Competition and market types in economic analysis

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-2

• Describe and provide examples of the four market

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-3

• Perfect competition (no market power)

– large number of relatively small buyers and

– very easy market entry and exit

– non-price competition not possible

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-4

– 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

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-5

• Monopolistic competition (market power

– large number of small firms acting independently

– market entry and exit relatively easy

– non-price competition very important

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-6

– small number of large mutually interdependent

– differentiated or standardized product

– market entry and exit difficult

– non-price competition important

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-7

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-8

• Examples: perfect competition

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-9

– pharmaceuticals with patents

– regulated utilities (although this is changing)

– last chance gas station on the edge of the desert

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-10

• Examples: monopolistic competition

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-11

– internet access and cell phone service

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-12

• Basic business decision: entering a

– How much should we produce?

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-13

• Key assumptions of the perfectly

– The firm is a price taker (it must accept the

– The firm makes the distinction between the short

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-14

• Additional key assumptions of the perfectly

– The firm’s objective is to maximize its profit (or

– The firm includes its opportunity cost of

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-15

• Perfectly elastic demand curve: consumers

– The firm receives the same marginal revenue

– There is no limit to the total revenue that the

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-16

Copyright ©2014 Pearson Education, Inc. All rights reserved. 8-17

• Total revenue/Total cost approach:

– Compare the total revenue and total cost

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• Marginal revenue/Marginal cost approach

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The point where

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The firm incurs a loss.

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 if CM > 0, the firm