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Lecture 11 - Perfect Competition and Monopoly

The document outlines pricing and output decisions in perfect competition and monopoly markets, detailing key assumptions and decision-making processes for firms. It emphasizes the importance of marginal revenue and marginal cost in determining optimal output levels, as well as the implications of economic profit and loss. Additionally, it discusses the long-run supply curve and the effects of market entry and exit on pricing in competitive markets.

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Muzammil Iqbal
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11 views39 pages

Lecture 11 - Perfect Competition and Monopoly

The document outlines pricing and output decisions in perfect competition and monopoly markets, detailing key assumptions and decision-making processes for firms. It emphasizes the importance of marginal revenue and marginal cost in determining optimal output levels, as well as the implications of economic profit and loss. Additionally, it discusses the long-run supply curve and the effects of market entry and exit on pricing in competitive markets.

Uploaded by

Muzammil Iqbal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Pricing and Output Decisions:

Perfect Competition
Perfect Competition

• Four Basic Market Types


• Pricing and Output Decisions in Perfect Competition
Basic Business Decision
Key Assumptions
Total Revenue - Total Cost Approach
Marginal Revenue - Marginal Cost Approach
Economic Profit, Normal Profit, Loss, and Shutdown
The Short Run and Long Run
Four Basic Market Types

•Perfect Competition
•Monopoly
•Monopolistic Competition
•Oligopoly
Four Basic Market Types : TextBook Fig 8.1a
Key Assumptions : Perfect Competition

• Price taker
• Distinction between short run and long run
• Objective is to maximize profit or minimize loss in
the short run
• Opportunity cost is included in decision making
Review of Costs

Review of terminology
• Economic cost includes explicit costs and
opportunity costs
• Normal profit occurs when revenue just covers
all of the firm’s economic cost
• Economic loss occurs when revenue fails to
cover the firm’s economic cost
• Economic profit occurs when revenue more
than covers the firm’s (total) economic cost
• The Demand Curve Facing the Firm

– Since the firm is a price taker,


the price to the firm for each
unit remains the same no
matter how much the firm sells
– Perfectly Elastic since
consumers are willing to buy
as much as the firm is willing
to sell at the going market price
– Horizontal at the market price
Key Assumptions : Demand Curve

• Marginal Revenue and Average Revenue


– Since the firm receives the
market price for each unit
sold, and this market price
does not change, the firm’s
marginal revenue (MR) and
average revenue (AR) curves
are also horizontal at the
market price.
Key Assumptions : Total Revenue

• Marginal Revenue
– Marginal revenue tells us how tot
al revenue changes as we sell an
additional unit.
– Marginal revenue represents
the slope of the total revenue cur
ve.
– Since MR is positive and
constant, the total revenue
(TR) curve is increasing at a
constant rate.
Selecting the Optimal Output Level TR-TC

• Graphically, find the output


level that maximizes the
distance between the total
revenue curve and the
total cost curve.
Selecting the Optimal Output Level MR=MC

• Marginal revenue is the revenue the firm receives


from selling an additional unit.

• Marginal cost is the cost the firm incurs by


producing an additional unit.

• If marginal revenue exceeds marginal cost it is


worthwhile for the firm to produce and sell an
additional unit.
Selecting the Optimal Output Level MR=MC

MR=MC Rule

• 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. In short, MR=MC.
• Applies to any firm that wishes to maximize
profit.
• For the perfectly competitive firm, the rule may
be restated, P=MC.
Profit Maximization for the competitive
Firm
W hat Q maximizes the firm’s profit?
If increase Q by one unit, revenue rises by MR, cost rises by MC. Profit-
maximizing
quantity can be found by comparing marginal revenue MR and marginal cost
MC.

If MR > MC, then increase Q to raise profit. As long as marginal revenue


exceeds marginal cost, increasing output will raise profit.

If MR < MC, then reduce Q to raise profit. If marginal revenue is


less than marginal cost, the firm can increase profit by decreasing
output.

If MR = MC, Maximum profit. Profit-maximization occurs where marginal


revenue is equal to marginal cost.
Profit Maximization : Perfect
Competitive
The firm maximizes profit by producing the optimal
quantity Q* at where marginal cost equals marginal
revenue. Costs
and
Revenue
MC

P2
ATC
P1 P 1= AR 1= M R1
AVC
P3

0 Q1 QMAX Q2 Quantity
Example : Optimal Output Level MR=MC

• Graphically, find the out


put at which MR=MC.
Label this Q*
• Profit ?
Example : Optimal Output Level MR=MC

• Graphically, find the out


put at which MR=MC.
Label this Q*
• Profit=TR – TC
=(Q* x P) – (Q* xAC)
=Q*(P - AC)
=Rectangle DABC
Example : Profit
Maximization
Pricing and output decisions in perfect competition
The point where P=MR=MC is the Case A: economic profit
optimal output (Q*)
 What is the firm’s Profit ?
 What is the Breakeven Price ?
 When do Firms Shutdown ?
and/or At what Price?
Is this a short run or long-run
decision?
The firm’s SR supply curve is the
portion of
its MC curve above AVC.

Farrukh Wazir Khan


Example 5 Cont’d/- : Profit
Maximization
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

18
Farrukh Wazir Khan
The Competitive Firm’s Long run Supply Curve

The firm’s Long Run Costs


LR supply curve is
MC
the portion of
its MC curve above LRATC
LRATC.

Q
Farrukh Wazir Khan 19
Supply Curve – Shutdown vs Exit

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

Farrukh Wazir Khan 20


Chapter Example : Two Panel Diagram – Firm and Market

Farrukh Wazir Khan


Pricing and Output Decisions:
Monopoly
Monopoly

• Four Basic Market Types

• Pricing and Output Decisions in Monopoly


Four Basic Market
Types
• Perfect Competition
• Monopoly
• Monopolistic Competition
• Oligopoly
Four Basic Market Types : TextBook Fig 8.1a
Structure / Characteristics of Monopoly Market

Monopoly
• A monopoly market consists of one firm.
• The firm is the market.
• Power to establish any price it wants.
• The firm’s ability to set price is limited by the
demand curve for its product, and in particular, the
price elasticity of demand.
Pricing
• In the graph, assume
and Output
– Demand is linear which
Decisions
implies that MR is linear
and twice as steep.
– Diminishing returns.
• How much should the firm
produce to maximize profit?
Understanding the Monopolist’s MR
Increasing Q has two effects on revenue:
Output effect: higher output raises revenue
Price effect: lower price reduces revenue
To sell a larger Q, the monopolist must reduce the price on all the units
it sells.
Hence, MR < P
MR could even be negative if the price effect exceeds the output effect
(e.g., when firm increases Q from 5 to 6).
Profit-
Maximization
Like a competitive firm, a monopolist maximizes profit by producingthe
quantity where MR = MC.

Once the monopolist identifies this quantity,


it sets the highest price consumers are willing to pay for that quantity.

It finds this price from the D curve.


The Monopolist’s Profit
Costs and
Revenue MC

As with a P
ATC
competitive firm, ATC
the monopolist’s
D
profit equals
MR
(P – ATC) x Q Q Quantity
Pricing and Output Decisions

Using the information in the following table,


determine how much the firm should produce in
order to maximize profits.
Pricing
and Output
Decisions
Pricing
and Output
Decisions
Pricing
• and Output
Monopoly Graphically:

• Set output whereDecisions


MR=MC

• At this output, read the price


to set off of the demand
curve.
• Profits = rectangle ABCD
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
Demand Curve faced by a
Monopolist
• In the graph, assume
– Demand is linear which
implies that MR is linear
and twice as steep.
– MC is constant.
• How much should the firm
produce to maximize profit?
The Welfare Cost of Monopoly

Recall: In a competitive market equilibrium,


P = MC and total surplus is maximized.

In the Monopoly eq’m, P > MR = MC


The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to produce that unit (MC).

The monopoly Q is too low – could increase total surplus with a


larger Q.
Thus, monopoly results in a Deadweight Loss.
The Welfare Cost of Monopoly

Competitive eq’m: Price Deadweight


quantity = QC loss MC
P = MC P
total surplus is P = MC
maximized
MC
Monopoly eq’m: D
quantity = QM
P > MC
MR
Deadweight Loss QM QC Quantity
References

Book:
Managerial Economics, Seventh Edition, Paul G. Keat

Farrukh Wazir Khan

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