Chapter 11 PRICING AND OUTPUT DECISIONS: PERFECT COMPETITION AND MONOPOLY

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Chapter 11PRICING AND OUTPUT DECISIONSPERFECT
COMPETITION AND MONOPOLY
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Market Structure

• The ultimate decision a manager needs to make
  involves price and output.
• In every price-output decision, there are three
  factors to consider
• 1. Cost
• 2. Demand
• 3. Market Structure
• Market structure refers to the competitive
  environment in which a firm operates and dictates
  how cost and demand will be factored into the
  decision process.

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Perfect Competition

• In a perfectly competitive market, the relevant
  decision questions are the following
• 1. Given the market price, how much should we
  produce?
• 2. In producing such an amount, how much of a
  profit will we earn (or how much of a loss will
  we incur?)
• 3. Should we be in this market at the present
  time? What are the long-run prospects for
  competing in this market?

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Key Assumptions of Perfect Competition

• The firm is a price taker.
• The firm makes a distinction between short-run
  and long-run.
• The firms objective is to maximize its profit in
  the short-run. If it cannot earn a profit, then
  it seeks to minimize its loss.
• The firm includes its opportunity cost of
  operating in a particular market as part of its
  total cost of production.

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Economic Profit

• E.g. The manager of a small supermarket wants to
  open and operate her own store. She will leave
  her current job and use 50,000 of her savings
  for this business venture. Her current salary is
  45,000 and her 50,000 savings are currently
  earning 10 interest in a savings deposit.

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Accounting and Economic Costs Related to Opening
Her Own Store
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Normal and Economic Profit
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Normal and Economic Profit

• The point of normal profit would be the economic
  break-even for the firm.
• Economic break-even indicates that the firms
  revenue is sufficient to cover both its
  out-of-pocket expense and its opportunity cost.
• It also means that the firm is earning an
  accounting profit that offsets the opportunity
  profit of being in that business as well.

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Decision About Price and Quantity
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• Assume that the market price is 110.
• Given this price, the firm is free to produce as
  much as or as little as it desires.
• Since the price to the firm remains unchanged
  regardless of its output level, the firm actually
  faces a perfectly horizontal demand curve.
• In other words, the firms demand curve is
  perfectly elastic.

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Revenue Schedule
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• With a perfectly elastic demand curve, the
  customers 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.
• The marginal revenue is also the price of the
  product.
• Also, from the demand curve, the price is the
  average revenue.

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• Hence, for a firm operating in a perfectly
  competitive market, AR MR P.
• This result indicates that a perfectly
  competitive firms demand is also its marginal
  and average revenue over the range of output
  being considered.

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Perfectly Elastic Demand Curve
TL/
MR AR D
P 110
Q
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Different Types of Demand Curves and Associated
Total Revenue Curves
TL/
TL/
P D AR MR
P D AR
Q
Q
MR
TL/
TL/
TR
TR
Q
Q
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Relevant QuestionOptimal Output Level

• Since the firm is maximizing its profits in the
  short-run, there are two equivalent ways in which
  the firm can achieve this objective
• 1. The firm can produce at the point where the
  difference between Total Revenue (TR) and Total
  Cost (TC) is at a maximum.
• 2. The firm can produce at the point where the
  difference between Marginal Revenue (MR) and
  Marginal Cost (MC) is equal to zero.

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Total Revenue - Total Cost Approach

• The optimal level of output is where either
  profits are maximized or losses are minimized.
• Graphically, this would be the point where the
  distance between the total revenue and total cost
  curves is maximized.

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/TL
TR
TC
Q
Q
At Q, the distance between the TR and TC curves
is maximized which means the profits are also
maximized.
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Marginal Revenue - Marginal Cost Approach

• The optimal level of output is where either
  profits are maximized or losses are minimized.
• A firm that desires 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.
• This is the point where MR MC and
• M? 0.

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MRMC in Perfect Competition

• Recall that
• 1. The demand curve for the individual firm
  is perfectly elastic in this market.
• 2. The demand curve is also the marginal
  revenue curve and the average revenue curve.

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The Case of Economic Profits
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MC
TL/
economic profit
A
B
DMRAR
AC
P110
C
D
AC77.30
AVC
0
Q
Q
The area of the rectangle ABCD gives the amount
of economic profits.
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The Case of Normal Profits
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MC
TL/
AC
AVC
P71.87
DMRAR
0
Q
Q
The firm is earning normal profits where P MR
MC AR AC.
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The Case of Economic Loss
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TL/
MC
AC
AVC
loss
C
A
DMRAR
P58.00
D
B
0
Q
Q
The area of the rectangle ABCD gives the amount
of economic loss.
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TL/
MC
AC
AVC
loss
C
A
DMRAR
P58.00
D
B
F
E
contribution to fixed cost
0
Q
Q
There is a loss but the firm will continue to
operate in the short-run since there is a
positive contribution margin and the firm is
recovering some of its fixed costs.
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TL/
MC
AC
loss
AVC
shutdown price
P50.00
DMRAR
shutdown point
negative contribution margin
0
Q
Q2
Q1
The firm should shut down since the price cannot
cover any of the variable or fixed costs and
continuing to operate would mean increasing
losses.
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Perfect Competition in the Long-Run

• In the short-run, the market price may result in
  normal profits, economic profits, or economic
  loss.
• In the long-run, the market price will settle at
  a point where the firms earn a normal profit.
• If prices allow firms to earn economic profits in
  the short-run, this will induce other firms to
  enter the market and the increase in the market
  supply will push the market price down, leaving
  only a normal profit for the firms to earn.

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• If prices are below the level where the existing
  firms can at least earn normal profits, some
  firms will have to leave the market in the
  long-run in order to minimize their losses.
• In the short-run, the firms will stay in the
  market if they have losses but a positive
  contribution margin at the same time.
• In the long-run, the firms with a loss will have
  sufficient time to liquidate all fixed assets and
  leave the market.

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S (short-run)
MC
S (long-run)
short-run economic profit
AC
AVC
P
P
Q1
Q1
market
individual firm
New firms enter in the long-run to pursue
economic profit.
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Short-run economic loss positive contribution
margin
S (long-run)
MC
AC
AVC
S (short-run)
P
P
Q1
Q1
market
individual firm
Firms with an economic loss exit in the long-run.
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Monopoly

• There is only one firm in the monopoly markets.
• The firm has power in determining the price of
  its product in the market.
• The firms power to set its own price is limited
  by the demand curve for its product and the price
  elasticity of that demand.

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TL/
forgone profit
P1
P
P2
D
MC AVC
0
Q
marginal loss
MR
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• If the firm chooses too high a price (P1), its
  marginal revenue will exceed its marginal cost
  and it will be forgoing some amount of marginal
  profit.
• If the firm sets its price too low (P2), its
  marginal cost will exceed its marginal revenue
  and the firm will experience a marginal loss.
• The firm will set its price at the point where
  marginal revenue is equal to marginal cost
  thereby be limited by the demand conditions in
  setting its price (marginal revenue is determined
  by the demand curve).

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• The price is not equal to marginal revenue since
  the monopolist firm is a price maker and not a
  price taker.
• The short-run economic profits earned by a
  monopolist are not subject to the threat of other
  firms entering the market in the long-run since
  this is a monopoly and there is only one firm in
  the market.

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MC
TL/
economic profit
AC
P
D
AC
Q 6
MR
Profits are maximized where MR MC.
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MC
TL/
AC
P?
Prev
D
Q?
Qrev
MR
Revenues are maximized where MR 0.