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Chapter 8

Pricing and Output Decisions: Perfect
Competition and Monopoly
Managerial Economics: Economic Tools for Today·s Decision Makers, 5/e By Paul Keat and Philip Young

Pricing and Output Decisions: Perfect Competition and Monopoly ‡ Competition and Market Types in Economic Analysis ‡ Pricing and Output Decisions in Perfect Competition ‡ Pricing and Output Decisions in Monopoly Markets ‡ The Implications of Perfect Competition and Monopoly for Managerial Decision Making
2006 Prentice Hall Business Publishing Managerial Economics, 5/e Keat/Young

‡ Provide specific actual examples of the four types of markets. ‡ Compare and contrast the degree of price competition among the four market types. 2006 Prentice Hall Business Publishing Managerial Economics. ‡ Explain why the P=MC rule leads firms to the optimal level of production.Learning Objectives ‡ Describe the key characteristics of the four basic market types used in economic analysis. 5/e Keat/Young .

Explain why this happens with particular attention to the key assumptions used in this analysis. 5/e Keat/Young . 2006 Prentice Hall Business Publishing Managerial Economics.Learning Objectives ‡ Describe what happens in the long run in markets where firms that are either incurring economic losses or are making economic profits. ‡ Explain how and why the MR=MC rule helps a monopoly to determine the optimal level of price and output. ‡ Explain the relationship between the MR=MC rule and the P=MC rule.

5/e Keat/Young 2006 Prentice Hall Business Publishing .Four Basic 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 ‡ 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 Managerial Economics.

5/e Keat/Young .Four Basic Market Types ‡ Monopolistic Competition (market power based on product differentiation) ‡ ‡ ‡ ‡ Large number of relatively small firms acting independently Differentiated product Market entry and exit relatively easy Nonprice competition very important ‡ Oligopoly (market power based on product differentiation and/or the firm¶s dominance of the market) ‡ ‡ ‡ ‡ Small number of relatively large firms that are mutually interdependent Differentiated or standardized product Market entry and exit difficult Nonprice competition very important among firms selling differentiated products 2006 Prentice Hall Business Publishing Managerial Economics.

Four Basic Market Types 2006 Prentice Hall Business Publishing Managerial Economics. 5/e Keat/Young .

5/e Keat/Young . how much profit will we earn? ‡ If a loss rather than a profit is incurred.Pricing and Output Decisions in Perfect Competition ‡ The Basic Business Decision: entering a market on the basis of the following questions: ‡ How much should we produce? ‡ If we produce such an amount. 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? 2006 Prentice Hall Business Publishing Managerial Economics.

Pricing and Output Decisions in Perfect Competition ‡ Key assumptions of the perfectly competitive market ‡ The firm operates in a perfectly competitive market and therefore is a price taker. ‡ The firm¶s objective is to maximize its profit in the short run. 5/e Keat/Young . ‡ The firm makes the distinction between the short run and the long run. If it cannot earn a profit. 2006 Prentice Hall Business Publishing Managerial Economics. then it seeks to minimize its loss. ‡ The firm includes its opportunity cost of operating in a particular market as part of its total cost of production.

‡ Firm receives the same marginal revenue from the sale of each additional unit of product.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. ‡ No limit to the total revenue that the firm can gain in a perfectly competitive market. equal to the price of the product. 2006 Prentice Hall Business Publishing Managerial Economics. 5/e Keat/Young .

2006 Prentice Hall Business Publishing Managerial Economics. In short. MR=MC. the MR=MC rule may be restated as P=MC.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. ‡ This is because P=MR in perfectly competitive markets. ‡ For the perfectly competitive firm. ‡ Marginal Revenue ± Marginal Cost Approach ‡ A firm that wants to maximize its profit (or minimize its loss) should 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. 5/e Keat/Young .

AC) · Q* 2006 Prentice Hall Business Publishing Managerial Economics.Pricing and Output Decisions in Perfect Competition ‡ The point where P=MR=MC is the optimal output (Q*) ‡ Profit = TR ± TC =(P . 5/e Keat/Young .

2006 Prentice Hall Business Publishing Managerial Economics. 5/e Keat/Young . ‡ However. the firm is better off producing in the short run. since price is greater than average variable cost.Pricing and Output Decisions in Perfect Competition ‡ The firm incurs a loss. because it will still incur fixed costs greater than the loss. At the optimum output level price is below average cost.

‡ CM = TR ± TVC ‡ If the contribution margin is positive. 2006 Prentice Hall Business Publishing Managerial Economics.Pricing and Output Decisions in Perfect Competition ‡ Contribution Margin (CM): the amount by which total revenue exceeds total variable cost. the firm should continue to produce in the short run in order to defray some of the fixed cost. 5/e Keat/Young .

Pricing and Output Decisions in Perfect Competition ‡ Shutdown Point: the lowest price at which the firm would still produce. This is where selling at the price results in zero contribution margin. the price is equal to the minimum point on the AVC. 2006 Prentice Hall Business Publishing Managerial Economics. The firm would be better off if it shut down and just paid its fixed costs. ‡ If the price falls below the shutdown point. 5/e Keat/Young . ‡ At the shutdown point. revenues fail to cover the fixed costs and the variable costs.

puts upward pressure on price and increases profits. the price in the competitive market will settle at the point where firms earn a normal profit. puts downward pressure on price and reduces profits. 5/e Keat/Young . ‡ Economic profit invites entry of new firms which shifts the supply curve to the right. 2006 Prentice Hall Business Publishing Managerial Economics. ‡ Economic loss causes exit of firms which shifts the supply curve to the left.Pricing and Output Decisions in Perfect Competition ‡ In the long run.

or at least at cost levels below those of their competitors. ‡ As new firms enter the market.Pricing and Output Decisions in Perfect Competition ‡ Observations in perfectly competitive markets: ‡ The earlier the firm enters a market. firms that want to survive and perhaps thrive must find ways to produce at the lowest possible cost. the better its chances of earning above-normal profit (assuming a strong demand in the market). 5/e Keat/Young . ‡ Firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead. 2006 Prentice Hall Business Publishing Managerial Economics.

the price elasticity of demand. 5/e Keat/Young . 2006 Prentice Hall Business Publishing Managerial Economics. ‡ Has the power to establish any price it wants.Pricing and Output Decisions in Monopoly Markets ‡ A monopoly market consists of one firm. ‡ The firm is the market. ‡ However. the firm¶s ability to set price is limited by the demand curve for its product. and in particular.

‡ Choose output where MR=MC. 5/e Keat/Young . ‡ Assume MC is constant. 2006 Prentice Hall Business Publishing Managerial Economics. It is downward sloping because the firm is a price setter.Pricing and Output Decisions in Monopoly Markets ‡ Assume demand is linear. set price at P*.

as is MR. ‡ MC is upward sloping.Pricing and Output Decisions in Monopoly Markets ‡ Demand is the same as before. which shows diminishing returns. ‡ Set output where MR=MC 2006 Prentice Hall Business Publishing Managerial Economics. 5/e Keat/Young .

Implications of Perfect Competition and Monopoly for Decision Making ‡ Perfectly competitive market ‡ Most important lesson is that it is extremely difficult to make money. ‡ Changes in economics of a business eventually break down a dominating company¶s monopolistic power. 2006 Prentice Hall Business Publishing Managerial Economics. ‡ Monopoly market ‡ Most important lesson is not to be complacent or arrogant and assume their ability to earn economic profit can never be diminished. ‡ It might pay for a firm to move into a market before others start to enter. 5/e Keat/Young . ‡ Must be as cost efficient as possible.