Download Market Price Under Perfect Competition

Lecture 7
From
Perfect Competition
to
Total Monopoly
A Spectrum
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Lecture 7
Who sets the price?
The market does
Price setting is a complex issue and is a function of the type of
competition prevailing in the market.
There is a spectrum of types of competition:
Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
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Lecture 7
Perfect Competition
In perfect competition there are many sellers, each supplying a
small part of the industry’s output. None has a dominant position.
Another feature of perfect competition is that products of an industry with
a market structure of perfect competition must be standardized, that is
they would produce identical or indistinguishably similar products.
There are not many industries that are under perfect competition,
examples might be agriculture
Those in perfect competition have NO control over the price
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Lecture 7
Monopolistic Competition
In a monopolistically competitive industry, there are also many sellers.
Like in the case of perfect competition, here also no one firm or seller can
dominate and each services a small segment of the market demand.
In a monopolistic competitive environment firms make similar and largely
substitutable but not identical products, that is they would produce
distinguishably similar products.
Many industries are under monopolistic competition, examples might
be retail trade or clothing manufacturing.
Those in monopolistic competition have some control over the
price
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Lecture 7
Oligopoly
In an oligopoly, there are a few sellers. Like in the case of perfect
competition, here also no one firm or seller can singly dominate and each
services a segment of the market demand.
Oligopolies produce similar or differentiated products
Oligopolies are the most dominant form of market structure, examples
range from OPEC to computer hardware or software manufacturing, or
private education
Those in an oligopoly have some control over the price
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Lecture 7
Monopoly
In a monopoly, the industry consists of a single seller who dominates
the market
Monopolies produce one product by definition
There are not very many absolute monopolies. There may be at times
monopolies or structures approaching one in a given precisely defined
market segment or location. For example public utilities, or the cable
company in your region.
Those in a monopoly have considerable control over the price
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
Market Price Under Perfect Competition
In perfect competition, market price is set purely by market demand
and supply. The price is set at the equilibrium point (or region). This is
where the supply curve and the demand curve will intersect.
Demand curve of the industry:
The demand curve of the entire industry is a typical downward sloping
demand curve.
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Lecture 7
Market Price Under Perfect Competition
Demand curve of an individual seller:
In contrast, the demand curve of an individual seller is nearly horizontal.
WHY?
Because there is near perfect product substitutability.
The slope of the curve will be proportional to the “influence” a seller
has on the market which in the case of perfect competition is not
much at all.
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Lecture 7
Market Price Under Perfect Competition
Price fluctuations are purely a function of supply and demand curve shifts
Demand curve shifts when there is a
change in:
Supply curve shifts when there is a
change in:
• Income
• Production Technology
• Consumer taste
• Input prices
• Product quality
• Environment (e.g. weather)
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Lecture 7
Output Decision Under Perfect Competition
The seller may not set the price but they can decide how much to supply.
Note that any one firm can decide how little or how much to sell and their
decision will not impact the market price but will impact their own revenue
Maximizing profit
We know that MR=MC for profit (Π) to be optimized. As such
dTR
MC  MR 
dQ
Therefore:
TR  PQ
MR  MC  P
dTR
d

PQ
dQ dQ
dQ
P
P
dQ
Note: the seller cannot set the
price but can set the marginal
cost or the quantity
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
Output Decision Under Perfect Competition
This is not the end of the story – however:
d2 
0
2
dQ
For the condition leading to MC=P to suggest a
maximum, the following fact must be satisfied:
As such:
d dTR d dTC

0
dQ dQ dQ dQ
dMR
0
dQ
Since MR=P and does not change with Q,
so for maximization we also must have:
dMR dMC

0
dQ
dQ
or
dMC

0
dQ
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or
dMC
0
dQ
Lecture 7
This means that under perfect competition, even if a firm is doing its best, it
may not earn a profit
At P0 the firm will produce X
ATC
MC
At P2 the firm will produce Y.
This will not produce profit but
the loss is less if they produce
than if they shut down
Price
per
unit
P0
P2
P3
P1
At P3 the firm might as well
cease production because the
firm loses a fixed cost whether
they produce or not, so they
might as well not produce
AVC
Z Y X
Q
Shutdown point
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At P1 the firm must cease
production because neither
variable or fixed cost is being
recovered adequately
Lecture 7
Example:
Fisheries Co. has a total cost function as follows:
TC  800  6Q  2Q2
If the market dictated price is P=$16 per ton, should they stay in business?
MC  6  4Q  16
Q  2.5
Therefore:
AVC  ( 6Q  2Q 2 ) / Q  6  2Q
AVC  6  2( 2.5 )  11
P  16  AVC  11
So they should continue to produce
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Lecture 7
Monopoly
Monopolists have considerable power but not absolute reign. Their success is
still subject to:
• Whether the customer wants their product. The customer may
have no choice from whom to buy, but always has the choice to
not buy at all.
• Whether the customer would buy something else. Please note
that whilst in perfect competition the product is standardized and
perfectly or nearly so substitutable, the converse is not true in a
monopoly. In a monopoly, the seller is the only seller of X in the
market but there may be someone else selling Y which whilst is
not X can stand in for it.
• Need to control costs. Even if there is great demand, supply has
to be adequately efficient.
• Government or social regulation
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
Output and Price Decision Under Monopoly
An unregulated monopolist can choose price and output quantity in such a
way that MC=MR. Doing so will give a maximum profit point.
Unlike the case of perfect competition where the price was forced to
P=MC=MR, in this case MR is not a constant as neither price nor quantity
need to remain fixed.
But we do know that in all cases:
MR  P [ 1  (
Where η is price elasticity of
demand. Rearranging, we have:
MR  P  (
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1

P

)]
)
Lecture 7
However we know that as η < 0, (
P

)
will always be negative
As such MR must always be less than price P. Or price must always be
greater than marginal revenue.
Also, it is natural and economic behavior that managers seek to operate
when MR >0. But if MR>0, then from MR  P  ( P ) we have that η < -1

P
otherwise ( ) will be larger than P and MR will be forced negative.

A monopolist WILL NOT produce in the inelastic range of its demand
curve if it is maximizing profit.
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
Similarly as MR=MC for profit maximization, then: MR  MC  P [ 1  (
or:
P  MC /[ 1  (
1

)]
since η < 0 then
[1(
which means that the price must exceed marginal cost.
ATC
AVC
PM
Demand
MR
QM
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1

)]  1
1

)]
Lecture 7
Example: Franchise war
Franchiser makes its money from collecting a
percentage of each store’s sales (or total revenue).
Franchisee makes its money from profit.
Franchiser wishes to maximize total revenue. It
does so by forcing the franchisee to sell more
burgers even when not profitable. i.e when MR≠MC
and by opening more stores
Franchisee wishes to maximize profit: that is
operate at MR=MC for the store.
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
MR  MC
and
Maximizing profit for
the store will require:
  1
Maximizing total
revenue will require:
MR  0
and
  1
Price
Demand
MR
MC
  1
Pee
Per
Qee
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Qer
Quantity
Lecture 7
Cost Plus Pricing
Monopolists often price their products by simply adding a fixed amount to
their cost.
This method is called Cost Plus pricing
The fixed amount added is often called profit margin or markup.
What should be your markup?
The markup is often not arbitrary and is instead usually a
percentage of cost and is added to the estimated average cost.
MU 
P C P
 1
C
C
or
P  C( 1  MU )
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Lecture 7
Some firms set a target rate of
return which in turn determines the
markup. Under such conditions,
the price is set equal to:
P C 
A
We can also analyze C:
C  L  M  K  AFC
Where:
Q
C is production cost
Where:
L is unit labor cost
P is price
M is unit materials cost
C is production cost
K is the unit marketing cost
A is total gross operating assets
AFC is the average fixed cost
π is the desired total profit on those assets
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
Does Cost Plus Pricing Maximize Profit?
Not Necessarily but it could
Recall that:
MR  MC  P [ 1  (
Rearranging:
P  MC[ 1 /[ 1  (
On the other hand:
P  C( 1  MU )
Combine and rearrange:
1

1

)]
)]]
MU  1 /(   1 )
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
Case Study:
Capture Inc. is the sole supplier of commodity X in several regions. X sells for
$27 a ton in the Northeast region
Costas Megalodrachmas is the owner of the monopoly operation. In a
recent statement he said; “people in the Midwest are very price-conscious
and our managers there know what to charge”.
A. Are the demand curves in the two regions mentioned the same? If so
why, If not how do they differ?
B. CM also said that; “our labor costs are higher in the NE and is almost
double that of the MW”. Is the marginal cost for X the same in the NE
and the MW?
C. Why is the price higher in the NE?
D. If marginal cost is 20% higher in the NE, and the price elasticity of
demand is -3 in the NE and -4 in the MW, what would be the price in
the MW?
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
A. Are the demand curves in the two regions mentioned the same? If
so why, If not how do they differ?
Demand curves are different. The demand curve is more price elastic
in the MW. A 1% price change will reduce demand by a larger
percentage.
B. Is the marginal cost for X the same in the NE and the MW?
No. The marginal cost is lower in the MW.
C. Why is the price higher in the NE?
P  MC /[ 1  (
1
)] As MC is higher and η is less elastic
We know that

in the NE, the profit maximizing price is higher in the NE
MGMT 7730 - © 2007 Houman Younessi
Lecture 7
D. If marginal cost is 20% higher in the NE, and the price elasticity
of demand is -3 in the NE and -4 in the MW, what would be the
price in the MW?
MCMW /[ 1  (
1
)]
PMW
MW

1
PNE
MCNE /[ 1  (
)]
NE
1
MCMW /[ 1  (
)]
4

 0.75
1
1.2MCMW /[ 1  (
)]
3
PMW  0.75  $27  $20.25
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