Chapter 8

Pricing and Output

Decisions:
Perfect Competition
and Monopoly

Copyright 2011 Pearson Education,

Chapter Eight 1
Inc. Publishing as Prentice Hall.
 Overview

Competition and market types

Pricing and output decisions in
perfect competition
Pricing and output decisions in
monopoly markets
Implications for managerial
decisions
Copyright 2011 Pearson Education,
Chapter Eight 2
Inc. Publishing as Prentice Hall.
 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
Copyright 2011 Pearson Education,
Chapter Eight 3
Inc. Publishing as Prentice Hall.
 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

Copyright 2011 Pearson Education,

Chapter Eight 4
Inc. Publishing as Prentice Hall.
 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

Copyright 2011 Pearson Education,
Chapter Eight 5
Inc. Publishing as Prentice Hall.
 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

Copyright 2011 Pearson Education,
Chapter Eight 6
Inc. Publishing as Prentice Hall.
 Four market types
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

nonprice competition important

Copyright 2011 Pearson Education,
Chapter Eight 7
Inc. Publishing as Prentice Hall.
 Four market types

Copyright 2011 Pearson Education,

Chapter Eight 8
Inc. Publishing as Prentice Hall.
 Four market types
Examples: perfect competition

agricultural products

financial instruments

precious metals

petroleum

Copyright 2011 Pearson Education,

Chapter Eight 9
Inc. Publishing as Prentice Hall.
 Four market types
Examples: monopoly

pharmaceuticals

Microsoft

gas station on edge of desert

Copyright 2011 Pearson Education,

Chapter Eight 10
Inc. Publishing as Prentice Hall.
 Four market types
Examples: monopolistic competition

boutiques

restaurants

repair shops

Copyright 2011 Pearson Education,

Chapter Eight 11
Inc. Publishing as Prentice Hall.
 Four market types
Examples: oligopoly

oil refining

processed foods

airlines

internet access

Copyright 2011 Pearson Education,

Chapter Eight 12
Inc. Publishing as Prentice Hall.
 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?

Copyright 2011 Pearson Education,

Chapter Eight 13
Inc. Publishing as Prentice Hall.
 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 firms 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
Copyright 2011 Pearson Education,
Chapter Eight 14
Inc. Publishing as Prentice Hall.
 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

Copyright 2011 Pearson Education,

Chapter Eight 15
Inc. Publishing as Prentice Hall.
 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 firms profits
or minimizes its loss

Copyright 2011 Pearson Education,

Chapter Eight 16
Inc. Publishing as Prentice Hall.
 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
Copyright 2011 Pearson Education,
Chapter Eight 17
Inc. Publishing as Prentice Hall.
 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*

Copyright 2011 Pearson Education,

Chapter Eight 18
Inc. Publishing as Prentice Hall.
 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
Copyright 2011 Pearson Education,
Chapter Eight 19
Inc. Publishing as Prentice Hall.
 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

Copyright 2011 Pearson Education,

Chapter Eight 20
Inc. Publishing as Prentice Hall.
 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

Copyright 2011 Pearson Education,

Chapter Eight 21
Inc. Publishing as Prentice Hall.