Chapter 8:

Perfect Competition and

Monopoly

Four Basic Market Types

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

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 Basic Market Types

Monopolistic Competition (market power based
on product differentiation)
Large number of relatively small firms acting
independently
Differentiated product
Market entry and exit relatively easy
Nonprice competition very important

Oligopoly (market power based on product

differentiation and/or the firms dominance of the
market)
Small number of relatively large firms that are mutually
interdependent
Differentiated or standardized product
Market entry and exit difficult
Nonprice competition very important among firms
selling differentiated products

Four Basic Market Types

Pricing and Output Decisions

in Perfect Competition
The Basic Business Decision:
entering a market on the basis of 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?

Pricing and Output Decisions

in Perfect Competition
Key assumptions of the perfectly
competitive market

The firm operates in a perfectly competitive

market and therefore is a price taker.
The firm makes the distinction between the
short run and the 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.

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 firms profits or minimizes its loss.

Marginal Revenue Marginal Cost Approach

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.
For the perfectly competitive firm, the MR=MC rule
may be restated as P=MC.
This is because P=MR in perfectly competitive markets.

Pricing and Output Decisions

in Perfect Competition
The point where
P=MR=MC is the
optimal output
(Q*)
Profit = TR TC
=(P - AC)
Q*

Pricing and Output Decisions

in Perfect Competition
The firm incurs a
loss. At the
optimum output
level price is below
average cost.
However, since
price is greater than
average variable
cost, the firm is
better off producing
in the short run,
because it will still
incur fixed costs

Pricing and Output Decisions

in Perfect Competition
Contribution Margin
(CM): the amount by
which total revenue
exceeds total
variable cost.
CM = TR TVC
If the contribution
margin is positive,
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. This is
where selling at the price results in zero
contribution margin.
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 which shifts the supply curve to
the right, puts downward pressure on
price and reduces profits.
Economic loss causes exit of firms which
shifts the supply curve to the left, puts
upward pressure on price and increases

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
(assuming a strong demand in the market).
As new firms enter the market, firms that want
to survive and perhaps thrive 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 Markets
A monopoly market consists of one
firm.
The firm is the market.
Has the power to establish any price
it wants.
However, the firms 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 Markets
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 Markets
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.

Monopoly market
Most important lesson is not to be complacent or
arrogant and assume their ability to earn economic
profit can never be diminished.
Changes in economics of a business eventually
break down a dominating companys monopolistic
power.