Managerial economics economic tools for todays decision makers 7th edtion by keat young and erfle chapter 08

Chapter Pricing and Output Decisions: Perfect Competition and Monopoly Chapter Outline • • • • Competition and market types in economic analysis Pricing and output decisions in perfect competition Pricing and output decisions in monopoly markets Implications of perfect competition and monopoly for managerial decisions Copyright ©2014 Pearson Education, Inc All rights reserved 8-2 Learning Objectives • Describe and provide examples of the four market structures • 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 in competitive markets • Explain how the MR=MC rule helps a monopoly to determine its optimum quantity • Contrast the relationship between the MR=MC rule and the P=MC rule Describe the shut down rule Copyright â2014 Pearson Education, Inc All rights reserved 8-3 Competition and Market Types in Economic Analysis • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-4 Competition and Market Types in Economic Analysis • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-5 Competition and Market Types in Economic Analysis • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-6 Competition and Market Types in Economic Analysis • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-7 Competition and Market Types in Economic Analysis Copyright ©2014 Pearson Education, Inc All rights reserved 8-8 Competition and Market Types in Economic Analysis • Examples: perfect competition – agricultural products – financial instruments – commodities Copyright ©2014 Pearson Education, Inc All rights reserved 8-9 Competition and Market Types in Economic Analysis • Examples: monopoly – pharmaceuticals with patents – regulated utilities (although this is changing) – last chance gas station on the edge of the desert Copyright ©2014 Pearson Education, Inc All rights reserved 8-10 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-18 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 (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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-19 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 Q* =(P - AC) · Copyright ©2014 Pearson Education, Inc All rights reserved 8-20 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 ©2014 Pearson Education, Inc All rights reserved 8-21 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 ©2014 Pearson Education, Inc All rights reserved 8-22 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 ©2014 Pearson Education, Inc All rights reserved 8-23 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 over the long run – Economic profit invites entry of new firms • Shifts the supply curve to the right • Puts downward pressure on price • Reduces profits to normal levels – Economic loss causes exit of firms • Shifts the supply curve to the left • Puts upward pressure on price • Increases profits to normal levels Copyright ©2014 Pearson Education, Inc All rights reserved 8-24 Pricing and Output Decisions in Perfect Competition • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-25 Pricing and Output Decisions in Monopoly Markets • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-26 Pricing and Output Decisions in Monopoly Markets Assume demand is linear: it is downward sloping because the firm is a price setter Assume MC is constant and choose output where MR=MC, set price at P* Copyright ©2014 Pearson Education, Inc All rights reserved 8-27 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-28 Implications of Perfect Competition and Monopoly for Decision Making • Lessons on perfectly competitive markets – 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-29 Implications of Perfect Competition and Monopoly for Decision Making • 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-30 Global Application • Example for discussion: Bluefin tuna What changes will occur in this market? • sushi restaurants operate in monopolistic competition • Bluefin tuna price determined by perfect competition • low profit margin Copyright ©2014 Pearson Education, Inc All rights reserved 8-31 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 Copyright ©2014 Pearson Education, Inc All rights reserved 8-32 .. .Chapter Outline • • • • Competition and market types in economic analysis Pricing and output decisions in perfect competition Pricing and output decisions in monopoly markets... is limited by the demand curve for the product, and in particular, the price elasticity of demand Copyright ©2014 Pearson Education, Inc All rights reserved 8-26 Pricing and Output Decisions in... reserved 8-16 Pricing and Output Decisions in Perfect Competition Perfectly Elastic Demand Curve Copyright ©2014 Pearson Education, Inc All rights reserved 8-17 Pricing and Output Decisions in Perfect