PRICING AND OUTPUT DECISIONS: PERFECT COMPETITION AND MONOPOLY

Competition and Market Types in Economic Analysis: - there are four types of markets perfect competition, monopoly, monopolistic competition, oligoply

Perfect competition (no market power) large number of relatively small buyers and sellers standardized product very easy market entry and exit non-price competition not possible

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 non-price competition not necessary

Monopolistic competition (market power based on product differentiation)

Large number of small firms acting independently differentiated product market entry and exit relatively easy non-price competition very important

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 non-price competition important

Examples: perfect competition agricultural products financial instruments commodities

Examples: monopoly pharmaceuticals with patents regulated utilities (although this is changing) last chance gas station on the edge of the desert

Examples: monopolistic competition boutiques restaurants repair shops

Examples: oligopoly oil refining processed foods

airlines internet access and cell phone service

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?

Key assumptions of the perfectly competitive market: The firm is a price taker (it must accept the market price) The firm makes the distinction between the short run and the long

run

Additional key assumptions of the perfectly competitive market: The firm’s objective is to maximize its profit (or minimize loss) in the

short run The firm includes its opportunity cost of operations in its total cost

of production

Perfectly elastic demand curve: consumers are willing to buy as much as the firm is willing to sell at the going market price

The firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product

There is no limit to the total revenue that the firm can gain in a perfectly competitive market

Perfectly Elastic Demand Curve

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

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 (i.e. MR=MC)

Both the TR/TC and MR=MC approach lead to the same price/output decision

For the perfectly competitive firm, the MR=MC rule may be restated as P=MC because P=MR in perfectly competitive market

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.

In the long run, the price in the competitive market will settle at the point where firms earn a normal profit over the long run.

Economic profit invites entry of new firms o Shifts the supply curve to the righto Puts downward pressure on price o Reduces profits to normal levels

Economic loss causes exit of firms o Shifts the supply curve to the lefto Puts upward pressure on priceo Increases profits to normal levels.

Perfectly competitive markets in action:

The earlier the firm enters a market, the better its chances of earning above-normal profit for a period of time 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

A monopoly market consists of one firm (the firm is the market) The firm has the power to set the price which maximizes profit. The profit maximizing price is limited by the demand curve for the

product, and in particular, the price elasticity of demand.

Implications of Perfect Competition and Monopoly for Decision Making

It is extremely difficult to make money over the long run. The firm must be as cost efficient as possible to survive. It might pay for a firm to move into a market before others start to enter, but that is a risk--demand may not materialize.

Monopoly market lessons The most important lesson is not to be arrogant or complacent and

assume the firm’s ability to earn economic profit can never be diminished. Changes in the business environment eventually break down a dominating company’s monopolistic power

Summary In the case of perfect competition, the firm has virtually no power to

set the price--they are price takers and make normal profits. A monopoly has market power to set its price. All firms attempt to produce at a quantity where MR=MC to maximize profit or minimize loss.