Chapters (8) Perfect Competition (8) Monopoly (8)

Pricing & Output Decisions

A. General 1. A market consists of all the actual and potential buyers and sellers of a product. Examples: Stock market, Capital market, Commodity market, Exchange market

2. The prices of products, the quantity produced, and the resource allocation efficiency are impacted by the degree of competition or monopoly. Generally speaking, consumers pay less, get more goods and services, and resources are efficiently allocated in competitive markets relative to monopoly markets.

3. Broad Market Structures Perfect competition - agriculture Monopoly - public utilities (electric, Gas) Monopolistic competition - fast food restaurants. Oligopoly - auto industry, steel, airline, etc.

4. Criteria for Market Classifications The number of firms in the industry. The type of products they produce (identical or differentiated). The extent of barriers to entry.

A. Perfect Competition 1. Basic Features  Large number of buyers and sellers (price takers)  Homogenous or identical products  Easy entry and exit from the industry  Perfect knowledge of market price Examples: agriculture, stock market

2. The demand for a competitive firm is horizontal or perfectly elastic, i.e. a firm can sell as many units as it desires provided that it charges the market determined price. 3. The objective of any business firm is to realize some margin of profit. This objective can be achieved by producing a level of output for which MR = MC.

4. In the short-run, a competitive producer can earn profit, just break- even, operate even at a loss provided AVC < Price < ATC, or minimize losses by going out of business if Price < AVC. Illustrate

4. SR Price Output Decisions for a competitive firm: Graphically illustrate. The profit making case: Price > ATC The break-even case: Price = ATC

SR Price Output Decisions Loss minimization by continuing operation: AVC<price<ATC Loss Minimization by going out of business: Price AVC

5. A supply curve shows the various quantities sold by a firm at different prices. The short-run supply curve of a competitive firm is represented by the portion of its marginal cost above the minimum point of its average variable cost. Illustrate.

6. In the long-run, all competitive firms will produce at the lowest point on their long-run average cost (LAC)curve and realize zero economic profit (loss). Why? Illustrate. The LR equilibrium is obtained at a rate of output for which P (MR) = minimum LAC = LMC. Desirable Aspects of Perfect Competition: 1. Competition leads to production efficiency as implied by P = minimum LAC 2. Competition leads to resources allocation efficiency as implied by P = LMC The above aspects make competition among firms to produce desirable outcomes for society (consumers and producers)

Assumptions about Industry Costs and LRIS Curve (p.360) Constant-cost industry=> entry of new firms will not affect costs=> Horizontal LRIS curve Increasing-cost industry=> entry of new firms will increase unit costs=>Upward sloping LRIS curve. Deceasing-cost industry=>entry of new firms will reduce unit costs => Downward sloping LRIS curve

7. Performance implications of competitive markets relative to Monopoly Competition yields efficient allocation of resources as implied by price = LMC. Consumers pay less for the goods and services than in any other market. Competitive producers sell more units of goods than in any other markets because they produce at minimum LAC.

Ch (8): Monopoly 1. Features of Monopoly It is a one firm industry - “price searcher” and “price setter.” Its products do not have close substitutes which helps it to enjoy a significant market power.

Entry into the industry is hindered by a number of barriers. Examples: public utilities - local electric or gas companies

2. Barriers to entry (Sources of monopoly) Ownership of strategic raw materials needed in the production of goods and services (bauxite in aluminum production). Patent rights or copyright (17 years). Economies of scale may necessitate large scale production by one producer only. Government regulation of a franchise may lead to monopoly. e.g. U.S. Postal Service.

3. A monopolist faces a downward sloping demand curve which implies that the monopolist will have to reduce price to sell more units of its product. For the monopolist, the demand curve= price = average revenue, but its marginal revenue is always below the demand curve. Why?

4. In the short-run, a monopolist may realize profit, break-even, operate even at a loss if AVC < Price < ATC, or go out of business to minimize losses if Price <AVC. Illustrate (Graph and equation) 5. In the long-run, a monopolist may continue to realize economic profit, or just break-even. Why?

6. Comparison of monopoly with perfect competition A monopolist may continue to enjoy economic profit in the long-run, but a competitive firm only realizes zero economic profit. A monopolist charges a higher price and produces less output than a competitive firm. Monopoly is subject to resource allocation inefficiency while competition leads resource allocation efficiency.

7.Monopoly Price Discrimination (pp ) Meaning- Charging different prices for same good or service to different to buyers for maximizing profits. Degrees of Price Discrimination (1 st, 2 nd, 3 rd )=> Separate them in terms of CS Example: Instate vs out-of-state tuition

Conditions for successful price discrimination  No arbitrage is allowed  Customers are separated based on the price elasticity of demand i.e. charge higher price in a market with inelastic demand and lower price in a market with elastic demand

Price-Output Decision Rule for a price discriminating Monopolist The firm produces where MR 1 =MR 2 = …= MR n = MC

8. Regulated Monopoly () Meaning: An industry in which the production decisions are made by private firms subject to price(rate) regulation. Example: Local electric company Local gas company

Forms of Regulation Average cost pricing (fair return pricing) Price = ATC (Most common, why?) Marginal cost-pricing: P=MC (Socially optimal pricing)- least common form of regulation. why? Price and Output Determination- Illustrate.