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Chapter 8
Pricing and Output
Decisions:
Perfect Competition
and Monopoly
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
1
Overview
Competition and market types
Pricing and output decisions in
perfect competition
Pricing and output decisions in
monopoly markets
Implications for managerial
decisions
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
2
Learning objectives
understand the four market types
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
explain how the MR=MC rule helps a
monopoly to determine its optimum
explain the relationship between the
MR=MC rule and the P=MC rule
describe what happens in the long run
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
3
Four 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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
4
Four market types

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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
5
Four market types

Monopolistic competition (market
power based on product differentiation)

large number of small firms acting
independently

differentiated product

market entry and exit relatively easy

nonprice competition very important
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
6
Four market types

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

nonprice competition important
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
7
Four market types
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
8
Four market types

Examples: perfect competition

agricultural products

financial instruments

precious metals

petroleum
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
9
Four market types

Examples: monopoly

pharmaceuticals

Microsoft

gas station on edge of desert
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
10
Four market types

Examples: monopolistic competition

boutiques

restaurants

repair shops
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
11
Four market types

Examples: oligopoly

oil refining

processed foods

airlines

internet access
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
12
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?
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
13
Pricing and output decisions
in perfect competition

Key assumptions of the perfectly
competitive market:
the firm is a price taker
 the firm makes the distinction between
the short run and the long run
 the firm’s objective is to maximize its
profit (or minimize loss) in the short run
 the firm includes its opportunity cost of
operating in a particular market as part
of its total cost of production

Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
14
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
 firm receives the same
marginal revenue from the
sale of each additional unit
of product; equal to the
price of the product
 no limit to the total
revenue that the firm can
gain in a perfectly
competitive market
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
15
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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
16
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 (ie. MR=MC)
Note: for the perfectly competitive firm,
the MR=MC rule may be restated as
P=MC because P=MR in perfectly
competitive market
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
17
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
=(P - AC) ·
Q*
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
18
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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
19
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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
20
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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
21
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


economic profit invites entry of new firms 
shifts the supply curve to the right  puts
downward pressure on price and reduces
profits
economic loss causes exit of firms  shifts the
supply curve to the left  puts upward
pressure on price and increases profits
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
22
Pricing and output decisions
in perfect competition

Observations in perfectly competitive markets:
 the earlier the firm enters a market, the better
its chances of earning above-normal profit

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 instead
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
23
Pricing and output decisions in
monopoly markets

A monopoly market consists of one firm
(the firm is the market)
•
firm has the power to set any price it
wants
•
however, the firm’s ability to set price is
limited by the demand curve for its
product, and in particular, the price
elasticity of demand
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
24
Pricing and output decisions in
monopoly markets
Assume demand is
linear: it is downward
sloping because the
firm is a price setter
Assume MC is
constant
 choose output
where MR=MC, set
price at P*
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
25
Pricing and output decisions 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
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
26
Implications of perfect competition and
monopoly for decision making

Perfectly competitive market

most important lesson is that it is
extremely difficult to make money

must be as cost efficient as possible

it might pay for a firm to move into a
market before others start to enter
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
27
Implications of perfect competition and
monopoly for decision making

Monopoly market

most important lesson is not to be
arrogant and assume their ability to
earn economic profit can never be
diminished

changes in economics of a business
eventually break down a dominating
company’s monopolistic power
Chapter Eight
Copyright 2009 Pearson Education, Inc.
Publishing as Prentice Hall.
28