Unit VII

Pricing and Output Decisions:

Perfect Competition
and Monopoly
 Overview
• Competition and market types
• Pricing and output decisions in perfect
competition
• Pricing and output decisions in monopoly
markets
• Implications for managerial decisions
 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
 Introduction
• A market consists of all the actual and potential buyers
and sellers of a particular products.

• Market Structure refers to the competitive environment

in which the buyers and sellers of the product operate.

• Four types of market structure are usually identified.

These are Perfect Competition at one extreme and
Pure Monopoly at other extreme, and Monopolistic
Competition and Oligopoly in between.
 Less Competitive
More Competitive
Perfect Competition

Monopolistic Competition

Oligopoly

Monopoly
 Introduction
• There are four main characteristics to
categorize market structure:
– Number, Size and Distribution of Sellers
– Number, Size and Distribution of Buyers
– Product Differentiation
– Conditions of Entry and Exit
 Four Types of Market
• 1. 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

 Four Types of Market
• 2. 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

 Four Types of Market
• 3. 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

 Four Types of Market
• 4. 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

Four Types of Market
 Basic Business Decision
• Following questions must be answered:
– 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?
 Pricing and output decisions in Perfect
Competition
• Key assumptions of the perfectly competitive
market:
– there must be a large number of sellers in the
market with no single seller able to exert
significant influence over price (all sellers are
price takers)
– there be a large number of small buyers, each
buyer being unable to influence price (all
buyers are price takers)
– there is easy entry and exit from an industry
– the product is totally undifferentiated
 Pricing and output decisions in Perfect
Competition
– Under perfect competition, there is perfect mobility
of resources.
– Under perfect competition, consumers, resource
owners, and firms in the market have perfect
knowledge as to present and future prices, costs
and economic opportunities in general.
– 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
 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
 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
 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
POINTS TO REMEMBER
 The point where MC crosses the MR curve is considered as the
point of production and perpendicular drawn on ATC is
considered as cost of production.

 Till the point where MR is above the AVC curve, contribution will
be positive.

 Till the point where MR is above the ATC, the firm is able to
cover its fixed costs also.

 A firm earns normal profits when MR curve is tangent to the AC

or ATC curve at its minimum. Price higher than these, the firm
will earn supernormal profits and below this the firm will earn
only contribution. And the point where contribution goes negative
is the shut-down point of the firm.
 POINTS TO REMEMBER

MC
Price

P=MR
ATC

AVC

Output

SUPERNORMAL PROFIT
 POINTS TO REMEMBER

MC
Price

ATC

P=MR
AVC

NORMAL PROFIT
 POINTS TO REMEMBER

MC
Price

ATC

P=MR
AVC

Output

POSITIVE CONTRIBUTION
 POINTS TO REMEMBER

MC
Price

ATC

AVC
P=MR

Output

ZERO CONTRIBUTION / SHUT-DOWN POINT/

SHUT-DOWN PRICE
 POINTS TO REMEMBER

MC
Price

ATC

AVC

P=MR

Output

SHUT-DOWN
 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*
 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
 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
 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
 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
Pricing and output decisions in Perfect
Competition
 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
 Pricing and output decisions in Monopoly
Market
• A monopoly market consists of one firm
(the firm is the market)
• There is no close substitute of the product
• Entry into the industry (of other firms) is very
difficult
• 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
 Pricing and output decisions in Monopoly
Market
• Sources of Monopoly: Four basic reasons
– Firm may control entire supply of raw materials
required to produce the product.
– The firm may own a patent or copyright that precludes
other firms using a particular production process or
producing the same product.
– In some industry economies of scale is operating over
a significantly large range of outputs as to leave only
one firm supplying the entire market. This is also
called as natural monopoly.
– Monopoly may be established by government
franchise.
Pricing and output decisions in Monopoly
Market
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*
Pricing and output decisions in Monopoly
Market
Demand is the same as
before, as is MR

MC is upward sloping, which

shows diminishing returns

 set output where MR=MC

 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
 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